This chapter examines the proposed modernisation of the UK's existing controlled foreign company regime.
This article is part of the PLC multi-jurisdictional guide to Tax on Transactions. For a full list of jurisdictional Q&As visit www.practicallaw.com/taxontransactions-mjg.
The UK has had controlled foreign company (CFC) rules since 1984. In common with similar regimes of other jurisdictions, their purpose is to ensure that the extra-territorial reach of the UK corporation tax system is not undermined by multinational groups establishing subsidiary companies in low tax jurisdictions. This is achieved by taxing profits diverted from the UK by apportioning the profits of non-resident subsidiaries to any UK holding company.
In recent years the existing CFC regime (the Original Regime) has been seen as increasingly outmoded in its scope and has been held in large part responsible for the exodus from the UK during the 2000s of a significant number of multinational groups. The Original Regime works on the basis that all activities that could have been undertaken by a UK company within the group should be taxed as if that was the case, unless one of a number of exceptions applies. Probably the two key exceptions have been:
The "motive test", which applies where the main purpose of the CFC was not tax avoidance.
The exclusion for "exempt" activities.
The Original Regime has been the subject of some recent "transitional" changes in expectation of the new regime (the New Regime) coming in. Consultation as to how the CFC rules should be "modernised" first started in 2007 as part of a wider updating of the UK corporate tax rules to a more territorial basis. As at April 2012, the New Regime is now largely settled and is included in the Finance Bill 2012 (which may, however, be subject to further change).
Against this backdrop, this chapter:
Provides an introductory overview of the differences between the New Regime and the Old Regime.
Explains when the CFC charge will apply under the New Regime.
Outlines how HM Revenue & Customs (HMRC) will manage the New Regime.
Gives a brief assessment of the New Regime.
The stated purpose of the New Regime is to protect UK tax revenues against the artificial diversion of profits from the UK while having a CFC regime that is territorial in its approach so that the UK is a more attractive location for holding companies of multinational groups. Other changes in recent years designed to increase the attractiveness of the UK as a holding company location have been:
The introduction of the substantial shareholding exemption for corporation tax on chargeable gains.
The new dividend regime, which exempts most dividends and other distributions payable to UK companies.
The foreign branch exemption.
The proposed Patent Box regime.
Given the numerous challenges to the Original Regime based on its failure to comply with EU law, it is interesting to note that the New Regime does not include any general motive-based exclusion; the rules still apply even where a multinational group has no underlying tax avoidance purpose. This is counterbalanced, however, by numerous targeted anti-avoidance rules (TAARs), which refuse access to a number of the New Regime's more attractive features where tax avoidance is involved.
The Original Regime was written on the basis that all profits of a CFC are included unless a specific exemption applies. In contrast, the principle underlying the New Regime is "all out, unless brought in": a CFC's "chargeable profits" are those profits for the accounting period that pass through the "CFC charge gateway" (the Gateway). The Gateway is designed to identify and bring into the scope of the CFC charge those profits that have been artificially diverted from the UK.
Separately, there are also a number of entity level and other exemptions and safe harbours, which may mean that, even if the CFC has chargeable profits (that is, profits that have passed through the Gateway), the CFC's profits for the relevant accounting period are exempt from the CFC charge. Although some of the exemptions are complex, they will generally provide a higher level of certainty than relying on the Gateway, which draws on a functional and economic analysis based on the Organisation for Economic Co-operation and Development (OECD) guidelines.
To the extent that a CFC has chargeable profits and none of the exemptions or safe harbours apply, then, as under the Original Regime, the profits are apportioned and taxed in the hands of any UK resident company with a 25% or greater interest in the CFC.
Probably the most significant of the exemptions for many multinational groups will be the finance company exemptions. These are entirely new and will allow multinational companies to ensure that the profits of their overseas finance companies are taxed at a low effective rate (5.5% once the headline rate of UK corporation tax has been reduced to 22% as from 1 April 2014) or zero.
Of further benefit to multinational groups is the way that IP holding companies are treated. To the extent that IP does not have a link to the UK, and in particular is created and managed offshore, then the UK CFC rules should not apply.
One of the objectives in the design of the New Regime has been simplification. It is questionable whether this objective has been met: the proposed rules as they currently stand include:
The Gateway with its five separate Chapters.
Five "entity level" exemptions.
Two finance company exemptions.
Two "safe harbours".
Numerous TAARs.
A wide array of closely related defined terms.
In addition, there is now considerable reliance on OECD concepts (such as "significant people functions" and "key entrepreneurial risk taking functions"), which have previously been of principal interest to transfer pricing specialists rather than "mainstream" corporate tax advisers.
Subject to enactment, the New Regime will apply to CFCs from the first accounting period to commence on or after 1 January 2013. The legislation will be found in new Part 9A of the Taxation (International and Other Provisions) Act 2010 (TIOPA).
References to Chapters are to Chapters of Part 9A of TIOPA. Other statutory references (unless otherwise stated) are to TIOPA.
