The UK tax legislation imposes an “exit tax charge” on the unrealised capital gains of a company which migrates from the UK. The exit of a taxpayer (or their assets) is generally the last point in which a taxing jurisdiction has the power to tax gains which have accrued during that taxpayer’s residence in the taxing jurisdiction. The relevant UK legislation deems a migrating company to have disposed and immediately reacquired all of its assets at market value prior to the cessation of UK tax residence. This treatment may result in a capital gain arising which is subject to UK corporation tax in the form of an exit tax charge.   

Critically, where a company has significant unrealised capital gains, the application of the exit tax charge may make a migration prohibitively expensive.

The legitimacy of exit tax charges in the context of two of the fundamental freedoms enshrined in the Treaty of the Function of the European Union (the “Treaty”), being freedom of establishment and free movement of capital, has been explored by the Court of Justice of the European Union (the “Court”) over many decades. The recent case of Gallaher Limited v HMRC (Case C707/20)(“Gallaher”) is the most recent case in that line, and is also the last reference made by a UK court to the Court following Brexit. 

The legitimacy of exit tax charges, according to the Court, rests on the role of such provisions in balancing the allocation of taxing powers between member states of the European Union. The fundamental position under European law is, very broadly, that exit tax charges are justified provided that the migrating taxpayer is permitted to pay the exit tax charge over a deferral period, which the Court has identified as being five years. Exit tax charges do not, however, need to permit the deferral of any resulting taxation where the taxpayer concerned obtains, by way of consideration for the disposal of the assets, an amount equal to the full market value of the assets disposed.

In Gallaher, the taxpayer company made two transfers. A transfer of intellectual property rights (relating to tobacco brands) to a Swiss-resident sister company (being a direct subsidiary of a common Dutch parent) was made in 2011 (the “Swiss Transfer”). A later transfer of shares to the taxpayer’s indirect Dutch parent company was made in 2014 (the “Dutch Transfer”). Both transfers were made for full market value consideration. As neither of the transferees were UK taxpayers, it was not possible for the transfers to qualify for the no gain/ no loss treatment between group members in the UK tax code.

The taxpayer argued that both transfers would have benefited from the no gain/ no loss treatment in the UK tax rules for group transfers had the transferees been resident in the UK. The taxpayer claimed it was being discriminated against – as a comparable transaction to a UK affiliated transferee company would not have resulted in a tax liability.

The key questions before the Court were:

• Could the Treaty protections for free movement of capital and freedom of establishment restrict UK taxation of the Swiss Transfer and Dutch Transfer?
• In both transfers, was any restriction of fundamental freedoms justified and proportionate where the disposals are made for full market value?

As regards the Swiss Transfer, the Court held that no restrictions of the fundamental freedoms existed. The taxpayer’s parent was a Dutch company, but there would have been no difference in treatment (and so no restriction) had that parent company been a UK company. The tax liability on the disposal of assets to the Swiss transferee in the Swiss Transfer would have happened regardless of the residence of the taxpayer’s parent company.

In respect of the Dutch Transfer, the Court found that there was a restriction of the freedom of establishment. The fundamental freedoms of the Dutch parent had been infringed. However, that infringement was both proportionate and justified by the balancing of taxing powers between European Union member states.  The immediate tax charge on unrealised gains would only be a disproportionate infringement of fundamental freedoms if tax was payable in a situation where no funds were available to pay the tax due. As both the Dutch Transfer (and Swiss Transfer) were made for full market value consideration, funds were available to meet the tax charge.

The Court determined that, in the context of European law, the relevant UK tax rules, dealing with relationships within a group of companies, fell primarily under the freedom of establishment and did not fall under the fundamental freedom ensuring free movement of capital. The most proximate factor in the UK legislation was a parent’s holding of capital in subsidiaries which led, in turn, to the exertion of definitive influence and control. This was, broadly, the area to be addressed in the context of the rules for the freedom of establishment. An independent examination of the fundamental freedom ensuring free movement of capital was not justified in that context (paragraph 61 of Gallaher). 

Post-Brexit, this is an important conclusion by the Court. It closes the door on taxpayers being able to argue that even if the rights of a taxpayer to freedom of establishment had been lost following Brexit, that taxpayer might still retain rights under European law by reference to the free movement of capital under Article 63 of the Treaty. This had been a possible argument, owing to the legal mechanisms in sections 4 and 5 of the European Union (Withdrawal) Act 2018. After Gallaher, however, that argument looks very difficult to sustain.

To some extent, the decision of the Court in Gallaher is of limited relevant to UK taxpayers owing to changes in tax legislation made after the UK First-tier Tax Tribunal decision in Gallaher. Those changes allow taxpayers to apply for deferral of the payment of corporation tax on group asset transfers within the European Union or the European Economic Area for accounting periods ended on or after 10 October 2018. However, the Court’s judgment in Gallaher, and in particular the statements clarifying the inter-connection of the fundamental freedoms in a corporate group context, may enhance the applicability of the case in other litigation on exit tax charges in a European context in the future.