CFC rules provide an intellectual problem

A MERE MONTH after it was due, the government’s controlled foreign companies (CFC) reforms have finally been released. They make good reading for multinationals, delivering on all the promises in March’s Budget.

There has been a change in approach concerning the legislation since the coalition government came to power. Whereas before it was perhaps viewed as a revenue raiser – a trend opposed by business – these reforms seem to set the legislation as an anti-avoidance measure, which the Treasury states has been its aim all along.

So far, so good. But where the reforms fall down, according to professionals, is in the treatment of intellectual property (IP). While there are many specific exemptions in CFC rules depending on size, sector and jurisdiction, companies that rely on IP will have far more trouble proving they should not be paying the full rate of UK corporation tax. So how much ambiguity continues to surround IP held in CFCs and how hard will these companies be hit?

One of the government’s main priorities for corporation tax was the reform of CFC rules. Companies were leaving the UK, we were told, including multinationals such as WPP, the advertising giant, media company UBM and Shire Pharmaceuticals. Although the UK’s perceived high corporation tax was one of the driving factors, business and ministers identified the CFC rules as offputting. Far from being an anti-avoidance measure, they were now raising revenue by draconian application that penalised companies that were headquartered in the UK by imposing the UK corporation tax rate on many of their foreign activities.

Two CFC problems

For business, there were two main complaints: the treatment of foreign financing companies and the treatment of IP held abroad. On the first point, the government has assuaged business concerns by introducing the “finance company partial exemption”, meaning the UK will tax only a quarter of the profits arising from overseas finance companies, a move welcomed by all.

However, on the role of IP it is not so clear. There is no specific exemption for intellectual property. Instead, companies will have to rely on two exemptions that are available to all businesses: the territorial business exemption (TBE) and a new general purpose exemption (GPE).

The TBE will apply to cases in which anything below a defined percentage of the foreign company’s IP relates to the UK in terms of expenditure, income and development within a timeframe.

Companies with more complex arrangements will have to argue that their expenditure should be exempt under the general purpose exemption. This replaces the “motive test”, one that was stringent enough to dissuade most businesses according to Crowe Clark Whitehill partner David Mellor.

There is one crucial difference between the GPE and the motive test, however: HMRC will no longer make a default assumption that profits received by the CFC would have arisen if the work had been undertaken in the UK. It will instead “consider the facts and circumstances of that CFC to assess whether any profits have been artificially diverted from the UK”, the consultation states. Where profits have been artificially diverted, only the profits diverted will be subject to UK tax. Genuine foreign-to-foreign business activity will remain exempt, it adds.

These exemptions might still leave IP-focused companies on unsafe ground. Simon Palmer, international tax partner at KPMG, says the rules cover a wider range of IP activity than they need to. Ideally, the rules would only apply to sales of IP overseas, he says. But under the proposals, licensing from the UK to lower jurisdiction territories could be caught by the rules. This means a UK multinational that licenses its brand or trademark to its CFCs faces the possibility of having to pay the full UK corporation tax rate on profits derived by the overseas company.

Rules could still prove complex

Furthermore, the rules could prove complex to administer for businesses. Andy Boucher, a tax partner at PwC, makes the point that the onus is on companies to work out how much of their profits are derived from UK-based IP. This is where the real tension with HM Revenue & Customs will lie.

It is relatively easy for multinationals to assign their IP across the group and therefore assign it to lower tax jurisdictions. As such, from the government’s point of view, a tough threshold for IP exemption is necessary to protect the Exchequer from lost revenue through tax avoidance.

But there is another strategy at work here, the carrot and stick, according to Baker Tilly international tax partner Kevin Phillips. This determination to prevent IP going offshore is part of the government’s strategy to build the knowledge-based economy. On the one hand, the government is retaining rules that make it difficult for multinationals to move IP away from the UK for tax purposes; on the other, it is offering generous research and development tax credits and a 10% corporation tax rate on patented products, which is one of the most competitive tax rates available.

As Accountancy Age has discussed previously, however, the patent box is obviously limited in scope. For drug companies with patents there is little incentive to avoid CFC rules because they will benefit from 10% tax rates. Yet for the multinational that licenses its international brands, there is no such luck; instead, it will have to argue on a general exemption that the overseas licensing was commercially driven and no profits were diverted from the UK as a result, which is not an entirely straightforward task.

Ramifications

So what are the ramifications for the UK? Well, there is little debate that even without an exemption for IP and the continued ambiguity, the rules are more favourable to business than the previous legislation. The territorial business exemption provides companies with a new basis for argument and even the general purpose exemption is an improvement on the existing rules. With this distinction, this looks far more like anti-avoidance measures than revenue raising.

Importantly, maintaining ambiguity around what IP qualifies for an exemption to the rules is a gamble the UK has to take. Without it, the Exchequer stands to lose a lot of revenue that it should not.

IP is a flexible commodity and the temptation to use offshore companies for UK profits would be strong for businesses. The proposals seem to strike the right balance, though this will only become apparent once multinationals that rely heavily on branding commit to the UK.