A quantum leap?
In a recent article published in Tax Advisor, Desmond Hanna looks at the proposed new legislation for controlled foreign companies
Key points:
· It has taken four years to get to the point of draft legislation for a complete reform of the CFC regime
· The proposals provide much more tightly targeted exemptions, and as a result it is intended that the CFC legislation will only tax profits artificially diverted from the UK
· The key risk areas of ‘swamping’ and intellectual property have been dealt with through carefully targeted exemptions designed to minimise risk to the UK tax base
The eagerly awaited CFC reform consultation document was released by the Treasury and HMRC in June, and I think that it is fair to say, that if it was targeted and detailed proposals for future legislation that business wanted, that seems to be what this document delivers.
The June 2007 discussion document
If you cast your mind back four years ago to June 2007 (Taxation of the foreign profits of companies: a discussion document), the landscape for CFC reform seemed quite different. That document suggested it was clear that a move to dividend exemption would open up new risks for the diversion of profits (by groups diverting profits out of the UK and paying them back as exempt dividends); so if the UK adopted a form of exemption, the CFC rules would have to assume a greater importance in terms of protecting the UK tax base. Exemption therefore pointed to the need for a different kind of regime – one that was both more targeted, but also more robust.
Indeed, later discussions around the issue of intellectual property (IP) suggested that in order to stop high value IP being moved out of the UK, legislation would be introduced to impose UK tax on profits produced by that IP, even if it was located in another jurisdiction. The idea was that where it could be shown that the IP produced had any connection with the UK (eg R&D or active management carried out in the UK), then it would seem the UK’s right, that where that IP was then moved overseas, the UK should be entitled to tax at least a proportion of the future profits produced.
This obviously went down like a lead balloon with most of the multinationals (in particular IP-rich groups) based in the UK. The argument put forward was that it was a major step moving to an exemption regime for dividends, but if the price to be paid was a strengthening of the CFC legislation all the benefits from exempting dividends would be undone; therefore if the government did not have a radical rethink in relation to new CFC legislation the UK economy would suffer.
A brave new world
If now we jump forward four years what, if anything, has changed? One of the main problems cited in relation to the current legislation (mainly the motive test), was that international tax planning within a group, which did not involve the UK, or the so-called ‘foreign-to-foreign’ transactions was not (in many people’s view) a diversion from the UK, because these transactions or profits did not (or never would) involve the UK.
To address this issue, the government has promised (and seems to have so far delivered) a proposed system that would be more territorial and targeted in its approach; and that the new legislation would only seek to tax profits that have been ‘artificially’ diverted from the UK. Furthermore, there would be no default position that in the absence of the CFC, that those profits would have been received by a UK company.
What might the new legislation look like?
The consultation document is over 100 pages long, and therefore it would be impossible to go through each of the proposals in detail; instead I will concentrate on what I think are the main areas of change. In essence the consultation suggests that the new legislation will be similar in many ways to the old regime, but the exemptions will be much more targeted and reflect how the modern economy operates.
Identifying a CF
A CFC (much like the current regime) is a company that is under UK control; is resident outside the UK and has its profits taxed at a lower effective rate than if it were resident in the UK.
The exemptions
Under the new regime it is proposed that a company can apply each exemption to its facts and choose the one which is most beneficial.
1. The low profits exemption is essentially the same as the current de minimis exemption, but the limit will be raised from £50,000 to at least £200,000 and maybe significantly more.
2. The temporary period exemption is much the same as the ‘period of grace exemption’ but far more generous.
3. The excluded countries exemption will operate in a similar way to the current excluded countries list (with a few changes to the non-local source income condition).
4. Territorial business exemptions (TBE) are designed to remove genuine overseas trading operations and foreign profits from the regime. They will include a safe harbour test to exclude companies with modest profits, and allow incidental finance income that arises from the working capital needs of the business.
5. Finance company rules which provide a finance company partial exemption (FCPE) which will in essence tax profits from overseas intra-group finance income at an effective rate of 5.75% (debt:equity ratio of 1:3) by the year 2014.