The CFC charge (provided in Chapter 2) is imposed on any "chargeable company", that is, broadly, a UK resident company which, together with its connected and associated persons, has a 25% or greater interest in a CFC (sections 371AA(1), 371BD and 371VH). There are certain exemptions for holdings in offshore funds (see below). The charge is by reference to the "chargeable profits" of the CFC (section 371BA(1)). If one of the entity exemptions (within Chapters 10 to 14) applies to a CFC for an accounting period then no CFC charge applies in relation to the CFC's chargeable profits for the accounting period in question.
Key questions relating to the CFC charge are:
What is a CFC?
What are the entity exemptions?
What is the Gateway (including the safe harbours) and what pre-conditions must be met for it to apply?
What are the finance company exemptions?
What interest in a CFC must a UK resident company have to be within the CFC charge?
How is the CFC charge calculated?
Although the legislation deals with the Gateway before the entity exemptions, the entity exemptions are dealt with here first as these are generally more familiar and straightforward.
A CFC is a non-UK resident company that is controlled, or deemed to be controlled, by a UK resident person or persons. For these purposes, a company includes "incorporated cells" and "unincorporated cells" (see box, Cells).
"Control" is defined in Chapter 18. A person (P) controls a company (C) if any of the following are the case:
P has legal control, that is, the power to secure that C's affairs are conducted in accordance with P's wishes through the holding of shares or the possession of voting power in, or by virtue of powers in, the articles of association or other regulating document of, C or any other company (section 371RB(1)).
P has economic control, that is, it is reasonable to suppose that, on a sale of C, a distribution of the whole of C's income or a winding up of C, P would receive (directly or indirectly) more than 50% of the proceeds, amount distributed or distributable amount (section 371RB(2)). In applying these economic tests, any shares or rights of a bank that is regulated in its territory of residence and acting in the ordinary course of its banking business are ignored (section 371RB(3)).
The "40% rule" applies, that is (section 371RC):
two persons (controllers), taken together, control C under the above legal or economic tests;
one of those two controllers is UK resident and has 40% or more of any of the above legal powers and economic rights; and
the other controller is non-UK resident and has 40% or more but not more than 55% of any of the above legal powers and economic rights.
P has control for accounting purposes, that is:
P is C's parent undertaking; and
under the CFC charging provisions, at least 50% of C's chargeable profits (assuming for these purposes that C is a CFC) would be apportioned to P and its UK resident subsidiary undertakings.
The accounting test is a new feature (not within the CFC control test under the Original Regime).
"Parent undertaking" and "subsidiary undertaking" have their Financial Reporting Standard 2 (FRS 2) meaning (section 371RE). The Treasury may amend this test to take account of changes to FRS 2 or any document replacing it.
For the purposes of the above three tests, rights and powers include future, jointly held and connected persons' rights and powers (section 371RD).
If two or more persons, taken together, meet the legal and economic tests in the first two tests, they are taken to control the company.
So, if P1 and P2 are both UK resident persons and between them have 51% of the voting power or economic rights in a non-UK resident company, the latter will be a CFC (whether or not P1 and P2 are connected). The company would also be a CFC if P2 was not UK resident but only if P1 had 40% or more and P2 had between 40% and 55% of the legal or economic rights.
See box, Examples of control, for diagrams illustrating "control" for CFC purposes.
Note that there is a TAAR under which a company (C) can be deemed to be a CFC if there is an arrangement the main purpose, or one of the main purposes, of which is to secure that C is not a CFC (section 371RG). HMRC have confirmed that this TAAR is not intended to act as an obstacle to genuine commercial restructurings by foreign parented groups or as an anti-inversion rule. As a result, the TAAR does not apply where both:
The arrangements involve the transfer of a foreign subsidiary to the ultimate foreign parent company such that it ceases to be controlled by a UK company.
After the transfer no, or only insignificant, economic benefit arises to any UK company from the foreign subsidiary (other than benefit derived from the supply by the foreign subsidiary of goods or services in the ordinary course of business).
The entity level exemptions (provided in Chapters 10 to 14) are designed to exclude from the regime CFCs that pose only a low risk to the UK tax base. They apply separately by reference to each accounting period of a CFC. Of the five exemptions, the low profits and low profit margin exemptions are relatively straightforward, while the tax and excluded territories exemptions are more complex. Due to its short exemption period, the exempt period exemption may prove to be of limited assistance only. The exemptions are described below in the order in which they appear in the legislation.
Exempt period exemption. The exempt period exemption (EPE) (provided in Chapter 10) is designed to exempt a CFC if it is a "new joiner", for example, if it is acquired by a UK group or its parent migrates to the UK. The exemption period is 12 months and is subject to the CFC undertaking any restructuring necessary to take it outside the CFC charge for subsequent periods, for example, by meeting one of the other entity level exemptions or having no chargeable profits. A period of 12 months may not be sufficient in practice (when contrasted to the three-year period in the Original Regime, as modified by the transitional provisions); for example, if the restructuring involves relying on the substantial shareholding exemption (which has a minimum 12-month period).
