UK Controlled Foreign Company Reform

Transcription

1 Consultation Document on Permanent Changes to the Controlled Foreign Company Rules SUMMARY On 30 June 2011 HM Treasury and the UK tax authorities, HM Revenue and Customs, issued a further consultation document as the next stage in the process of reforming the UK s controlled foreign company ( CFC ) rules. The consultation document sets out the framework for a new regime in quite some detail, although many points remain open. While still complicated, the regime as proposed improves on the current one in several respects. The government is looking to bring in the new rules from mid- to late What s new? The definition of control is now in play Most exemptions are now partial, rather than covering all the CFC s income The exempt activities test and the limited UK connection exemptions brought in by the Finance Act 2011 have been remodelled Overseas property rental and big-ticket operating leases are no longer classed as investment, which represents a relaxation of the previous position There is more detail on the finance company partial exemption and the government is considering a full exemption for some cases A general purpose exemption will replace the much-criticised motive test New York Washington, D.C. Los Angeles Palo Alto London Paris Frankfurt Tokyo Hong Kong Beijing Melbourne Sydney

2 BACKGROUND The story so far The process of reforming the UK s CFC rules started life as part of the wider project to reform its treatment of foreign profits generally. The government published a discussion document in July 2007 proposing a new dividend exemption, changes to the rules on relief for interest payments and replacement of the old Treasury consent rules with reporting requirements. At the same time, the government proposed moving from the existing entity-based CFC rules to an income-based controlled companies regime. This was intended in part as a revenue-raising measure to counterbalance the dividend exemption. In addition, the CFC rules were under attack on the basis that they were not compliant with EU law. The government proposed to deal with this by extending the rules to UK subsidiaries. The CFC proposals met with fierce resistance from business. One of the aims of the foreign profits package was to encourage multinationals to remain in, or come to, the UK. But one of the key factors cited by groups redomiciling out of the UK was the burden of the UK s CFC regime. In response to these concerns, the government made only minor changes to the CFC rules as part of the foreign profits package enacted in Fundamental CFC reform was tackled separately. By spring 2010, it had become clear that this would take longer than the government had expected. CFC reform was again divided into two: limited interim improvements to the current regime, now enacted in the Finance Act 2011; and root-andbranch reform, to form part of the Finance Act Changes to the CFC regime: Finance Act 2007: qualifying work exemption; removal of public quotation exemption Finance Act 2008: changes to control Finance Act 2009: foreign profits changes Finance Act 2011: interim improvements Finance Act 2012: new regime? Now read on Four years on, and many discussion papers and working group meetings later, the government has published its blueprint for the new regime. 1 The consultation document is considerably more detailed and comprehensive than anything the government has published as part of the consultation process so far. 2 It runs to 110 pages and contains 80 questions. The number of questions shows that the reforms are still very much a work in progress. The deadline for responses is 22 September. 1 2 The consultation document and related materials are available on the HM Treasury website at: See our client memoranda of 8 January 2009, 5 February 2010, 2 August 2010, 2 February 2011 and 22 February 2011 on the earlier stages in the consultation. -2-

3 Reasons for change The proposed changes are intended: to make the UK s tax system more competitive; to ensure that the new rules comply with EU law; and to close loopholes in the existing regime. On the competitiveness front, the UK has moved towards a territorial system of taxation with the dividend exemption introduced in 2009 and the elective exemption for non-uk branches brought in by this year s Finance Act. 3 The government is also conscious that a CFC regime carries a significant compliance burden. On the other hand, the increased sophistication of the UK s transfer pricing rules has reduced the pressure on the CFC regime. Meanwhile, the European Court of Justice and the UK courts have seen challenges to the UK s CFC rules as infringing the EU law right to freedom of establishment. The Court of Appeal sought to resolve this by reading in a new exemption to the UK legislation reflecting the rulings of the European Court of Justice. The full implications of this remain to be explored because that case subsequently settled. 4 While the cases were going through the courts the government made its own attempt to EU-proof the UK regime, by allowing companies to apply to reduce the charge where staff of the CFC carry out qualifying work in a member state of the European Economic Area. (The European Commission has now sent the UK government a reasoned opinion that this provision does not go far enough.) The cases did, however, make it clear that taxpayers entering into wholly artificial arrangements may not be able to invoke EU law to protect themselves against national provisions. The desire to compete with other jurisdictions and the need to comply with EU law are both reflected in the government s focus on taxing only profits artificially diverted from the UK. However, the government s various aims may also conflict with each other: 3 4 It is possible to opt out of the dividend exemption; taxpayers must opt in to the branch exemption. In Vodafone 2 v Revenue and Customs Commissioners (No 2) [2009] EWCA Civ