6. A general purpose exemption (GPE) which is similar to the current motive test, in that it will consider the facts and circumstances of that CFC to assess whether profits have been artificially diverted from the UK. However, only those profits that have been diverted from the UK will be taxed.
The huge challenge which faced the Treasury and HMRC coming into this consultation was how to design a piece of legislation which delivers the policy on growth and competition, while providing the necessary protection which anti-avoidance legislation is intended to do. As highlighted in the consultation the areas of most concern were ‘swamping’ and IP.
What is swamping?
An exempt activities test company with a large turnover, is also used as a group Treasury company which gets a large injection of equity from other group companies which it lends around the group. The interest it receives on group loans (or bad income) is swamped by trading profits (good income) and the Employment Appeal Tribunal therefore still applies. The benefit is that the interest received by this company invariably benefits from a low rate of tax.
The new legislation
To stop this practice, the consultation proposes that if a CFC wants to benefit from the TBE, only an incidental amount of finance or investment income will be allowable to remain in the CFC, the consultation then puts forward three options, none of which will allow anywhere near the 50% interest income that some exempt activities test companies engaged in ‘swamping’ currently enjoy.
However, it does not end there. Some multinational groups argued that they still should be allowed to benefit from some kind of system that allows them to centralise the treasury function and to have this function (if they wished) in a regime that offers certain low tax benefits.
In response the government recognised that financing is an important part of how the multinational operates on a global basis, particularly in today’s economic environment. The consultation therefore sets out proposals to partially exempt (FCPE) overseas intra-group financing companies applying a debt:equity ratio of 1:3, so long as certain conditions are met ie no significant upstream loans to the UK, or significant income earned on deposits with third parties. Consequently (on the basis that most of these finance companies are wholly equity funded), an effective tax rate of 5.75% would be applicable. The consultation also suggests that it may look to situations where there would be justification for full exemption.
These proposals I believe are targeted (allowing only incidental income in the TBE) and also generous (the FCPE allowing an effective rate of tax of 5.75%). However, cash is fungible and it remains to be seen in practice how effective the new legislation will be at stopping the artificial movement of funding from the UK.
Intellectual property
The transfer of UK IP to low tax jurisdictions is a big issue for the government. Particularly when that IP has been developed in the UK, and benefitted from the generous R&D regime.
The new legislation
The consultation proposes two exemptions that will apply to IP, the focus is on designing IP legislation which will only tax artificially diverted UK profit; TBEs will be available to exempt CFCs involved in the exploitation of IP that does not pose a significant risk to the tax base. However, high risk areas such as IP which has been recently transferred from the UK or where the IP is effectively managed in the UK will be dealt with by the GPE.
Concentrating on high risk areas; the GPE will need to be considered where:
1. The CFC is involved in exploitation of IP which has been transferred from the UK in the last six years (or before this if the transfer has resulted in an apportionment or some other charge to UK tax in the last two years).
2. The CFC exploits IP and more than 50% of the expenditure in relation to the IP is with related parties in the UK, or 20% of the CFC’s income is from the UK.
3. Where the CFC is an IP money box, ie
4. Its income is passive and not in relation
5. To active exploitation.
Where IP has been transferred from the UK and is a high risk area, anyone applying the GPE will need to consider:
a. Whether the transfer would have taken place between independent persons under competitive conditions.
b. Whether the profits are commensurate with the activity of the CFC. The document goes as far as producing factors to be taken into account to determine whether the transfer is tax driven (at Annex E) e.g. ‘there is evidence of “hand holding” of the CFC by the UK’.
Detailed guidance will be published with the final legislation and there will be a clearance system.
In my opinion the proposals are far more realistic and proportionate than the original proposals suggested i.e. that where there was any kind of link to the UK then it should have the right to tax. However, the complexity of intellectual property in a globalised world, whereby R&D, maintenance and exploitation of IP could take place in many different countries, may make it impossible to ascertain exactly how much of the profits produced by the IP should be taxable in the UK.
General purpose exemption
The general purpose exemption (GPE) is an attempt to overcome the shortcomings of the motive test. It is consistent with the objective of moving towards a more territorial regime and will be proportionate in that only profits artificially diverted from the UK will be apportioned (therefore getting away from the current all or nothing motive test). There will be no default assumption that profits would have arisen in the UK, and genuine profits will not fall within the UK tax charge.
