Controlled foreign companies (CFCs) in low tax jurisdictions are a headache for tax authorities, with the potential for profit to be earned at a low tax rate and not contribute to the coffers of the government of the parent company’s location. The potential for profits to be perhaps relocated to the lower tax jurisdiction has resulted in rules to stop such relocation. In the US, the rules are known as Subpart F; in the UK, they are simply the CFC rules.
In both cases, the result of the rules is some or all of the profits of the CFC are attributed to the parent/shareholder, and so become subject to that in that way in the parent/shareholder’s country. In the UK (and elsewhere) these rules haven’t quite kept up with the changes in the way in which businesses – particularly multinationals – are run, and it has become clear over the last decade or so that something needs to change.
Perhaps unsurprisingly, income from IP is one of the concerns with CFCs – IP doesn’t pass any border controls when you move it from one owner to another.
The latest CFC reform document is a start at a comprehensive overhaul of a system that ceased to be fit for purpose some years ago; for that alone, it should be applauded, although the detail still needs to be considered carefully before the applause goes on for too long.
There are three key features to the proposed reform:
- the CFC charge should apply to artificially diverted UK profits;
- foreign profits should be exempted where there is no artificial diversion of UK profits; and
- profits from genuine economic activity offshore should not be subject to UK tax.
All three obviously overlap somewhat and, of course, remain with the budgetary constraints set by the Treasury – no new money has been found to relax the system further.
Something things remain much the same
There is still the three-stage structure –
- is there a controlled foreign company in a low tax jurisdiction (less than 75% of equivalent UK corporation tax)?
- if so, do any exemptions apply?
- and how much profit is attributed to the UK company?
The definition of “control” for CFC purposes is open for consultation, with different approaches being considered, but nothing definite has been settled on that. The question of whether loans can give control is being looked at as part of this.
The main changes are with the exemptions. Some of the old exemptions have been gone for a couple of years now, rendered obsolete with the introduction of the foreign dividend exemption. Finance Act 2011 has introduced a couple of new exemptions – for foreign-to-foreign trading and IP holding companies – as well as extending the period of grace for acquisitions and restructuring, and increasing the de minimis from £50,000 to a slightly more helpful £200,000. The consultation document discusses the possibility of raising this, perhaps in line with the size of a group, so that it changes according to the perceived risk levels.
The main new exemption introduced in the consultation document is the well-trailed finance company partial exemption, which caused consternation to the Guardian and others when it was realised that this exemption will lead to an effective 5.75% tax rate for UK companies on the finance income of non-UK group companies.
Three territorial business exemptions are also introduced in the consultation document:
- a safe harbour for low profits: where the CFCs profits are 10% or less than its profits base
- an exemption for manufacturing companies
- an exemption for commercial activities
In all cases, there must not be an arrangement to divert profits from the UK.
The consultation document discusses an excluded countries exemption, to exclude CFCs with a low risk of artificial diversion of UK profits. There are various possibilities put forward, including a list of territories (perhaps with conditions attached in some cases), general non-territory specific conditions, or a(nother) targeted anti-avoidance rule.
Finally, there is to be a new general purpose exemption to replace the infamous motive test (which is almost impossible to satisfy). We will have to wait for the general purpose exemption to come into force to see whether it really will be more accessible than the motive test but it is certainly a step in the right direction that there is now a statement that there will be no automatic assumption that profits would have been earned in the UK if the CFC did not exist.
The general purpose exemption is intended to be flexible, so that a CFC can show that (on its own facts and merits) that a UK company should not be subject to tax on some or all of the profits of the CFC. The exemption requires that the CFC have an establishment, with sufficient management (in quantity and seniority, perhaps following the “significant people” idea in attribution of profits to permanent establishments, under the OECD guidelines). If that’s the case, then the UK company will be exempt from tax on the profits of the CFC so far as:
- the profits are in line with the CFC’s activities and aren’t artificially diverted form the UK (perhaps to be tested against transfer pricing-style arm’s length arrangements); or
- where profits are above that arm’s length hurdle, those profits aren’t diverted from a UK company or from non-incidental investment income
What does this mean for IP?
There’s no further exemption from IP to add to the foreign-to-foreign IP holding company exemption in Finance Act 2011, so CFCs with IP that don’t meet that exemption will need to look at the territorial exemption and the general purpose exemption for their UK parents or associates to escape UK corporation tax on the CFCs profits.
The main territorial business exemption that’s likely to apply to IP companies is the commercial activities exemption, as “commercial activities” can include the exploitation of non-UK IP (again, provided that this isn’t part of arrangements to divert profit from the UK). There will be similar restrictions to those in the foreign-to-foreign exemption, so that profits from IP which has been owned in the UK in the previous six years won’t be exempt. Similarly, where more than 50% of the expenditure on IP is in the UK, or more than 20% of the IP income is from the UK, the exemption is not likely to be available.
There have been suggestions that some form of tapering may apply, so that IP can be burnt out – where the IP is continually developed, the IP that leaves the UK on a transfer to a CFC may look very different to the IP that is owned by the CFC a few years later. In this sort of scenario, it has been suggested that the proportion of profits that would be subject to UK tax under the CFC rules should decline, to reflect the investment by the CFC outside the UK. HMRC aren’t enamoured of this idea (perhaps because it would not be easy to put into statute), but part of the point of consultation is to convince HMRC!