The UK Treasury has released its discussion document regarding the taxation of the foreign profits of UK companies, as foreshadowed by the Chancellor in his March budget and his following informal discussions with large businesses in recent months.
The Government’s stated purpose in putting forward these proposals is to rationalise and simplify the corporation tax system for multinational companies following a number of representations that the United Kingdom is becoming less and less competitive as a result of reforms elsewhere in Europe. Other recent proposals to streamline the administration of corporation tax by introducing a system of rulings and clearances, and to expedite the handling of transfer pricing inquiries, should be seen in the same light.
The reforms are also intended to protect the corporation tax base following a number of decisions in the European Court of Justice which had the potential to upset the coherence of the existing system: notably the recent Cadbury Schweppes and the FII Group Litigation cases, which considered the compatibility of the United Kingdom’s controlled foreign company (CFC) rules and its treatment of foreign dividends with European law.
The discussion document seeks comments of business on the general principles of the proposed reforms. Consultation on the proposals is open until 14 September 2007, following which the Government will issue detailed proposals for further consultation if it decides to proceed with the reforms. Any legislative changes are likely to come before Parliament in 2009.
Foreign Dividend Exemptions
The principal proposal is to exempt dividends received by large and medium sized UK companies in respect of shareholdings in foreign companies in excess of 10 per cent—a so-called “participation exemption” similar to that found in many other European countries.
“Small” companies (those with fewer than 50 employees and 50 employees and either turnover or a balance sheet total below €10 million) will continue to be taxed on their foreign dividends with credit for foreign tax. The Government has indicated that the rules governing the availability of tax credits for such companies will be simplified (possibly by abolition of the “mixer cap” restrictions on the availability of credits introduced in 2001), and that they will be subject to a simplified CC regime.
The Controlled Company
In addition, the United Kingdom’s CFC (anti-deferral) rules will be refocused to apply only to passive or other non-mobile income. The new “controlled company” (CC) rules will, broadly speaking, apply equally to UK and foreign investments.
The concept of the CC is central to the new rules. A company wherever resident in the United Kingdom or elsewhere will be a CC where a UK company holds a 10 per cent interest in it: a reduction from 25 per cent which is the current threshold for the operation of the CFC rules.
If this threshold is met, although dividends paid by the CC to the UK parent will be exempt from tax in the United Kingdom, the CC’s passive income will be taxable in the hands of the parent (either by means of a deemed dividend to the parent, or by the simple apportionment of the CC’s profits to the parent, as happens under the current CFC rules). Where the CC is a UK company itself, it will be entitled to claim a corresponding adjustment in respect of profits taxed in the hands of the parent.
The scope of the definition of control for the purposes of determining whether a CC exists is therefore likely to be crucial. The discussion document indicates that the starting point will be the existing CFC control definition which is based upon voting rights or equivalent rights allowing power to influence the conduct of the company’s affairs. The definition will be modernised to ensure that the purpose behind the rules is not frustrated. Particular reference is made to structures that involve a company being held through a partnership or hybrid entity. This will be addressed in the new rules, and will undoubtedly have the effect of broadening their scope. It remains to be seen whether the proposals will broaden the application of the rules yet further.
Where a CC exists, an appropriate proportion of its passive income will be taxed in the hands of the CC’s UK shareholders. Passive income includes dividends, interest, annuities, royalties, rents and other income of a similar nature, plus other substantially similar forms of income. The rules will also extend to other mobile income which the government is seeking to define as active income arising from intra-group transactions as the result of the diversion of UK sales and service income outside the United Kingdom.
Exceptions from CC apportionments will apply to income deriving from genuine active financial business, and to certain intra-group interest income arising from group treasury activities. The government is also proposing specific exemptions for income from intra-group transactions within the same country, for income incidental to a main trading activity, and for conduit income, where income is received in a fiduciary capacity for financing that does not involve the avoidance of UK withholding tax.
Deductibility of Interest
It had been rumoured that these proposals would be accompanied by tighter restrictions on the availability of deductions for interest, possibly based upon some form of interest apportionment or expense matching. Such rules are common in other jurisdictions which apply an exemption method for taxation of dividends.
The Government has come down against generalised restrictions of this nature in favour of more targeted measures.
Firstly, there will be a restriction on claiming deductions in the United Kingdom by reference to the total consolidated external finance costs of the group as a whole. The intention of this proposal appears to be to prevent excess debt being pushed into the United Kingdom by foreign-based multinationals. Further details are awaited on these proposals, including how they will interact with the international arbitrage rules introduced in 2005, which appear to share a similar purpose.
Secondly, the existing rules denying interest deductions on the basis of an “unallowable purpose” will be broadened to cover situations where the loan relationship itself does not have an unallowable purpose but forms part of a scheme or arrangement which does. Further, the definition of an “unallowable purpose” will be amended to encompass situations where it is reasonable to believe that tax avoidance was a main purpose of the loan relationship or scheme or arrangement, as the case may be. This makes the test an objective one rather than one based on the subjective intention of the taxpayer as is currently the case. This will undoubtedly make it easier for HM Revenue & Customs (HMRC) to assert a tax avoidance motive.
Taxation of portfolio dividends
The Treasury is also asking for comments on the reform of the taxation of portfolio dividends in the hands of companies (being dividends on shareholdings of less than 10 per cent). The FII case held that the failure by the United Kingdom to give credit for underlying tax paid by the foreign distributing company was unlawful, given that UK-sourced dividends were exempt from tax altogether.
The Government is considering three options. Two of these (the providing of credit for underlying tax in respect of portfolio dividends, and the exemption of foreign dividends altogether) are broadly positive for the taxpayer. The alternative proposal is for UK-sourced dividends to be made subject to tax without credit for underlying tax, and is likely to be unpopular as it will generate additional compliance obligations for companies without significantly increasing the tax take.
Abolition of Treasury consents regime
The final element of the reforms is the abolition of the Treasury consents regime, which criminalises certain transactions by UK companies in respect of foreign subsidiaries without the prior consent (either general or specific) of the Treasury. The rules have long been seen as an anachronism and there has been consistent lobbying for their abolition in recent years. The Government has proposed the introduction of a reporting requirement instead.
Overall, we anticipate that the proposals will be warmly received as a welcome simplification of the existing regime, acknowledging the fact that the existing credit system for dividend taxation generates relatively little revenue for the Government but necessitates complicated group structuring by UK-based groups in order to maximise the availability of foreign tax credits.
However, the broader CC regime could potentially affect existing structures that are currently outside the scope of the CFC regime by virtue of the rate of tax paid by the CFC or the existing “motive test”: both of which will be abolished as filters for the application of the rules and also brings its own administrative challenges.
The absence of an exemption for the income of group IP holding companies (to mirror that for group treasury companies) is striking and seems to reflect a deeper view within the Government that such companies do not undertake a genuine economic activity. This is likely to be a point of contention. Similarly, the possibility that UK-to-UK portfolio dividends may be brought into tax where they are currently exempt is likely to provoke concern and add complexity to structuring arrangements in much the same way that extending transfer pricing to intra-UK transactions did in 2004.
Additionally, the changes introduce a differential treatment between the taxation of large and medium sized businesses on the one hand, and small businesses on the other (which will continue to be subject to the existing credit-based regime). It remains to be seen whether this in fact has the effect of introducing distortions into the tax system rather than simplifying it and whether it poses any problems for growing companies with international interests which will find themselves subject to a different regime once crossing the small company threshold.