The much anticipated consultation on the future shape of the U.K. controlled foreign company (CFC) rules was published on 30 June 2011.
The 110 page document clearly requires detailed analysis and this will be undertaken over the coming days. It is immediately clear, however, that the U.K. government has taken on board many of the comments made by the U.K. business community and we continue to move towards an international tax framework for the U.K. that will be attractive for both U.K. and non-U.K.-headquartered businesses. We expect a significant relaxation of the U.K. CFC rules and, importantly, there is a policy intent to retain a broad basis for deducting interest as a business expense, regardless of whether the funds are used for investment in the U.K. or overseas. This, combined with the retention of a dividend participation exemption and the exemption for capital gains arising on the disposal of shares in trading companies/trading subgroups, make the U.K. attractive to global enterprises and go a long way to accommodating modern global supply chain models.
The overall tone of the CFC announcements is that U.K. international tax policy is geared towards the taxation of income arising in or closely connected with the U.K. Income arising from non-U.K. activity should not be subject to U.K. tax due to:
- A new elective exemption for income arising in the foreign branch of a U.K. company;
- The dividends received exemption introduced in 2009; and/or
- The CFC relaxation discussed here.
There are three particular areas where we would expect the CFC proposals to lead to significant opportunity for taxpayers:
1. A new financing regime that targets an effective rate of tax of 5.75% for offshore interest income;
2. A 10% rate of tax for income arising from the exploitation of patents; and
3. A general overhaul of the CFC legislation as it relates to trading transactions, which should eliminate many of the perceived barriers to the use of low tax jurisdictions for the location of supply chain principal companies.
Taken together, we might now see further examples of U.K. quoted companies re-domiciling back to the U.K. and a continuation of the trend for non-U.K.- headquartered groups to use the U.K. as the legal and financial gateway into EMEA and other international markets.
The consultation document invites comment by 22 September 2021 with the intention that draft law will be published later in 2011 for enactment in 2012. The likely commencement date will be accounting periods beginning on or after Finance Bill 2012 Royal Assent, e.g. companies with December year-ends would have a likely start date of 1 January 2013. Notwithstanding the planned 2012 implementation date, it is important to note that there have been several recent cases where the U.K. tax authorities (HMRC) have been prepared to engage in discussion around a more flexible approach to the current CFC motive test to reflect the direction of the new proposals.
Summary of CFC proposals
The highlights of the CFC consultation document are as follows:
- The new rules will apply to individual entities (as now). In contrast to the current rules, which adopt an “all or nothing” approach, a CFC charge will only arise on the proportion of overseas profits that have been “diverted” from the U.K. This will be welcome as it potentially facilitates mixed use companies without introducing the risk of tainting “good income.”
- The rules will operate in a similar way to the current rules by identifying low taxed foreign companies controlled from the U.K. and then providing a number of exemptions to remove such companies from the regime where there is no artificial diversion of U.K. profits.
- It is recognized that an accounts-based test for identifying low taxed subsidiaries may be more straightforward in some respects.
- The regime will focus on CFCs that pose what the government considers to be a high risk of being used to artificially divert U.K. profits. The high risk areas and the proposed approach for dealing with these are:
. Monetary assets - A partial exemption for financing companies, as announced previously. The document discusses four possible design options, and views are invited from business on which option provides the most suitable solution. A full exemption may apply where the finance company is not funded by taking on U.K. debt.
. Intellectual property (IP) - The CFC regime will target the following high risk situations: (1) where IP has been developed in the U.K. and is transferred to a low tax jurisdiction; and (2) where IP is located in a low tax jurisdiction, but significant amounts of activity to maintain and/or generate the value of the IP are undertaken in the U.K.
. Other situations - Cases where profits and risks are not commensurate with economic activities (e.g. captive insurance companies), although there will be no CFC charge on “foreign-to-foreign” transactions.
- The new regime will operate as follows:
. Step 1: Identify CFCs - An approach similar to that used under current rules, i.e. (a) under U.K. control; (b) resident outside the U.K.; (c) subject to a lower level of tax.
. Step 2: Exempt CFCs that pose a low risk to the U.K. tax base. The proposed exemptions include:
. Low profits exemption - Similar to the existing de minimis test, but possible changes to how the de minimis amount is calculated; for example, one proposal is to vary it based on group size.
. Excluded countries exemption - Again, similar, in principle, to the existing excluded countries list test, but with possible changes to introduce additional categories to the list and changes to the current non-local source income rules.
. Temporary period exemption - This would allow a temporary exemption from the CFC rules for a period of up to three years where an overseas subsidiary comes within the scope of the CFC regime as a consequence of a reorganization or a change to U.K. ownership (a similar exemption was recently introduced as part of the interim improvements to the existing regime).
. Territorial business exemptions - This is designed to remove genuine overseas trading operations and foreign profits from the regime. A safe harbor test is proposed to remove overseas entities from the rules that have a relatively modest operating margin. There also would be exemptions for CFCs carrying on a manufacturing trade and a more general exemption for CFCs carrying on commercial activities where there is a low risk of artificial diversion of profits from the U.K. (e.g. trading between the CFC and other foreign businesses, whether connected or unconnected). The treatment of certain property and leasing activities will be relaxed compared to the current rules, such that this type of activity may qualify for exemption if certain conditions are satisfied.
. Finance company rules - As noted above, the finance company partial exemption will result in an effective corporation tax rate of 5.75% on profits from overseas intragroup finance income by 2014. Credit for foreign tax paid in respect of the apportioned profits will be given. The relief will be proportionate to the profits that are subject to tax in the U.K. The finance companies rules also will apply to trading companies that make loans in addition to their trading business. The exemption is unlikely to apply to most income earned from loans to the U.K and also will exclude non- incidental surplus cash on bank deposit.
. General purpose exemption - A catch-all flexible test that can be applied to CFCs not fitting within one of the other exemptions. Broader than the existing motive test, and additionally with no default presumption that profits would otherwise have arisen in the U.K.
. Step 3: Calculating a CFC charge - Where a CFC charge arises, it will be proportional to the U.K. profits that have been diverted, rather than a full apportionment of all profits, as under the current regime.
Overall, these are welcome changes to encourage and facilitate competitive global business structures and should go some way to stemming or reversing the historic trend in some quarters of moving activities away from the U.K.
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