The period may be extended by HMRC if a notice requesting an extension is given during the 12-month period and it can be shown that the CFC could not feasibly have completed a restructuring necessary to take it out of the CFC charge, for example, due to circumstances outside its control. Where a CFC's three-year exempt period under the Original Regime begins before the New Regime takes effect in relation to the CFC, the three-year period will continue to apply.
A TAAR disapplies the EPE where there is an arrangement that either (section 371JF):
Is linked to the application of the EPE, has as its main purpose, or one of its main purposes, the securing of a tax advantage and involves the CFC making finance profits or holding intellectual property (IP).
Involves the CFC having a short accounting period and the main purpose, or one of the main purposes, of the arrangement is to secure that the EPE applies.
IP is defined as any patent, trade mark, registered design, copyright or design right, or any licence or other right relating to any such rights. Know-how is not included.
Excluded territories exemption. The excluded territories exemption (ETE) (provided in Chapter 11) is intended, broadly, to exempt CFCs resident in a jurisdiction with a headline rate of corporation tax that is more than 75% of the UK rate. With the gradual reduction of the UK rate from 24% for financial year (FY) 2012 to 22% for FY 2014, ETE will potentially become of wider application.
The ETE applies for a CFC's accounting period if each of the following conditions is satisfied:
For the accounting period, the CFC is resident in an excluded territory (to be specified in HMRC regulations (see the draft Controlled Foreign Companies (Excluded Territories) Regulations 2012) (similar to the current "white list")).
For the accounting period, the CFC's "bad income", if any, does not exceed the greater of 10% of the CFC's accounting profits (ignoring transfer pricing) and GB£50,000 (as at 1 March 2012, US$1 was about GB£0.6). "Bad income" is, broadly, income that escapes the tax net or is subject to reduced tax in the CFC's territory of residence (for example, due to a local investment incentive scheme or a local tax ruling) (section 371KD(3)).
The "IP condition" is met. The IP condition (which is used elsewhere, in relation to the trading company safe harbour (see below, The Gateway and its pre-conditions: Chapter 4 of Gateway: business profits)) is met if the CFC's profits for the accounting period do not include income from IP or, if they do, then one of the following applies (section 371KJ):
none of the IP was (directly or indirectly) transferred to the CFC by, or derived from IP held by, a UK related person (that is, a UK resident related person or the UK permanent establishment of a non-UK resident related person) during the current accounting period or the previous six years (the "relevant period");
if part only of the CFC's IP was so transferred or derived, then such part is not a significant part of the CFC's IP and the CFC's profits are not significantly higher as a result; or
the value of IP held by the related persons was not significantly reduced by the transfer or derivation (section 371KJ).
The CFC is not, at any time during the accounting period, involved in an arrangement the main purpose, or one of the main purposes, of which is to obtain a tax advantage for any person.
Where a UK resident related person has transferred IP to the CFC then, even if this was by way of a sale at full market value to the CFC, the IP condition may still be breached.
Low profits exemption. The low profits exemption (LPE) (provided in Chapter 12) applies if either (section 371LB):
The CFC's accounting or assumed taxable total profits are not more than GB£50,000.
The CFC's accounting or assumed taxable total profits are not more than GB£500,000 and the non-trading element is not more than GB£50,000.
A CFC's accounting profits (determined by sections 371VC and 271VD) are those shown in its financial statements provided they are prepared in accordance with an acceptable accounting practice (meaning international accounting standards (IAS), UK generally accepted accounting practice (UK GAAP) and accounting practice generally accepted in the CFC's territory of residence). If they are not prepared in accordance with an acceptable practice then the profits are those that would be shown if the accounts were prepared in accordance with:
The accounting practice usually followed by the CFC, provided this is acceptable.
If it is not acceptable, then IAS.
The following adjustments are made:
Dividends that would be exempt (if the CFC was a UK company), any property business profits (but seemingly not losses) and capital profits and losses are ignored.
Settlement income where the CFC is a settlor or beneficiary and the CFC's share of any partnership income are included.
Transfer pricing adjustments (based on UK rules) of GB£50,000 or more are made.
The adjustment in the second bullet point above would appear to create the possibility of double tax where the same income is taxed in the hands of a beneficiary and the CFC as settlor (unless the beneficiary is a CFC with chargeable profits) (section 371SB(4), (7) and (8)).
The LPE is subject to a TAAR, which applies where there are arrangements the main purpose, or one of the main purposes, of which is to secure the application of the LPE, for example, where:
A group fragments its profits between a number of CFCs to take advantage of the LPE.
"UK intermediary services" are provided by the CFC, that is, where UK services are provided by an individual through an arrangement involving the CFC (rather than directly to the "client").
