Controlled foreign company reform an update

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International Tax Services Controlled foreign company reform an update On 6 December 2011 HMRC published the document Controlled Foreign Company (CFC) Reform response to consultation together with

1 International Tax Services Controlled foreign company reform an update On 6 December 2011 HMRC published the document Controlled Foreign Company (CFC) Reform response to consultation together with most of the draft legislation on the full reform of the CFC rules. On 31 January HMRC published a policy update document and revised draft legislation for the reform of the CFC rules. The revised legislation includes the rules applicable to exempt foreign permanent establishments and amended rules for the treatment of finance profits, including two circumstances in which full exemption will be available for financing company profits. The remainder of the draft legislation is broadly as originally published, with some changes for how the rules will apply to the finance sector. These are not considered in this alert. The policy update document includes details on the new rules relating to the temporary period of exemption, the commencement provisions and potential changes to the Gateway that would provide clear entry conditions, but legislation for each of these areas has not yet been published. Gateway The Gateway is intended to exclude all companies from the scope of the CFC charge other than those with the highest risk of artificial diversion of UK profits, without consideration of further detailed exemptions being required. In response to feedback that HMRC has received on the proposed legislation, a working group is focusing specifically on developing the Gateway to provide clear entry conditions which work on a qualitative basis and allow groups to be able to quickly assess whether a foreign subsidiary is outside the scope of the rules. This is a welcome development that should reduce the need for companies to carry out detailed calculations required under the current

2 Gateway, except in circumstances where there is a reasonable probability that a charge will arise. HMRC has confirmed that revised draft legislation on the Gateway will be shared with business when it is available. Temporary period exemption (TPE) HMRC has confirmed that it intends to preserve a time limited exemption as part of the new CFC regime to deal with acquisitions and certain reorganisations, for example where a foreign company becomes a UK CFC for the first time following the acquisition by a UK group company, or a move to the UK by a non-uk group. However, whilst the existing TPE applies for up to three years from the date on which the foreign company becomes a CFC, it is proposed that the new TPE will apply for an initial 12 month period (with potential for extension) and will be subject to the CFC undertaking any restructuring necessary so that no CFC charge arises in subsequent periods. HMRC has confirmed that it is intended that a CFC that is fully exempt under the existing TPE rules, or that obtains a TPE before the rules in Finance Act 2011 are repealed, will continue to be exempt until the temporary period ends. At that point the new CFC rules will apply. Commencement provisions HMRC is proposing that the new rules should apply to accounting periods commencing on or after 1 January 2013, and that the commencement rule will operate by reference to the CFC s accounting period rather than that of the UK controlling company. Exemption for profits from qualifying loan relationships The draft legislation published on 6 December 2011 includes partial exemption rules for profits arising on qualifying loan relationships, reducing the effective CFC tax rate on non-trading finance profits on qualifying loans to one quarter of the UK corporation tax headline rate. This will result in such profits being subject to tax at an effective tax rate of 5.75% from 1 April The legislation has now been updated to include two sets of circumstances where non-trading finance profits on qualifying loans will be fully exempt from the charge to tax. The circumstances are: Where profits arise from loans that are funded out of qualifying resources (the intention being that these are loans created in a way that makes no demands upon group funds originating outside the borrowing company s territory of residence), and Where a CFC charge would cause the group s UK financing income to exceed its UK financing expense. The definition of qualifying loan relationship is broadly the same as before. However, the new rules include a targeted restriction to prevent a loan relationship from being a qualifying loan relationship if it is paid as part of an arrangement to replace foreign external debt with UK debt, and the main purpose or one of the main purposes of the arrangement is to obtain a tax advantage for any person. Controlled foreign company reform an update 2

3 Qualifying resources Full exemption will be available for profits arising on loans that are funded out of qualifying resources. Qualifying resources are any of the following: 1. Funds arising from lending to group companies in the same territory as the ultimate borrower s territory of residence. 2. Funds derived directly or indirectly from an issue of shares to the group s shareholders. 3. Funds received by the company in relation to shares held by the company, but only to the extent that the funds are derived directly or indirectly from specific funds. In 3, if the company making the loan derives funds from shares it holds in a group company, they are qualifying resources if they are derived directly or indirectly by the company from the following sources: profits from the group s operations in the ultimate borrower s territory of residence, excluding any profits derived from lending to or holding equity investments in group companies outside the relevant territory, or amounts that reflect consideration given by the group in a share for share exchange. A share for share exchange refers to the acquisition of shares in a company from unconnected shareholders in exchange for newly issued shares. Where a purchase is made partly for shares and partly for other consideration, or where an extraordinary dividend is paid to shareholders in connection with the share for share exchange, only a proportion of the value derived from the transaction represents qualifying resources. Appropriately structured leverage dividends transactions could fall within number 3 above, although it is noted that, as currently drafted, the receivable would no longer qualify if subsequently assigned to another group company which didn t own shares in the borrower group. A restriction to qualifying resources applies where the loan is created as part of an arrangement that directly or indirectly results in new debt in the UK. The loan will not be treated as arising from qualifying resources to the extent that it is linked with the new UK debt. Full exemption for qualifying loan relationships funded out of qualifying resources will only be available if a claim is made to HMRC. If full exemption is claimed, profits from a qualifying loan relationship will be fully exempt to the extent that the loan is funded from qualifying resources. To the extent that the qualifying loan relationship is funded from other resources, the profits from those funds will be fully taxable i.e. it will not be possible for the full and partial exemption regime to apply at the same time on the same loan. Therefore, it will only be worthwhile claiming the full exemption if at least three quarters of the funds used to create the loan are from qualifying resources. Otherwise, partial exemption will result in a lower CFC charge. Controlled foreign company reform an update 3

