London, 25th March 2010
by Helen Blenkinsop
The trickle of UK PLC headquarters to foreign shores isn't a flood yet, but it's gathering pace. Countries like the Netherlands and Switzerland are actively courting both UK PLCs and high net worth individuals, like hedge fund managers. And it's no wonder that companies and individuals are starting to leave. Switzerland offers an attractive tax and commercial environment, and if you like skiing too, why not take a one-way trip to the Alps? It's against this background that we should view the Government's latest proposals for controlled foreign company ("CFC") reform.
CFC reform - what's it all about?
The proposals are the latest instalment of the Government's changes to the taxation of foreign profits, in other words, the taxation in the UK of profits earned outside the UK by subsidiaries of UK companies. The two earlier instalments were a corporation tax exemption for foreign dividends paid to the UK (UK dividends were already exempt) and rules to restrict tax deductions for interest if a group's borrowings in the UK exceeded the group's worldwide borrowings. The CFC rules already allowed the Government to tax UK companies on unremitted profits of foreign subsidiaries. Although there was broad agreement that change was necessary, there was little agreement on the detail, so the CFC rules had to sit in the "too difficult" pile until the dividend exemption and debt cap were enacted. The current proposals, in the form of a discussion document posted on the Treasury website, were issued by the Treasury and HMRC at the end of January 2010. The document sets out the direction of travel, while recognising that details have yet to be agreed.
The Government is too afraid of losing revenue to scrap the CFC rules altogether. Instead, it wants to simplify them, enhance the UK's competitiveness as a place to do business and ensure the rules comply with EU law. It is debatable whether the existing CFC rules are or ever have been compliant with EU law. Suffice to say that I expect cases on the subject will be keeping lawyers busy for many years to come.
Plus ça change
The Treasury's approach to the CFC proposals is coloured by the Government's desperate need for tax revenues and its desire to make the UK competitive. The current CFC regime broadly says that all UK-owned foreign companies are CFCs and their profits taxable on their UK owners, unless one of a number of a number of exemptions is met. The new CFC rules would take the same approach. The exemptions would be different, but apparently easier to operate. There is, however, a real danger that extra complexities would be layered into the rules to collect more tax.
Small is beautiful
The proposed exemptions are similar to existing ones. Capital gains continue to be ignored. There is an existing de minimis exemption for income under £50,000; it is proposed that this is increased. Life would be even easier if the limit were tested against local accounting profits rather than, as now, by calculating UK taxable profits. That, however, is a matter of detail to be covered in the next phase of the consultation.
A whitelist, but who is good enough?
The existing exemptions for high tax rates and "good" excluded countries both involve analysis and calculations; either a calculation of UK taxable profits or analysis of income to prove that most of it is really sourced in the good excluded country. They would be replaced by a simple white list of good countries. A vast improvement, although HMRC has yet to decide which countries are good enough for the white list.
Good news for traders and treasurers…
The exempt activities test currently removes trading companies and some holding companies from a CFC tax charge. Its replacement, an exemption for trading companies, will be more widely drawn so that treasury companies and "active" intellectual property ("IP") owning companies fall within it as well.
The extension for treasury and active IP operations has arisen as a result of determined lobbying by business, and it is encouraging that the Government has listened. There are pitfalls, though. The definition of qualifying treasury activities is restricted to short term borrowing and lending at a profit, and providing treasury services such as cash pooling. Other financial activities, like lending long term within the group, could attract CFC tax. Here, the options suggested by the Treasury start to look rather complicated. One proposal is to levy UK tax on a deemed interest charge unless the finance company is appropriately debt-capitalised. The Treasury is seeking recommendations for an appropriate debt:equity ratio. The irony here is that, while generally HMRC wants UK companies to minimise debt on their balance sheet (thus keeping tax-deductible interest low), I suspect that in this instance, it would like foreign finance subsidiaries to be capitalised with a high level of debt. Even then, the Treasury is very nervous of overseas subsidiaries lending cash back to the UK, and has suggested further restrictions
...and intellectual property, but there's a sting in the tail
The IP proposals would exempt foreign subsidiaries that receive IP income, as long as they either manage all their IP themselves or their IP has no UK connection; for example, a patent developed by a French company, owned and managed in the Netherlands and licensed to an Australian company. The definition of IP management is comprehensive, covering development, legal protection, negotiation and quality control over licence agreements, and brand management. If any of this is outsourced, an active IP company would be expected to employ knowledgeable staff to supervise the outsourcing.
