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Sweeping CFC Reforms will affect International Groups

UK companies with overseas subsidiaries or associates need to understand how significant changes to the UK’s controlled foreign companies (‘CFC’) rules will affect them so that their tax position is optimised. The changes are expected to come into effect later this year.

19/01/2012

Reform of the UK’s CFC rules is finally nearing its conclusion. The Government’s stated aim of the new rules is to prevent groups “artificially” diverting profits from a UK company to a foreign group company. When the CFC rules apply,  those diverted profits will be taxed on a UK member of the group. The driving forces behind the reform are both defensive and opportunistic: repairing the rules after successful challenges at the European Court of Justice, recognition of the need to modernise the rules and, on the positive side, a desire to increase the attractiveness of the UK as a tax friendly location for international groups. 

The first set of draft legislation was issued in December 2011, with more promised later this month. We have yet to see the draft legislation for the widely anticipated finance company partial exemption, which promises an effective UK tax rate of only 5.75% on offshore group finance company profits by 2014. We expect this will offer an opportunity for UK groups to reduce their global effective rate of tax.

The proposals that have been published so far are a mix of a more ‘territorial’ approach combined with some more familiar feeling entity based exemptions. A significant shift is the introduction of a Gateway test, intended to define those profits which will be caught – i.e. artificially diverted profits.  If profits do not fall within the Gateway definitions they will not be caught. There are separate Gateway tests for business profits and finance profits, but the underlying theme is identifying profits realised overseas as a result of UK activity (referred to as significant people functions’ or SPFs for short). For business profits, where there is a separation of key assets and risks from SPFs which is tax motivated and would not have taken place between independent enterprises, the profits will be regarded as artificially diverted. This approach is novel and it will remain to be seen how easy it is to apply in practice.

However, groups have other options.  In addition to the Gateway test, there are ‘safe harbours’ and entity based exemptions that can remove certain profits or whole companies from the scope of the CFC rules. These are more mechanical rules, specifying strict conditions which must be met for the exemption to apply. As such they are more familiar and some do broadly replicate current exemptions of a similar nature. 

One welcome development is the exclusion of property income under a property safe harbour.  Trading companies are excluded by a safe harbour provided detailed requirements are met as regards having local business premises and not breaching limits on the amount of income and management expenditure connected with the UK. However, the safe harbour is denied where valuable IP has been transferred from the UK in the previous six years, or where targeted anti-avoidance applies. Incidental finance income is covered by a separate safe harbour and will exempt finance income up to 5% of profits before interest and tax, or greater amounts where it arises from funds held for the purpose of the company’s business. This will be of interest not only to traders, but to property companies and holding companies. Consultation is ongoing regarding banking and insurance safe harbours.

Entity based exemptions as currently proposed are summarised in broad terms below:

  • Low profits exemption –the CFC’s accounting profits are less than £500k and any non-trading income is less than £50k, so is a valuable exemption to smaller companies. However, anti-avoidance provisions apply to prevent abuse.
  • The excluded territories exemption – similar to the current excluded countries regulations and will apply where the headline rate of tax in the CFC’s territory of residence is greater than 75% of the UK main corporation tax rate, subject to exclusions for low taxed income as defined if this exceeds 10% of accounting profits or £50k. Again, the exemption will not apply if valuable IP has been transferred within the previous six years.
  • The tax exemption - effectively turns the current not ‘subject to a lower rate of tax’ get out into a statutory exemption. Provided the foreign tax payable on profits is at least 75% of the UK tax the CFC would pay under UK tax rules, the CFC will be excluded. However, this does not apply where the foreign tax rates can be manipulated through a ‘designer’ tax rate.

The temporary period exemption, which applies following the acquisition of foreign companies by a UK company, is still under consideration.

What should groups be doing?

The proposals are detailed and complex, with more to follow.  Whilst we can expect changes as a result of the ongoing consultation process, we now have a much clearer picture of the landscape ahead. As the changes are expected to be introduced in Finance Act 2012, groups need to be prepared for their impact. This means reviewing all foreign subsidiaries and JV companies to assess which companies are expected to be excluded (provided the ongoing conditions are likely to be met) and those which have profits which are likely to be apportionable on a direct or indirect UK shareholder of the CFC. Attention can then be focused on problem areas with a view to considering how the tax efficiency of the group can be improved. This will need to be considered hand in hand with the partial finance company exemption proposals when these are published later this month.

For more information please contact Rosemary Blundell .

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