The British government won a partial victory on Tuesday as the top EU court said it could stop companies from making wholly artificial arrangements to avoid tax by setting up foreign units.
The ruling by the European Court of Justice was based on a complaint from Cadbury Schweppes, the world's largest confectionery group, that Britain discouraged firms from setting up shop abroad.
Cadbury was disputing an 8.6 million pound tax demand from the British government for 1996.
UK legislation on CFC can apply only to wholly artificial tax arrangements, the court said in a ruling expected to have wider implications for cross border companies in the EU.
About 20 claimants, known as the CFC and Dividend Group, were awaiting the court ruling.
In a blow for the government, the European court said there should be an objective assessment of what constitutes wholly artificial tax arrangements.
In order to determine whether a CFC is carrying on a genuine activity, the national authorities should take account of objective factors which are ascertainable by third parties, and not only subjective considerations, the court said.
The ruling follows an opinion from an adviser to the court.
An intention to obtain tax relief is not enough to conclude there is a wholly artificial arrangement, the court said.
There must be objective and ascertainable circumstances produced by the company as to the extent the CFC physically exists as regards premises, staff and equipment, it added.
Experts have said that trying to prove in court that tax arrangements were wholly artificial may be difficult and could force Britain to amend its tax laws.
Cadbury has units in Ireland, an EU member state with low corporate taxes, to raise finances for the group's operations.