Foreign Profits Reform – Finance Bill 2009 Update - Mazars - United Kingdom

The Finance Bill 2009 includes draft provisions at Schedules 14 to 17 in respect of the proposed reforms of the taxation of foreign profits of companies. The draft provisions in respect of the worldwide debt cap in particular have been significantly changed and are improved on the previous draft which contained many anomalies.

Nevertheless, the debt cap provisions are still incomplete, with a Ministerial statement published shortly after the Finance Bill highlighting areas on which draft legislation is yet to be developed, including, for example, provisions to make clear that transfer pricing rules under Schedule 28AA ICTA 1988 will apply prior to application of the debt cap. The debt cap will not apply until accounting periods commencing on or after 1 January 2010, whereas the other provisions come into effect from 1 July 2009.

One development from the previous draft legislation is the abandonment of the proposals to extend the anti-avoidance provision for loan relationships and derivatives in respect of ‘unallowable’ purposes.

The draft legislation is complex and will apply to many groups – including to wholly domestic UK groups (except for the controlled foreign companies provisions).

Key points are set out below. However, groups will need to carefully assess what these changes will mean to them to avoid increasing their tax liabilities unnecessarily. In certain areas, the need to review the position is now urgent.

Distribution Exemption

Under the proposals, dividends received by UK companies and UK permanent establishments that are large or medium sized will, in most cases, be exempt from tax regardless of the source. A significant change since the original proposals is that small companies will benefit fully from the distribution exemption (previously proposed to restrict the exemption to dividends from portfolio holdings). The distribution exemption will apply to dividends received on or after 1 July 2009.

• Income distributions will be taxable but most will then qualify for an exemption (subject to anti-avoidance). There is no minimum shareholding requirement, or minimum period for which the shares have to be held.
• Capital distributions (e.g. from a company in liquidation) will continue to be taxed under the chargeable gains regime.
• Dividends will not be exempt if the payer gets a tax deduction, where the distribution is interest in excess of a commercial rate of interest or where the dividend is taxed under another ‘head’ e.g. as trading income.
• It will also be possible to opt out of the exemption, but this will only be likely to be of relevance where a CFC pays an ADP (for an AP beginning before 1 July 2009) or to obtain the treaty rate of withholding tax where the DTA requires the dividend to be ‘subject to tax’ in the recipient’s territory.
• A significant change to the original proposals is to include ‘small’ companies within the exemption, but with a different set of rules to large and medium sized companies. For small companies, the distribution exemption will apply provided certain conditions are met – principally that the paying company must be resident in a ‘qualifying territory’ and the payer should not obtain a tax deduction for the dividend. The small companies exemption has its own mini anti-avoidance rule in that the distribution must not be part of a tax advantage scheme.
• A ‘small’ company follows the Commission Recommendation 2003/361/EC of 6 May 2003 but with the modification that none of the following are ‘small’ companies:
  • Open ended investment companies;
  • Authorised unit trusts;
  • Insurance companies;
  • Friendly societies.
• A ‘small’ company is one with:
  • fewer than 50 employees, and annual turnover,
  • or balance sheet total not exceeding €10 million

As usual, these tests are applied to the group as a whole.

• For large and medium sized companies, there are five ‘exempt classes’ of dividend. Exemption need only be obtained under any one of the classes. However, it is advisable to check group shareholdings prior to dividend payments to confirm which exemption will apply, and also that it will not be denied by virtue of the anti-avoidance provisions.

The five classes of exemption are:

1. Dividends and other distributions from controlled companies
2. Dividends and other distributions in respect of non-redeemable ordinary shares
3. Most portfolio dividends and other distributions
4. Dividends derived from transactions not designed to reduce tax
5. Dividends from shareholdings accounted for as liabilities

• It may be necessary to seek advance clearance that the exemption will apply to some distributions.
• To prevent potential avoidance schemes, especially those involving diversion of profits overseas, there are three targeted anti-avoidance provisions in respect of specific exemptions whereby that exemption will not be available where tax avoidance is a purpose of a scheme of which the main purpose, or one of the main purposes, is to obtain a tax advantage. In addition, there are four general anti-avoidance rules.

Worldwide Debt Cap

Subject to the many exceptions, the objective of these proposals is that the net financing cost that is deductible in computing profits or losses within the charge to UK tax should be no greater than the worldwide group’s consolidated gross finance expense. The debt cap has been introduced in conjunction with the distribution exemption; the expressed reason being to limit the cost to the UK Treasury of the distribution exemption. A ‘gateway’ test prevents the debt cap applying where UK average net debt is less than 75% of the average worldwide gross debt.

The commencement date depends on the accounting date of the company. It will first apply to accounting periods of companies that commence on or after 1 January 2010. There is no splitting of accounting periods. So a group with a 31 March year end will first come within the legislation for its year to 31 March 2011. Planning should be considered now, particularly in conjunction with the post 30 June 2009 exemption for foreign dividend income.

As the legislation is still very much developing in this area, caution must be taken as further significant changes are anticipated.

