After the introduction in 2009 of a corporation tax exemption for foreign dividends, 26 January 2010 saw the start of the next stage of the United Kingdom’s reform of the taxation of foreign profits, with the release by HM Treasury of a discussion document outlining proposals for reform of the Controlled Foreign Companies (CFC) rules.
After fears at the start of the process that the Government was looking to extend the scope of the existing rules significantly, the proposals contained in the discussion document offer considerable reassurance. The document proposes the retention of the existing entity-based approach, with which taxpayers are generally familiar, and in a welcome recognition of modern business practice, proposes a widened exemption for foreign trading companies and new exemptions for overseas finance and IP management companies.
Whilst encouraging in principle, the document is lacking in detail. The effectiveness of these proposals will largely depend on whether the Government can successfully distil them into clear, simple and effective legislation.
Scope of Rules
The current rules apply to foreign companies under the control of UK companies which are subject to a lower level of tax, being less than 75 per cent of the UK tax that would be payable were the foreign company to be UK resident.
The existing definition of “control” covers situations where the UK company holds voting control or similar contractual rights in the foreign company, as well as situations where the UK company holds a preponderant economic interest in the capital of the foreign company. It appears that this test will remain unchanged.
The “lower level of tax” test has been criticised in view of the complex calculations required of taxpayers in order to apply it. The Government has therefore floated the possibility of an alternative test which would exclude from the application of the rules foreign companies operating in jurisdictions with similar statutory rates and tax basis to the United Kingdom. This test, possibly based on a short list of factors, could also replace the existing “white list” of excluded territories. It remains to be seen whether a sufficiently simple test along these lines can be developed.
Exempt Activities Exclusion
Currently, companies carrying on “exempt activities” are excluded from the application of the CFC rules. The definition of exempt activities is designed to encompass most bona fide trading activities conducted with unconnected parties, but does not extend to companies engaged in wholesale, distributive, financial or service businesses if the majority of their receipts relate to transactions with connected persons.
The discussion document proposes removing these blanket restrictions on intra-group transactions, but replacing them with provisions targeted at transactions “posing a risk to the UK tax base”. It is as yet unclear what these transactions would be, and why the Government has concluded that transfer pricing rules do not already provide an adequate safeguard.
The Government also hints at some form of “anti-swamping” rule, to prevent groups diverting interest income or other passive income receipts into a company carrying on exempt activities in order to shelter the passive income from a CFC charge. This may involve some mechanism for identifying and taxing income streams inserted into an entity for the purposes of securing a tax advantage which would be somewhat inconsistent with the objective, entity-based approach forming the basis of the overall CFC proposal, and for that reason, unwelcome.
Wider Exemptions for Specific Industries
A number of specific extensions to the exempt activities definition have been proposed as a result of the initial consultation process:
Re-insurance subsidiaries managing non-UK risks will be outside the CFC rules provided there is no erosion of the UK tax base.
Property subsidiaries managing non-UK properties will be outside the CFC rules if they are “appropriately funded”. The Government’s objection may be to UK companies borrowing in order to provide equity capital to a foreign subsidiary formed to own or manage a property where interest deductions at the UK company level would not be offset by taxable receipts from the foreign sub (because of the tax exemption for dividends), and would thus erode the UK tax base.
Finance/Treasury companies. The Government proposes to exempt treasury companies from the CFC rules. A treasury company, broadly speaking, appears to be defined as a company engaged in the active management of the short-term cash needs of a group of companies and the performance of other treasury services. Such companies are generally primarily capitalised by debt.
The CFC rules will potentially apply to finance companies – that is, group companies making available longer term structural debt. The Government has floated the idea of some form of “fat capitalisation” test, whereby a finance subsidiary might be a CFC if its UK parent does not earn a taxable return (which would be the case if the finance subsidiary was largely equity funded. Finance companies that lend back to the United Kingdom would also not be eligible for this exemption.
- IP companies. The Government has finally recognised that intellectual property (IP) management can be an active trade, and that an offshore IP company can have a genuine commercial basis. The Government proposes exempting foreign companies that are actively engaged in managing IP offshore, and identifies a list of functions that might qualify as “active” management.
There is also an assumption that offshore management can involve an element of intra-group and third party subcontracting, although in the case of any intra-group arrangement it must be of a type that could be contracted out to third parties.
An IP company that is not engaged in active management might still qualify for the exemption but would be subject to similar base erosion rules as would apply for finance companies – such as a fat capitalisation test and an exclusion from the exemption for companies licensing their IP into the United Kingdom.
The Government has also raised a specific concern over IP that is transferred out of the United Kingdom and subsequently rises significantly in value. It proposes a tax charge that would apply for a finite period where the value of the IP at the date of transfer is difficult to calculate and then significantly increases after it is transferred – in effect, a form of tax “earn out”. This is perhaps the most ill-defined concept in the discussion document and needs considerable clarification.
Companies unable to rely on the exempt activities test or the white list at the moment are generally required to rely on the “motive test”. This allows companies to claim an exemption from the CFC charge if they can show that both the transactions that the company entered into, and its very existence, were not motivated by a desire to avoid UK tax by diversion of profits out of the United Kingdom. The Government’s intention is to widen the motive test somewhat – in particular by allowing it to apply to “near misses” of the exempt activities test, and to allow a period of grace for UK companies which have acquired an unconnected foreign group to reorganise their affairs so as to satisfy one of the other exemptions..
More generally, the Government wishes to remove the presumption that activities that could have been carried on in the United Kingdom are carried on abroad for tax avoidance purposes – although this may make relatively little difference if reliance on the motive test is sought, as the onus will still be on the taxpayer to show why a CFC charge should not apply.
De minimis test
Foreign companies with profits of less than £50,000 are currently outside the rules. The Government has indicated that that this threshold (which has not been raised since 1988) will be increased as part of the reforms.
Consultation on the proposals will run until 20 April 2010. The Government will then release draft legislation later in 2010, with a view to legislating in spring 2011. There will be a general election in the meantime which may well result in a change in Government, but this is not currently expected to change this timetable significantly.