The GPE will exempt a CFC’s profits to the extent that they are commensurate with the activities undertaken, eg one person with limited experience operating a global treasury function in Ireland, where millions of pounds of profit are being generated by that CFC, may struggle to show that the activity being undertaken by the CFC is commensurate with the profit it receives.
Some commentators have said that the consultation process has taken too long ... I disagree ...
In essence when applying the GPE, an analysis of the CFC’s profits has to be undertaken (the consultation document provides a very useful diagram on page 42). Those profits that relate to foreign activity (territorial approach) and those profits that are commensurate with the CFC activity, will be exempt. Whereas any non-incidental investment income or any other excess profits that rightly belong to the UK will be apportioned to the UK.
The consultation document also suggests one possible way of calculating profits that are commensurate with CFC activity is to use Art 7 of the OECD Model Tax Convention ie determine the assets and risks that the CFC would more likely than not own and bear under uncontrolled conditions. The profits that accrue to these assets and risks will be commensurate profits together with the profits arising to the CFC in relation to the activities it actually performs.
On first glance at the GPE it certainly does overcome the problems of the ‘all or nothing’ motive test and the default position that profits of the CFC (if it did not exist) would arise in the UK. For example a CFC under the current regime may have 35% of income being regarded as passive or bad income (eg upstream loans to the UK) with the other 65% being good income. The bad income may be enough for the CFC to fail the motive test and all of its income would be taxed in the UK; under the new regime only 35% would be taxed in the UK.
The areas in my opinion which are going to be difficult in applying the GPE is calculating the profits that are commensurate with CFC activity (under Art 7) and how the term ‘more likely than not’ will be applied. Although the consultation document is not suggesting that the GPE will be bound by Art 7, any practitioner and HMRC official trying to calculate profits that are commensurate with CFC activity will have to be very familiar with the contents of Art 7, and then try to apply to some unique business situations the principles contained therein. I can see some pretty protracted arguments in the future when this part of the test is applied.
Conclusion
The government wants the CFC rules to work so as to protect the UK tax base without distorting or inhibiting the way in which groups manage their commercial operations overseas. The great difficulty with this consultation process has been the complexity involved; formulating rules, which will suit companies in many different industries; from pharmaceutical companies to banks to mining companies (which all require different consideration) is a huge challenge. The government has also recognised that mechanical legislation is not always the best way to protect the UK tax base as in some cases it has been seen in the past that legislation can be easily planned around. Therefore the possible step towards a more principles based legislation must also be seen as a positive one.
Some commentators have said that the consultation process has taken too long and that the proposed legislation will be too complex, I disagree on both counts. The legislation is dealing with some of the most complex cross-border transactions and structures and providing certainty in relation to whether a situation is caught by the legislation or not cannot be dealt with in a few pages. With regards to the time the consultation has taken; there has been so much pressure to get this legislation right (threat of further inversions) and indeed a change of government and a financial crisis in the process, that I do not feel that four years has been too long to wait (the interim changes deal with some of the problems of the current legislation).
In my opinion the policy objectives set by the government seem to have (so far) been met and it seems to me that business should be happy with the result. However, we will have to wait and see whether the final legislation delivers all that is promised ie providing flexibility for overseas trade for companies based in the UK while ensuring that profits which belong in the UK, stay in the UK.
Maven Partners is a specialized taxation and financial advisory recruitment business.
Des Hanna is the managing director of Consilium Tax. He has over 15 years tax experience spent in practice, the retail industry, the property industry, banking and within the large business service and international division of HMRC where he was a senior international tax specialist involved in technical and policy issues concerning many areas of international tax. He also acted as a specialist technical adviser in some of the largest enquires in UK history, some of which were litigated but the majority were settled. He is a qualified accountant, a member of the chartered institute of tax and has recently completed the advanced diploma in international tax (ADIT).
Des can be contacted at des.hanna@consiliumtax.com | www.consilliumtax.com