Low profit margin exemption. The low profit margin exemption (LPME) (contained in Chapter 13) applies if the CFC's accounting profits (before any deduction for interest) for the accounting period are no more than 10% of the CFC's operating expenditure excluding the cost of goods purchased by the CFC, unless the goods are used by the CFC in its territory (therefore excluding the cost of goods purchased for resale without being imported to the CFC's territory), and excluding expenditure that gives rise to income of a person related to the CFC.
The LPME is subject to a TAAR which, as with the LPE, applies to prevent fragmentation of CFC profits.
"Accounting profits" has the same meaning as for the LPE.
The tax exemption. The tax exemption (TE) (contained in Chapter 14) applies to a CFC for an accounting period in which the CFC pays a "local tax amount" (excluding any capital gains and losses) of at least 75% of the "corresponding UK tax".
The TE cannot apply to a CFC if either:
It has no territory of residence.
The local tax amount is determined under "designer tax rate provisions", that is, provisions that appear to HMRC to be designed to enable companies to exercise significant control over the amount of tax they pay and are specified in HMRC regulations.
The local tax amount is reduced to reflect:
Income that is taken into account in determining the CFC's local chargeable profits but is not taken into account in determining the CFC's assumed taxable total profits.
Expenditure that is not taken into account in determining the CFC's local chargeable profits but is taken into account in determining the CFC's assumed taxable total profits.
Any repayments of tax, or payments in respect of tax credits, made to any person other than the CFC in respect of tax paid by the CFC in respect of the CFC's local chargeable profits.
A CFC's territory of residence is relevant to the ETE and the TE. (See box, Determining a CFC's territory of residence for the relevant rules .)
Before any profits of a CFC can be subject to the CFC charge, they must pass through the Gateway. This reflects the "all out, unless brought in" approach. In other words, the new legislation only captures income that falls within the scope of, or passes through, the Gateway, and so the starting assumption is that the legislation will not apply.
The Gateway is contained in Chapters 4 to 8. Unless and to the extent that profits of a CFC fall within the scope of one of these chapters they will not pass through the Gateway.
The new legislation draws a fundamental distinction between "business profits" and "finance profits". Chapter 4 deals with business profits, which expressly excludes business property profits and non-trading finance profits (section 371DA(2)).
Finance profits are dealt with in Chapter 5 (which covers non-trading finance profits) and Chapter 6 (which covers trading finance profits, and so will be of most relevance to banks and other financial institutions).
Chapters 7 and 8 cover captive insurance companies and solo consolidation respectively.
When the draft CFC legislation was first released, there was considerable concern that the process of determining whether a CFC's profits passed through the Gateway would place an unduly heavy compliance burden on business.
To alleviate this, the draft legislation was amended by the introduction (in Chapter 3) of what are, in effect, a number of pre-conditions to each of Chapters 4 to 8 applying. If the pre-conditions for each Chapter are not met, then the CFC's profits will not fall within the scope of that Gateway Chapter.
This section sets out the pre-conditions for each Chapter, and how the chapters themselves operate.
The Chapter 4 pre-conditions. The pre-conditions to Chapter 4 (profits attributable to UK activities) applying for the accounting period are in section 371CA. If any of conditions A, B, C or D apply then Chapter 4 will not apply.
Condition D (section 371CA(11)) is simple. If the CFC's profits comprise solely non-trading finance profits or property business profits then Chapter 4 does not apply. This would apply to a CFC that holds solely investment property and surplus cash. Conditions A to C are more complex.
Condition A (section 371CA(2)) is a tax avoidance condition. It is likely to be of relevance to the most taxpayers. However, its application will often be unclear due to its subjective nature.
Condition A excludes from Chapter 4 profits of a CFC if the CFC does not, at any time during the accounting period, hold assets or bear risks under an arrangement which has:
A main purpose of reducing or eliminating UK tax (or duty).
A consequence that the CFC expects the business to be more (than negligibly) profitable than it would have been but for the arrangement.
There must also be an expectation that one or more persons will have their tax liabilities (of any jurisdiction) reduced or eliminated and it must be reasonable to suppose that, but for this expectation, the arrangement would not have been made.
Condition B (section 371CA(5)) is that the CFC does not, at any time during the accounting period, have any assets or bear any risks that are managed or controlled to a significant extent from the UK (the UK control and management condition).
Note that the UK control and management condition refers to the control of an asset or risk. This is separate from the board level control of the CFC that will likely be outside the UK. For example, the condition would not be satisfied if a UK based employee (either of a UK parent company or the CFC (otherwise than through a UK permanent establishment of the CFC)) managed a CFC's IP portfolio from the UK. Management of an asset includes its acquisition, creation, development and exploitation.
Condition C (section 371CA(6)) applies if, despite the fact that the UK control and management condition is not satisfied (because the CFC has one or more UK managed assets or risks), at all times during the accounting period, the CFC itself has the capability to ensure that its business would remain commercially effective were the management of these risks or assets to stop being in the UK. This includes the ability to select unconnected persons to provide it with goods or services, and to manage its transactions with unconnected persons.
