The Treasury is set to drop plans to limit interest relief and focus on abuses of controlled foreign companies rules by multi-nationals, as part of a long-awaited response to the challenge from the European Court of Justice.

In documents released last week, the government gave a clear indication of how it planned to protect the tax base and keep the UK tax system competitive.

Advisers are arguing the statements by the government mean an attack on interest relief is less likely and that the tax authorities plan to defend the line on multi-national tax through an attack on the use of offshore Treasury functions and profit-diverting subsidiaries.

‘Business has expressed a preference for reform where options that will be considered include European-style exemption for foreign dividends and income-based CFC rules,’ the Treasury said.

The Treasury is still to conduct a consultation on the taxation of foreign profits, due in the spring, but Bill Dodwell, head of tax policy at Deloitte, said the tone of the announcement on Europe gave a clear indication of the government’s long-term strategy.

‘The Treasury mentions income-based CFC rules, which suggests that it will attempt to limit the types of CFC income eligible for tax relief to cover for an exemption on foreign dividends,’ Dodwell said.

The Treasury said the consultation on its proposals would ‘also consider the implications of any such reform for other aspects of the UK tax regime, such as interest relief’.

Dodwell said amendments to interest relief were improbable: ‘It looks like the real battleground will be on CFCs, where it will have to be decided what kinds of CFC income are deemed to be eligible for tax relief.’

The government has been looking to limit the tax benefits of income derived from ‘capital,’ implying that it thinks offshore functions, often Treasury arrangements, involve no staff and are simply cash deposits in low-tax jurisdictions.

Advisers reacted bitterly to the distinction, calling it an ‘insult’ to business.