Key points to note include:

• A stand alone company which is not a member of a 75% group will never be subject to the debt cap legislation. So a joint venture company, for example, will not be affected.
• The rules require at least one member of the group to be other than a company that is micro, small or medium sized, as these terms are defined in EC Commission Recommendation 2003/361/EC. Broadly, a company’s size will cause a group to come within the debt cap rules if firstly its headcount is 250 or more, and secondly either its turnover is over €50m, or its gross balance sheet assets are over €43m. Again, this test needs to be applied annually, so for groups at the margin of medium/large, it will be possible to move in and out of scope of the regime in the same way this possibility exists for transfer pricing.
• The debt cap will not apply under the ‘Gateway test’ if the total of the UK companies and UK permanent establishments net debt is no greater than 75% of the group’s worldwide “gross debt” (using average values).
• Under the Gateway test in Para 3, Part 2, Schedule 15, there is a de minimis rule which applies if the average of the net debt of a company is less than £3m and treats such companies as having a nil amount of net debt in the UK. Dormants are also excluded if they meet certain conditions.
• If the Gateway test is not passed, such that the debt cap provisions come into play the group’s UK corporation tax relief for interest expense will be restricted by the amount that the “tested amount” exceeds the “available amount” (known as the total disallowed amount). Broadly speaking, the tested amount is the total of the amounts of net finance expense of group members’ activities that are within the charge to UK corporation tax, and the available amount is the gross finance expense of the worldwide group.
• Subject to limitations, when a group suffers a debt cap disallowance, and there are UK members of the group with net finance income, the net finance income will be exempt from tax.
• In general terms, the disallowance of tax deducible finance expense in the group as a whole will be the amount by which the aggregate net finance expense of the UK activity exceeds the gross finance expense of the worldwide group. However, this is a simplification as, for instance, companies which fall below a £500k de minimis of finance income or finance expense are ignored.
• There are exclusions for group treasury companies, short term loans and financial services sector companies.
• Anti-avoidance provisions apply to block the use of ‘schemes’ to get round the rules.

Controlled Foreign Companies

The CFC reforms in Finance Bill 2009 are only temporary measures pending more sweeping changes to come – likely to be in 2011. The current proposals are limited to the abolition of the acceptable distribution policy (ADP) and the non-local holding company exemptions in the exempt activities test. Both changes are significant, but the repeal of the non- local holding company exemptions may have a significant impact on tiered group structures. There is two year transitional period for exempt international and superior holding companies, but given the conditions which must be met, groups must not assume they will be able to benefit from this. It is good news however that the exemption for local holding companies will now be retained. The changes apply from 1 July 2009 and there are transitional rules dealing with straddling accounting periods.

Key points to note are:

• The acceptable distribution policy (ADP) exemption will be repealed for accounting periods beginning on or after 1 July 2009. It will still be possible to pay an ADP in respect of all accounting periods (including the first portion of the straddling period) ending before 1 July 2009. Where a CFC pays an ADP on or after 1 July 2009, it will not be exempt from tax under the distribution exemption.
• The non-local holding company exemptions will be abolished from 1 July 2009 (subject to transitional rules), but the local holding company exemption will now be retained.
• A two-year transitional period to 1 July 2011 is available for ‘qualifying holding companies’ (QHC) which meet certain additional tests in order to allow groups time to restructure. Qualifying holding companies therefore cease being exempt under the IHC or SHC exemptions from 1 July 2011.
• In order to be a ‘qualifying holding company’ the holding company must have been an exempt holding company throughout its last accounting period to end before 1 July 2009 (not including the deemed AP where an AP straddles 1 July 2009). In other words, it must have qualified as an exempt international or superior holding company. Therefore, the holding company’s last accounting period before 1 July 2009 will be critical in determining whether the two year period of grace is available or not.
• If a QHC satisfies certain additional requirements in the two year transitional period as regards its income and ownership, it will continue to be exempt.

Treasury Consents

Treasury consents and the equivalent EU reporting requirements will be abolished. A new quarterly reporting requirement will be introduced which will require a report to be made within six months of a reportable event or transaction taking place, where this is on or after 1 July 2009. The report will need to be made by the top UK resident holding company in the group, regardless of whether or not the group is UK parented. Reportable events will be restricted to transactions exceeding £100 million, or where it is otherwise specified in the legislation and include:

• An issue of shares or debentures by a foreign subsidiary;
• A transfer of shares or debentures of a foreign subsidiary;
• A foreign subsidiary becoming, or ceasing to be, a controlling partner in a partnership.

There will be some exclusions from the reporting requirement, such as where the transaction is carried out in the ordinary course of the trade. Failure to comply will be subject to a penalty.

Conclusions

These reforms will have a significant impact on some groups and the tax efficiency financing arrangements and of group structures where the non-local holding company exemptions in the CFC regime have been removed. It is important groups understand how these provisions apply to their particular circumstances so their tax position can be optimised.

Professional advice should be taken before any action is taken.

Mazars LLP accept no responsibility for any action which any individual or business may take or not take based on their reading of this article.