So, if a CFC had a UK-managed portfolio of IP it could still satisfy this condition if it were capable of managing that IP itself (or arranging for unconnected persons to do so) and could continue to be commercially effective.
The Chapter 5 pre-condition. The pre-condition to Chapter 5 (non-trading finance profits) applying is that, for the accounting period, the CFC has non-trading finance profits (sections 371CB to 371CD). For these purposes, profits do not count as non-trading finance profits if they arise from the investment of funds held by the CFC for the purposes of either:
A trade, no profits of which pass through the Gateway.
A property business.
Chapter 5 will also not apply to a CFC unless it has non-trading finance profits (which, for this particular purpose, includes profits from the investment of trading or property business profits) which, broadly, form more than 5% of the aggregate of the profits of the CFC that arise from either:
A trading or property business.
"Exempt distribution income" from its subsidiary companies in which it has at least a 51% interest in (51% subsidiaries). Exempt distribution income for these purposes is, broadly, distributions that would qualify for exemption from UK corporation tax if the CFC were UK resident.
This is often described as being the "incidental finance income safe harbour", although the legislation does not describe it as such. It is important to note that, in determining the CFC's non-trading finance profits, any non-trading finance profits of the CFC's 51% subsidiaries must be added in.
This safe harbour can still apply where a CFC's non-trading finance profits form more than 5% of the total profits of the CFC but a substantial part of the CFC's business involves holding 51% subsidiaries. In these circumstances, Chapter 5 will only apply where the non-trading finance profits of the CFC (excluding profits from the investment of trading or property business profits, but including any non-trading finance profits of the CFC's 51% subsidiaries) exceed 5% of the CFC's exempt distribution income.
The Chapter 6 pre-conditions. The pre-conditions to Chapter 6 (trading finance profits) applying are that, for the accounting period, the CFC has trading finance profits and, at any time during the accounting period, the CFC has funds or other assets that derive from a UK connected capital contribution (that is, a capital contribution made (directly or indirectly) from a UK resident company (whether or not the contribution is made by way of share subscription)).
The finance company exemptions will not apply to these profits (see below, The finance company exemptions (Chapter 9)). However, a group treasury company can elect for its trading finance profits to be treated as non-trading finance profits and so avail itself of the finance company exemptions. A group treasury company is one that undertakes treasury activities for the group and whose income is at least 90% from group treasury activities (sections 316(5) to (11)).
The Chapter 7 pre-condition. The pre-condition to Chapter 7 (captive insurance business) applying is that the CFC's main business for the accounting period is to provide insurance to either:
A connected company that is UK resident or has a UK permanent establishment.
A UK resident person where the insurance is linked to the provision of goods or services to that person (section 371CF).
The Chapter 8 pre-condition. The pre-condition for Chapter 8 (solo consolidation) applying is that, very broadly, the CFC is the subject of solo consolidation for the accounting period (section 371CG).
Chapter 4 of Gateway: business profits. The main aim of Chapter 4 is to ensure that only those business profits that have been artificially diverted from the UK pass through the Gateway (sections 371DA and 371DB). Chapter 4 achieves this by relying on certain OECD concepts to determine the connection that profits have with the UK.
The chapter first requires an analysis of those assets held and risks borne by the CFC that have generated the CFC's profits (excluding assets and risks that have a negligible impact on the profits).
Once these relevant assets and risks have been identified then the significant people functions and key entrepreneurial risk-taking functions (SPFs) that are relevant to the economic ownership of the assets or to the assumption and management of the risks must be identified.
SPFs is an OECD concept that is particularly relevant to transfer pricing. The use of this concept is likely to increase the administrative burden for businesses, which are unlikely to have determined for their own purposes what SPFs are related to each asset and risk. They will therefore need to incur the expense of the (potentially complicated) process of determining exactly what these SPFs are, and who performs them.
Once the relevant SPFs have been identified, the business must then determine whether any of these SPFs are carried out in the UK (otherwise than by the CFC through a UK permanent establishment).
To the extent that the SPFs are carried out in the UK, there is then an assumption that they are carried out by the CFC through a permanent establishment in the UK. The profits of the CFC attributable to this notional permanent establishment must then be determined.
Once this has been done, the following are then excluded from the profits attributable to the notional permanent establishment: profits that are generated from an asset or risk where the profits generated by the CFC from that asset or risk are 50% or less than the profits attributable to the notional UK permanent establishment.
The remaining profits of the CFC that are attributable to the notional UK permanent establishment are the profits that pass through the Gateway, subject to the following three additional exclusions (section 371DD and section 371DE):
Non-tax value exclusion: this exclusion applies in relation to the profits arising from any asset or risk where, in essence:
the profits made from the asset or risk in question exceed what would have been made had the asset or risk been solely held by a UK resident company connected with the CFC; and
a significant proportion of the excess profits that have been achieved does not derive from the reduction of tax.
