UK fails to untangle foreign company tax

THE CONSULTATION on Controlled Foreign Companies (CFC) reform has been going on for around five years – about twice the gestation period of an elephant. And the Consultation Document issued on 30 June is very large, has a number of grey areas, and a lot of wrinkles still to be ironed out. Will it achieve the Government’s objective of being competitive for business while still protecting the UK tax base?

The new proposals look superficially similar to the old regime. A CFC is defined as a company which is resident outside the UK, controlled by UK residents and subject to a lower level of tax. There is then a range of exemptions, which include a low profits exemption and an excluded countries exemption, as well as a “Territorial Business Exemption” (TBE) and a “General Purpose Exemption” (GPE). The TBE is broadly aimed at exempt activities, and the GPE replaces the old motive test. There is also a three year temporary period exemption, which gives a breathing space for companies which come under UK control as a result of commercial transactions.

There are, however, some important differences in the structure as well as in the detail. The focus is now on profits “artificially diverted” from the UK, and any apportionment will be only of the relevant proportion of overseas profits. There is a new regime for finance activities (the “Finance Company Partial Exemption” or FCPE) and complex rules for Intellectual Property (IP).

Artificially diverted profits

There is clearly still nervousness about avoidance, and the document stops short of giving a clear definition of what is meant by “artificially diverted” profits. Two examples are included:

• transactional diversion – for example, a transaction giving rise to a UK tax deduction that would not have arisen had the arrangements been at arm’s length; or
• diversion through the transfer of assets – for example, the separation of an intangible asset (previously in the UK) from the active decision-making regarding the risks inherent in the ownership of the asset.

This lack of a clear definition is likely to put pressure on the General Purpose Exemption, which in turn means that the clearance process will be important. There will also be Targeted Anti-Avoidance Rules (TAARs), which will add to complexity and uncertainty unless they are clearly focused on abuse.

It is helpful that there will no longer be an automatic assumption that profits received by a CFC would have arisen in the UK if the CFC did not exist. This is a clear improvement on the current motive test.

Finance Companies

The Finance Company Partial Exemption, or FinCo regime, is a pragmatic attempt by the UK Government to compete with other low-tax finance regimes. For offshore finance companies providing intra-group loans, only one quarter of the profits will be subject to CFC apportionment, giving an effective tax rate of 5.75% from 2014.

Groups will therefore be able to borrow externally in the UK and put the money as equity into a FinCo which lends to overseas operating companies. If the deduction in the operating company is at around 30%, the total tax relief for financing costs will be close to 50% – UK relief, plus overseas relief, less tax at 5.75% in FinCo.

This is a generous relief which accounts for virtually the whole of the estimated £840m pa cost of the new regime. It is likely that many groups will restructure their overseas financing arrangements to take advantage of the new regime.

The IP regime

By contrast, the new rules for IP appear nervous and tentative. Where IP has been owned in the UK within the last six years, or continues to be effectively managed from the UK, the group will have to rely on the GPE. This will require a calculation of whether the profits of the CFC are “commensurate with the CFC’s activities”: if profits in the CFC are too high, and represent amounts artificially diverted from the UK, then the excess will be subject to an apportionment.

The rules seem to be an admission that HMRC is unable to apply existing transfer pricing rules robustly. If IP is transferred out of the UK at its full market value, how does that lead to “artificially diverted profits”? And if the UK continues to manage the IP with high value services, surely the answer is for a high price to be charged for that service under OECD principles?

The EU angle

CFC legislation is a restriction on the freedom of establishment, but can be justified if its purpose is to prevent avoidance. However, the proposals stop short of offering a simple exemption for genuine business activities in the EU, and are therefore likely to lead to continuing challenges in the EU courts.

The new rules have some welcome features, particularly the move to a partial apportionment and the generous regime for finance companies. However, overall there is a disappointing level of complexity. The UK wants to be seen as “open for business”, but it is unlikely that it will be the first choice for a European holding company location, due to the failure to give a clear and simple message that genuine EU activities will be exempt. After five years of consultation, it is disappointing that this opportunity has been missed.

Heather Self is director of tax at McGrigors LLP. She recently moved from HMRC, where she was a member of the Monetary Assets Working Group consulting on the FinCo regime for CFCs

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