EU firms that establish Irish subsidiaries to reduce their tax burden do not break European law if they can prove they are genuine businesses.

But tax authorities can claw back corporate tax from parent companies that set up artificial firms abroad wholly to evade higher taxes, Europe's highest court has ruled.

The judgment yesterday by the European Court of Justice (ECJ) was welcomed by Irish tax experts as a boost for the Republic's strategy of attracting foreign investment by offering one of Europe's lowest corporate tax rates.

The Institute of Chartered Accountants in Ireland said the ruling meant attempts by other countries to tax Irish profits arising in multinational groups of companies would be illegal under EU law save in "exceptional circumstances".

However, the ruling leaves it up to national authorities to determine these circumstances, causing the Irish Taxation Institute to say it was disappointed the ECJ had not outlawed controlled foreign companies (CFCs) entirely as contrary to EU rules on freedom of establishment.

The ECJ issued its landmark ruling in a case involving the confectionery group Cadbury Schweppes.

It alleged British tax rules, that seek to claw back profits from overseas subsidiaries, break EU law and discourage firms from establishing overseas.

Cadbury Schweppes, which set up two IFSC operations to benefit from Ireland's low corporate tax rate in the 1990s, claims it is owed about €12.5 million for tax that Britain unfairly retained on profits made by its Irish subsidiaries in 1996. The two subsidiaries are involved in raising and providing finance to other subsidiaries in the Cadbury Schweppes group.

Britain's inland revenue ruled that the two subsidiaries fell foul of Britain's CFC tax rules, which enable the authorities to levy tax on an overseas subsidiary of a British parent firm if there is a substantial difference in tax rate.

In the ruling, the ECJ said CFC rules were not illegal, but they could only apply to "wholly artificial tax arrangements".

It said that national authorities should take account of objective factors that are ascertainable by third parties, and not only subjective considerations, when determining what was a "genuine activity".

The Cadbury Schweppes case will be sent back to a UK tax tribunal which must decide how the ruling will apply to the Cadbury case. Lawyers say it will be difficult for national tax authorities to prove that firms are not genuine businesses.

If the tribunal rules in favour of the company, up to 20 claimants, known as the CFC and Dividend Group, could launch similar proceedings against Britain to recoup tax.