Independent companies exclusion: this exclusion applies to profits that arise from assets or risks managed through a UK SPF carried out by a company connected with the CFC, in circumstances where:
if the SPFs were carried out by companies not connected with the CFC, they would be carried out under similar arrangements to the existing arrangements; and
those new arrangements would have the same commercial effect on the CFC's business as the existing arrangements.
Trading profits exclusion or "safe harbour": all trading profits of a CFC are to be excluded from Chapter 4 if the following conditions are met (known as the trading company safe harbour) (sections 371DF to 371DL)):
business premises condition: the CFC has business premises in the territory in which it is resident which have, or are intended to have, a reasonable degree of permanence;
income condition:
no more than 20% of the CFC's trading income derives from UK resident persons (excluding income arising from the sale in the UK of goods produced by the CFC); and
no more than 10% of the CFC's trading income derives from UK resident persons (excluding interest from UK resident companies associated or connected with the CFC).
management expenditure condition:
no more than 20% of the expenditure of the CFC on managing or controlling relevant assets or risks (management expenditure) relates to UK based staff or individuals;
the above condition would be met if there were excluded any asset or risk on which the management expenditure of the CFC that relates to UK based staff or individuals is no more than 50% of the total management expenditure for that asset or risk.
IP condition: this condition is not met if the CFC derives income from IP and:
the IP includes IP which, in the current accounting period or any of the last six years, was transferred by, or derived from, IP held by a UK resident related person (or the UK permanent establishment of a non-UK resident person) to the CFC and this has significantly reduced the value of the IP held by that related person (relevant IP); and
the relevant IP forms a significant part of the IP that the CFC exploits or the CFC's profits are significantly higher because of this transfer.
export condition: no more than 20% of the profits of the CFC derive from goods exported from the UK, other than exports to the CFC's own territory of residence.
The trading profits safe harbour is designed to ensure that the profits of genuine trading activities do not pass through the Gateway. It contains a TAAR that disapplies the safe harbour if its conditions would not have been satisfied but for an organisation or reorganisation of a significant part of the business of the CFC's group, a main purpose of which was to satisfy such conditions.
The trading company safe harbour is unfortunately complex. In particular, it will be administratively burdensome for businesses to determine whether they satisfy the management expenditure condition.
The safe harbour will be of particular relevance to IP holding companies, for which a separate CFC regime was originally suggested, but which will now be likely to fall within the CFC provisions (if at all) if their profits fall within Chapter 4.
Chapters 5 and 6 of Gateway: finance profits. Chapter 5 (non-trading finance profits) is likely to be the most relevant chapter to multinational groups of companies that are looking to establish a finance company to fund the group's activities in foreign jurisdictions.
Non-trading finance profits will pass through the Gateway in Chapter 5 in any of four circumstances:
UK SPFs: if non-trading finance profits satisfy the same test as that set out in Chapter 4 (that is, the SPFs that are involved with the management of the assets or risks that have generated the non-trading finance profits are UK SPFs).
UK funds: if, in essence, they derive from a capital contribution from a UK person (whether or not that capital contribution is by way of a share subscription).
Arrangements in lieu of dividends: if, in essence, they arise from an arrangement with a connected UK resident company (or a non-UK resident company for the purposes of its UK PE) to invest these funds as an alternative to paying those funds out by way of a dividend, where those arrangements are motivated by tax related reasons.
Finance leases: if they arise from certain finance leases.
Chapter 6 (trading finance profits) (section 371CE) is of most relevance to banks and insurance companies, as it only applies where a business is carrying on a trade of making profits from loan relationships or derivative contracts.
In essence, profits will pass through this Gateway to the extent that they arise from "free capital", that is, funding provided to the CFC for which it is not entitled to a deduction against its non-trading finance profits or its trading finance profits.
Regulations may be introduced to provide exclusions from the Gateway for banks and insurance companies in certain circumstances.
Chapters 7 and 8 of Gateway: special cases. Profits that arise from captive insurance companies (defined in Chapter 7) and solo consolidation (defined in Chapter 8) can also pass through the Gateway. Because these areas are only of relevance to specialist practitioners, this chapter does not deal with them in any further detail.
The finance company exemptions are probably the most important exemptions in the entire CFC legislation, in that it is these exemptions that have been yielded by the government to tempt back to the UK multinational groups, which have, in recent times, moved their headquarters offshore.
The finance company exemptions are different to the entity exemptions in that they only exempt certain profits of a CFC that qualify for the exemptions (unlike the entity exemptions that will exempt all of the profits of a CFC that fall within their scope).
A taxpayer needs to make a claim for the exemption to apply (section 371IA(3)). If it does apply, then it takes precedence over Chapter 5 in determining what (if any) of the CFC's non-trading finance profits from its qualifying loan relationships (QLRs) pass through the Gateway.
