The Government stands to lose hundreds of millions of pounds in tax revenues following a landmark victory by Cadbury Schweppes in Europe’s highest court.

The European Court of Justice said laws under which the Government charges UK tax rates on profits from the foreign subsidiaries of British companies were incompatible with EU law - unless the UK could prove the subsidiary was set up for the sole purpose of dodging tax.

The court accepted Cadbury’s argument that where a subsidiary was established to carry out genuine economic activity, charging UK tax rates was a breach of EU rules on freedom of establishment - the right to establish a business in any member state.

Cadbury challenged the UK tax authorities after receiving an £8.6 million bill relating to profits from two Irish subsidiaries in the 1996 tax year. The subsidiaries, which carry out financing activity for Cadbury, paid lower taxes than they would have if they were based in the UK.

The case will now return to the UK courts where, according to the ECJ’s ruling, the burden of proof falls on the tax authorities to show that the Cadbury subsidiaries are "wholly artificial" or set up exclusively to avoid tax.

Leading tax lawyers predict that this will be extremely difficult to do because the subsidiaries are genuine companies with premises and staff that have a definable business role in the Cadbury group.

Hartley Foster, tax partner at DLA Piper, said the ruling means that Cadbury and other companies in the same situation will no longer have to meet their tax demands.

Today’s ruling, which followed a preliminary ECJ opinion given in May, will be seen as a test case for other companies, including Vodafone and The Prudential, which have challenged the Government on the same issue.

"The financial impact of this case on the UK exchequer will be measured in the hundreds of millions of pounds," Mr Foster said, adding that the impact in other EU member states would be equally significant.

Chris Bates, a tax partner at Norton Rose, said: "The decision strikes a fair balance between the need for member states to counter artificial avoidance schemes and the freedom for businesses to run their affairs with certainty and wherever they choose within the EU."

But the Treasury said today it was studying the judgement and would announce "as soon as possible what, if any, changes to the…rules are needed to sustain their effectiveness in protecting tax revenues."

According to David Harkness, tax partner at Clifford Chance, changing the rules immediately would be an admission of defeat by the Government, which can still fight the case in the UK courts.

More likely, Mr Harkness thinks, is that the Government will table the amendments in the next budget.

Any changes will only apply to future cases and would not be able to be applied retroactively to Cadbury and other companies, he added.

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