Because of HMRC's evident reluctance to exempt IP owning companies with any connection to the UK, I fear that groups will be motivated to outsource IP management to third parties and group companies outside the UK. It would be unfortunate if HMRC's caution resulted in less work, and therefore jobs, for patent and trademark specialists in the UK.
The Treasury is also concerned that IP could be transferred from the UK too cheaply, especially in the case of newly developed IP that doesn't generate profits yet. The Treasury's answer is to revalue IP on an earn-out basis several years after the move offshore. If there has been an increase in value, HMRC will collect more tax. Naturally, if the IP has fallen in value, no tax refund will be forthcoming. This one-way bet for HMRC appears to ignore risk inherent in the IP's value when it is transferred, as well as the contribution made outside the UK to the IP's growth in profitability. The measure would introduce uncertainty: when IP was transferred offshore, no one would know if a large tax charge loomed ahead. Perhaps, rather than apply a stick, the Treasury could give a carrot by improving its proposed patent box regime. This initiative already offers low tax rates for patent royalties from 2013.
Loopholes to close
A widely used loophole will be closed. At the moment, exempt trading companies can receive non-trading income without any effect on their CFC position. A common tax planning technique known as swamping involves loading a trading company with low-tax interest or royalties amounting to just less than half of its profits. In future, only incidental non-trading income will be relieved from a CFC tax charge. Comments are being sought on the definition of "incidental". My guess is that we will land somewhere around 10% to 20% of profit before tax.
Holding companies – watch this space
The Treasury admits that it hasn't decided what to do about holding companies, and is open to ideas. The simplest option would be to treat holding companies like trading companies, and refrain from a CFC tax charge if they receive only dividends plus, say, non-dividend income below the de minimis exemption limit.
Are your motives good?
The Government's intention, repeated throughout the discussion document, is to prevent the artificial diversion of profits from the UK. They recognise that, however widely drawn, the specific exemptions may not cover every company established overseas for commercial reasons. It is possible today to claim a motive test exemption in this situation, by persuading HMRC there is no tax avoidance motive and no loss of UK tax. Although my experience of the motive test has been positive, I understand that HMRC hasn't always been persuaded in other cases. A more user-friendly motive test is promised in future. The Government is moving away from the default assumption that all activities that could have been undertaken in the UK would have been undertaken there, were it not for the tax advantages offered overseas. Instead, the focus will be on proving a commercial rationale. There may also be a statutory period of grace for newly acquired companies (HMRC already allows this, but it isn't enshrined in statute) and flexibility where other exemptions are narrowly missed.
Keeping it simple
To summarise, the direction of travel is encouraging. The Government is making a welcome effort to design new CFC rules that are simple and fair. Yet, there is a real danger that they won't be simple enough or fair enough. Concerned taxpayers should give their views to the Treasury by 20th April 2010, the deadline for comments on the discussion document. Equally, HMRC should resist the temptation to collect more tax by adding complexity and retrospective tax charges. Multinationals will vote with their feet otherwise.
"Helen Blenkinsop FCCA, trained and worked as a corporate tax manager in the Big 4 before moving in-house. She spent 12 years heading two international FTSE tax teams and recently completed senior interim assignments in the insurance and packaging industries. The CFC rules have played a bigger part in her life than she cares to mention."
For more information contact Rob Stephenson, Managing Partner of Maven Partners on 0207 061 6421.