The finance company exemptions do not apply to any non-trading finance profits that do not arise from QLRs. The definition of a QLR is complex, with a number of detailed exclusions (section 371IG and 371IH). However, very broadly, a QLR is any loan relationship between a CFC and a connected company, provided that:
The CFC has a business presence that has a reasonable degree of permanence in the jurisdiction in which it is resident.
The debits from the loan relationship are not otherwise taken into account in determining UK tax liability.
There are two different finance company exemptions that can be claimed:
A full exemption on the profits from all of the CFC's QLRs that are made out of qualifying resources (FCFE) (section 371IB and 371IC).
A partial exemption on the profits from all of the CFCs QLRs (FCPE) (section 371ID).
Regardless of which exemption is claimed, the profits of a CFC from its QLRs will always be exempt in certain circumstances where the worldwide debt cap also applies to the CFC group (section 371IE).
The FCFE. A CFC can claim that percentage of its QLRs that it believes should benefit from the FCFE. To benefit from the FCFE, the QLRs must be made wholly out of qualifying resources.
Qualifying resources for these purposes are, very broadly, resources that are available to the CFC from its own activities, and do not relate to funds provided from, for example, the proceeds of a share subscription by the CFC's UK parent.
To the extent that a finance company generates profits from its own finance activities, it is able to reuse these profits to make QLRs, the proceeds of which can potentially benefit from the FCFE.
The FCPE. If the FCFE does not apply but the CFC has made a claim for the finance company exemption to apply, then 75% of the profits of the finance company from its QLRs will qualify for the FCPE.
This means that, at most, only 25% of the profits from the CFC will be chargeable profits that can be subject to the CFC charge. As a result, at the current corporation tax rate of 24%, a UK parent company can ensure that the maximum UK corporation tax liability it is subject to in respect of the QLRs of its finance company CFC is 5.75% (when the UK corporation tax rate is reduced to 22% from 2014 this will come down to 5.5%).
The basic charging provision is in section 371BA, in Chapter 2.
Assuming that the CFC has chargeable profits and no entity exemption applies, then the CFC charge will apply to any chargeable company.
A CFC's chargeable profits are its "assumed taxable total profits" for the accounting period to the extent that such profits pass through the Gateway (section 371BA(3)).
A CFC's assumed taxable total profits (ATTP) (defined in section 4(2) of the Corporation Tax Act 2010) for an accounting period are what the CFC's taxable total profits for the period for corporation tax purposes would be based on the "corporation tax assumptions".
The corporation tax assumptions include assumptions that:
The CFC is, has been and (unless the CFC ceases to be a CFC at the end of the relevant accounting period) will continue to be UK resident.
The CFC is not a close company.
The CFC makes all claims and elections for relief save for:
certain specified reliefs such as an election under section 18A, Corporation Tax Act 2009 (the foreign branch exemption); and
those that may be notified to HMRC by a chargeable company or companies to which more than 50% of the CFC's chargeable profits, so far as would be apportioned to chargeable companies, would be apportioned.
Each chargeable company is then charged to corporation tax on a percentage of the CFC's chargeable profits apportioned to it, less its proportion of any creditable tax (being, broadly, credits for tax suffered by the CFC including tax withheld from payments to the CFC). The rules for apportionment are in Chapter 17. These provide for apportionment according to shareholdings where the CFC has only one class of shares and there are no other "relevant interests". If this is not the case then apportionment is on a "just and reasonable" basis.
Offshore funds. Chapter 2 contains provisions that modify the application of the regime to holdings in non-UK resident companies and other structures that fall within the UK offshore funds regime, a regime designed to prevent untaxed income being rolled up offshore. Broadly, these are open-ended funds and certain closed-ended funds whose investors have a reasonable expectation of realising an amount calculated by reference to net asset value of the underlying investments on disposal of their holdings. If a fund is an offshore fund, then its UK resident investors are charged to tax on disposal profits as if those profits were income rather than capital gain, unless the fund has "reported" its income to HMRC for each accounting period so that UK resident investors can be taxed on fund income whether or not it is distributed to them.
The manager of an offshore will not be liable to a CFC charge on its share of CFC profits of the offshore fund, even if its percentage shareholding exceeds 25%, provided that the manager's holding was a "seeding" investment, held mainly to attract investors, and the offshore fund satisfies the genuine diversity of ownership condition in regulation 75 of the Offshore Funds (Tax) Regulations 2009.
In the case of open-ended funds, a participant's percentage holding may fluctuate significantly as a result of subscriptions and redemptions by other investors. It is therefore provided that an investor will not be a chargeable company if it reasonably believes it is below the 25% threshold and the actions causing it to exceed the threshold were not taken by that investor or any person connected with it.
There is also an exemption for certain interests in offshore funds that are taxed on a "fair value" basis, that is, the increase in value during an accounting period is taxed as income even if the investor receives no income or disposal proceeds. Examples include interests in bond funds, whether held direct or through a UK open-ended investment company (OEIC) or authorised unit trust.
