United Kingdom: Discussion document on CFC reform issued

The U.K. tax authorities (HMRC) and Treasury (HMT) issued a discussion document on 27 January 2010 setting out the government's proposals for reforming the U.K. tax treatment of controlled foreign companies (CFCs). The proposals outlined in the document are more positive than the suggestions (the controlled company proposals) put forward in 2007 and contain a number of improvements. We welcome the document but the proposals are still very high level and there is much work to do, particularly on the principles relating to financing and in providing a detailed model of how the proposals will operate.

The government intends to publish a more detailed outline for the new regime along with draft legislation for consultation later in 2010, with a continued objective of legislation for Finance Bill 2011.

The policy principles document on CFC reform, published in July 2009, stated that one of the objectives of reform was to enhance U.K. competitiveness whilst providing adequate protection of the U.K. tax base. The discussion document reinforces this message by stating the "Government is committed to making the U.K. an increasingly attractive place in which to invest and do business."

Therefore, the key question is whether the proposals can help achieve this goal?


Framework

The proposals put forward generally operate on an entity basis rather than an income basis, with the same starting point as is assumed under the current rules, i.e. all offshore subsidiaries are within their scope and are subject to exclusions that may remove them from the regime, rather than an approach that only includes specific companies where there is a perceived risk to the U.K. tax base. However, in certain cases, the income flows of the entity may need to be considered, for example, where the entity has excess cash (see below).

The proposals would apply to foreign subsidiaries under U.K. control. It is not (as had been suggested under the 2007 controlled companies proposals) currently intended that they will also apply to U.K. entities.

It is also proposed that objective tests will be designed to remove companies that do not exist for the artificial diversion of U.K. profit from the regime (e.g. trading companies, genuine offshore treasury operations and the active management of IP).

A number of other welcome exclusions suggested include:

- Exclusion for companies in territories with similar tax rates and bases to the U.K. (to replace the lower level of tax test and excluded countries lists);
- Increasing the de minimis threshold (currently GBP 50,000);
- Capital gains would continue to be excluded (subject to existing anti-avoidance rules);
- Possible exemptions for group reinsurance of non-U.K. risk and for subsidiaries holding non-U.K. property (where subsidiaries are appropriately funded); and
- Continuation, and possible extension, of the "period of grace" whereby the CFC rules are suspended for a period of time when an entity/ group is acquired that had no prior connection with the U.K.

The discussion document emphasizes two particular areas of difficulty and how these may be addressed under CFC reform: the treatment of monetary assets and intellectual property.


Group financing arrangements

The document suggests a distinction can be drawn between treasury operations (that are debt funded and exist to manage short-term cash positions, making a small margin) and finance companies (which are often equity funded and provide longterm structural funding). The broad proposal is to exempt treasury companies and to exempt finance companies that have an "appropriate" debt-to-equity ratio or fall within specific safe harbors (to form part of the discussions). Equity funding over this level would trigger a CFC imputation on an equivalent interest return on the "excess" amount.

The proposal to use a debt-to-equity ratio as a proxy for U.K. profit diversion within group financing arrangements does not seem well-targeted. This approach is likely to bring arrangements within the CFC charge that do not represent U.K. profit diversion, e.g. where funds generated offshore are used to finance other parts of the non-U.K. group. It will also be difficult to set debt-to-equity limits that are applicable cross-industry and that take into account all local legal requirements.

The risk of U.K. profit diversion arising where an exempt finance company lends funds back to a U.K. group company is also noted. Despite the fact that the worldwide debt cap rules were recently introduced to target exactly this situation, the document proposes that, where a finance company makes such a loan, it would either not be an exempt entity or the U.K. income would not be eligible for exemption.

In addition, the document notes that artificial diversion of U.K. profit can exist where a trading company (that would otherwise be exempt) holds an uncommercially high level of surplus cash. By lending this cash elsewhere in the group (and generating an investment return), there is a concern that this is eroding the U.K. base. Therefore, it is proposed that, where the amount of interest earned by a trading company is more than "incidental or ancillary" (to be defined), the excess would be subject to a CFC charge. This indicates a move away from the current approach where either all or none of the income of the CFC is subject to a potential CFC charge. This proposal could be seen as relatively controversial and debate will be needed to ensure any moves are restricted only to cases of potential abuse.


Intellectual property

The proposals in this area suggest that, where active management of IP is taking place offshore (as opposed to passive investment), this should be exempt from the CFC rules. In considering the question of active management, it is proposed that various characteristics of the IP company, as well as its general substance, should be considered, e.g. the relevant expertise of the company. In addition, there is a suggestion that, where IP has no connection to the U.K., it should also be exempt.

Where IP is transferred out of the U.K. at a point when its value cannot be accurately determined (e.g. early in the development stage), the document notes the concern that the tax on exit may have undervalued the IP. Therefore, the document proposes a finite earn-out period over which a U.K. charge could apply if the IP significantly increases in value. Clearly, this creates the risk of a potential "double" U.K. tax charge. HMRC has confirmed that double taxation is not its intention and that it does not want the active management exemption for IP to encourage groups to hold such assets outside of the U.K. in the future. Instead, it wishes to promote the U.K. through a more attractive taxation regime (e.g. the proposed patent box).


EU compatibility

The document suggests a revised motive test that, together with the hoped for "proportionality" of the objective exemptions, should ensure that the new regime is compatible with the EU treaty. As a result, HMRC and HMT do not expect it to apply to U.K. companies. The proposal is to exempt subsidiaries that are properly established overseas and are not intended to divert U.K. profit; the suggestion is that the commercial (non-tax) rationale for the company would need to be demonstrated. It is interesting to note, however, that the recent jurisprudence in the Cadbury and Vodafone cases did not place importance on the motive underlying the establishment of a subsidiary in an EU Member State, but rather emphasized the importance of conducting genuine economic activities. Therefore, it is unclear how this meets the objective of EU compliance.