4 Matched interest The matched interest rule reduces the CFC charge on partially exempt qualifying loan relationship profits to the aggregate net borrowing costs of the UK group. The rules apply with reference to the worldwide debt cap. If the tested income amount for the period of account is equal to or exceeds the tested expense amount before any CFC charge on partially exempt qualifying loan relationship profits is made then the CFC charge is reduced to nil. If the tested income amount for the period of account would exceed the tested expense amount as a result of CFC charges on partially exempt qualifying loan relationship profits, a proportion of each CFC charge will be exempt across the group such that the tested income amount equals the tested expense amount. The matched interest rule is considered after any claim to partial or full exemption and will be of particular benefit to groups that have no or little aggregate net borrowing costs in the UK to limit the CFC charge on profits from qualifying loan relationships. Foreign permanent establishments The exemption for profits attributable to foreign permanent establishments (PE) was introduced in Finance Act The current provisions include an anti-diversion rule, which reflects the lower level of tax test and the motive test in the current CFC legislation. Under the revised legislation the existing anti-diversion rule is repealed and replaced by legislation that reflects the new CFC rules. The new anti-diversion rule will prevent profits from being exempt if profits are diverted profits, and none of the exemptions apply. Diverted profits are defined by reference to the definition of chargeable profits. The first step in determining whether there are any diverted profits is to establish whether the company with the foreign PE has any profits that would be chargeable profits if it were not UK tax resident. The second step is then to determine whether any of those profits are attributable to the foreign PE. The exemptions from the new anti-diversion rule which could apply are the low profits exemption, low profit margin exemption, excluded territories exemption, the tax exemption (new lower level of tax test). The Gateway can also apply to restrict chargeable profits to those attributed to a UK significant people function. Profits from investment business Where a foreign PE has profits from an investment business, exemption of this income will be restricted to amounts arising from assets that are effectively connected to a trade or property business carried on in the overseas territory. Controlled foreign company reform an update 4

5 Ernst & Young LLP Assurance Tax Transactions Advisory Profits that are incidental to a trade or property business will qualify for exemption to the same extent as those profits would be exempt from the CFC charge. Finance profits in excess of allowed amounts may qualify for full or partial exemption although this is not yet reflected in the draft legislation. As expected, exemption will not be available for foreign PEs that undertake pure financing activities. Changes to the existing legislation Under the current rules, an election for the PE exemption to apply must be made in an accounting period of the company. The proposed changes to the legislation mean that it will be possible for an election to be made before a company s first accounting period. This will mean that newly incorporated companies will be able to benefit from the PE exemption from the start of the first accounting period. A balancing adjustment is required for transfers of plant and machinery to a PE. The proposed changes mean that this will not apply where the transfer occurs due to the transfer of a lease and the profits from the lease are excluded from the PE exemption. Response to consultation The deadline for responses to the consultation remains 10 February HMRC recognises that this is a much shorter period than is generally available. If comments on the new legislation cannot be made by the deadline, HMRC has asked that they are submitted as soon as possible after that date. Further information For further information, please contact one of the following or your usual Ernst & Young contact: Alison Christian achristian@uk.ey.com About Ernst & Young Ernst & Young is a global leader in assurance, tax, transaction and advisory services. Worldwide, our 152,000 people are united by our shared values and an unwavering commitment to quality. We make a difference by helping our people, our clients and our wider communities achieve their potential. For more information, please visit Ernst & Young refers to the global organisation of member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. Gay Deuchar gdeuchar@uk.ey.com Ruth Donaldson rdonaldson@uk.ey.com David Evans devans@uk.ey.com Lawrence Hall lhall11@uk.ey.com Noam Handler nhandler@uk.ey.com Shaun Lucey slucey@uk.ey.com Amber Mace amace1@uk.ey.com Craig McAree cmcaree@uk.ey.com Matthew Mealey mmealey@uk.ey.com Matthew Newnes mnewnes@uk.ey.com Jason Short jshort@uk.ey.com Fiona Thomson fthomson@uk.ey.com Gill Turner gturner@uk.ey.com The UK firm Ernst & Young LLP is a limited liability partnership registered in England and Wales with registered number OC and is a member firm of Ernst & Young Global Limited. Ernst & Young LLP, 1 More London Place, London SE1 2AF. Ernst & Young LLP Published in the UK. All Rights Reserved. Information in this publication is intended to provide only a general outline of the subjects covered. It should neither be regarded as comprehensive nor sufficient for making decisions, nor should it be used in place of professional advice. Ernst & Young LLP accepts no responsibility for any loss arising from any action taken or not taken by anyone using this material.. Steve Wasley swasley@uk.ey.com Duncan Whitecross dwhitecross@uk.ey.com Controlled foreign company reform an update 5

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