Chapter 21 provides HMRC with two potentially significant new powers to allow it to manage the CFC regime efficiently.
One relates to the application of the just and reasonable basis of apportionment of the CFC's profits where this is required by Chapter 17 (that is, where the CFC has more than one class of share or there are relevant interests other than shares in the CFC). In such cases, HMRC will have the power to determine another basis (from that adopted in a company tax return) on which the CFC charge should be apportioned between the relevant persons with interests in the CFC (section 371UC).
This means that, in such cases, HMRC can increase the amount of the chargeable profits that have been apportioned to a chargeable company, increasing its UK corporation tax liability. However, an affected company can appeal an amendment to its tax return that has been made as a result of such a re-determination of the correct apportionment but only on the basis that it believes that the new apportionment of the profits is no longer on a just and reasonable basis.
Where such an HMRC determination affects more than one company, each of those companies is entitled to be a party to the appeal (section 371UE). The situation could arise where two companies are opposing one another on the appeal, with one company supporting the determination made by HMRC because it gives rise to less corporation tax for that company.
The other new power relates to where a company subject to the CFC charge fails to pay corporation tax when it is due (the "defaulting company"). In such cases, HMRC has the power to recover that tax (plus interest) from any other UK resident company that holds, or has held, the interest in the CFC that has given rise to the CFC charge (the "responsible company") (section 371UF).
This could mean that, if a UK company has transferred its shares in a CFC to another UK resident company, the transferor could be liable for unpaid corporation tax of the transferee if the transferee becomes a defaulting company.
This provision appears to be worryingly broad in its scope. It does not appear to be subject to any time limit after which a company that ceases to hold an interest in the CFC can no longer be liable, nor does it cease to apply where a company has transferred its shares subject to a bona fide commercial transaction without any knowledge or reason to believe that the purchaser may default on its tax liabilities. So, if company A sells its shares in a CFC to company B, which then, at some point in the future, and without the knowledge of company A, sells its shares to company C, company A can be liable for the unpaid corporation tax of company C if company C is a defaulting company. Further, there is no statutory indemnity for the responsible company.
There is a lot to be said in favour of the proposed CFC legislation. A lot of thought and effort has gone into trying to ensure that only those profits that have been artificially diverted from the UK are subject to UK tax.
However, the rules themselves are unfortunately drafted, and are overly complex in nature. The reliance on OECD concepts is likely to impose an additional administrative burden on multinational groups; some groups may have to learn to grapple with what may well be unfamiliar concepts.
The new finance company exemption will be particularly attractive to multinational groups, which will be able to secure that their offshore finance companies are taxed at a maximum effective rate of 5.5%. IP holding companies should, where structured properly, be able to avoid the scope of the CFC rules altogether unless, broadly, the IP has been exported from the UK.
Time will tell if the rules tempt back to the UK those multinational groups that have migrated under the Original Regime; the government will certainly hope so as it would help vindicate the conscious effort to move to a more territorial basis of taxation. Indeed, it is realistic to consider that, with the new CFC regime and the other favourable changes made in the last decade, foreign multinational groups (including those based in the US) will have good reason to move their headquarters to the UK.
For the purposes of the CFC rules, companies include "unincorporated cells" and "incorporated cells" (by whatever name known); both are treated as if they were non-UK resident companies (section 371VE).
Unincorporated cells are identifiable parts of a non-UK resident company to which, under the law of the jurisdiction in which the company is incorporated or formed and the company's constitution, particular assets and liabilities of the company can be allocated to particular members.
Incorporated cells are entities established under the constitution of a non-UK resident company which, under the law of the jurisdiction in which the company is incorporated or formed, have their own legal personality distinct from that of the company.
The Treasury may pass regulations extending these rules to other similar "cell like" entities and arrangements.
A CFC's territory of residence for an accounting period is the territory in which the CFC is liable to tax by reason of domicile, residence or place of management (an "eligible territory") (and not, for example, because it has a source of income in a territory that levies tax on that income).
If there are two or more eligible territories then one of them can be specified by election or designation (see below), failing which it is the CFC's place of effective management, provided this is an eligible territory. If the CFC is effectively managed in two or more such territories, and at the end of the accounting period more than 50% of the CFC's assets are situated in one of them, then that is the territory of residence.
If the residence is still undetermined, if over 50% of the CFC's assets are situated in an eligible territory, then that is the territory of residence. An election can be made, broadly, by one or more interested UK chargeable companies (provided the proportion of the CFC's chargeable profits apportionable to it or them would be likely to exceed 50% of those profits). A designation can be made by an officer of HMRC, on a just and reasonable basis (Chapter 20).
T +44 20 7067 3390
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E mark.joscelyne@olswang.com
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Qualified. England and Wales, 1981
Areas of practice. Tax.
Recent transactions Advising:
T +44 20 7067 3372
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E matthew.wentworth-may@olswang.com
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Qualified. England and Wales, 2003
Areas of practice. Tax.
Recent transactions