4 Next steps Although the consultation came out a month later than intended, the government s intention is still to publish draft legislation in the autumn (likely to mean December) and enact the new regime in next year s Finance Act. It now considers that the earliest date from which the new rules could become effective is for accounting periods beginning on or after the date when Finance Bill 2012 receives Royal Assent (sometime in July 2012). It would not be surprising if the timetable slipped again. OVERVIEW Like the current regime, the new regime takes a three-step approach: Step 1: Identifying CFCs Step 2: Exempting some CFCs Step 3: Calculating a CFC charge. Step 1: Identifying CFCs As before, the regime will target companies resident outside the UK subject to a lower effective rate of tax than they would be in the UK and controlled by UK residents. The government proposes changing the definition of control and is considering the treatment of foreign transparent entities, such as limited liability companies in the US. 5 Step 2: Exempting CFCs As before, a CFC may benefit from one or several exemptions. However, the government proposes several changes. Move to partial exemptions. The old regime took a purely entity-based, all-or-nothing approach: if the CFC fell within an exemption, there was no charge. The Finance Act 2011 interim improvements saw a move towards partial exemptions. This continues in the proposals for the permanent regime. In part this is due to the focus on profits artificially diverted from the UK. As a result, a wider range of CFCs will benefit from some level of exemption. But a major reason is the crackdown on swamping. Here a CFC carries on trading activity and thereby benefits from exemption, which allows it to shelter finance income (or other investment income, such as royalty income) from a CFC charge. The size of the CFC s other activities is sufficient to swamp the finance income, so the exemption is not lost. The government s 5 In the recent decision of the Upper Tribunal in HMRC v Anson (FTC/39/2010) a Delaware LLC was found to be opaque in the UK, at least for the purposes of giving credit for foreign tax. The implications of this decision are discussed in our client memorandum of 24 August

5 response has been to exclude investment income from many of the exemptions, except where it is incidental to the CFC s other business. Incidental finance income. The consultation document sets out several options for defining incidental finance income: up to a fixed percentage of the CFC s profits; up to a fixed percentage of the CFC s gross income; a flexible definition which takes account of the CFC s actual need for working capital; or a combination of these. Incidental income from other investments. The government is considering whether the same limitation could be applied to all other investment income, including royalties, or whether there should be a separate limit for non-finance incidental investment income. Simple exemptions. Three of the exemptions are relatively simple to apply. These are intended to deal with specific situations where avoiding UK tax on profits is unlikely to have been a factor in choosing the CFC s jurisdiction of residence: where the CFC s profits are low the low profits exemption ; where it is resident in a jurisdiction where it is unlikely to pay less tax than in the UK the excluded countries exemption ; or where it was not previously controlled by UK residents the temporary period exemption. Exemptions of these types are already in place following the interim improvements of the Finance Act The consultation document proposes changes to the details of the first two. Complex exemptions. The remaining exemptions show more of a break with the old regime, not least because they may provide only partial exemption from a CFC charge. The new exemptions consist of: three territorial business exemptions or TBEs ; two sector-specific exemptions, for banking and insurance; a finance company partial exemption or FCPE ; and a general purpose exemption or GPE. To benefit from these a CFC must meet threshold conditions for local management and, in some cases, local establishment. In short, a brass plate non-uk company cannot qualify. -5-

6 The diagram below sketches the development of the exemptions from the old regime to the new. -6-

7 Step 3: Calculating a CFC charge The government proposes mostly minor changes here. Assuming that the CFC s profits are not fully exempt, its chargeable profits (that is, profits computed under UK tax rules, excluding capital gains 6 ) are calculated as if it were resident in the UK, except that any profits to which a partial exemption applies will be stripped out. (Under the current rules, all of the partial exemptions are available only on application to HMRC.) The consultation document outlines a few changes to make the rules here more sophisticated. Foreign and UK tax suffered on those profits is then computed, giving creditable tax. (To the extent that profits are exempted under a partial exemption, credit will not be available for the tax suffered on them.) The profits (and creditable tax) are apportioned to the substantial participators in the CFC, who may be direct or indirect shareholders. (The threshold will continue to be a 25% interest, including the interests of any affiliates.) Profits are apportioned to the UK participator(s) closest to the CFC in the chain of ownership. The participator(s) are then liable to a tax charge equivalent to corporation tax. It is intended that the new legislation will continue to eliminate any economic double taxation following an apportionment where: the UK participator disposes of shares (presumably, where the shares carry the ownership of the CFC, whether directly or indirectly); or the UK participator has received dividends from the CFC and elected to have them taxed, rather than claiming the benefit of the UK exemption for dividends and other corporate distributions. DEFINITION CFCs will still be defined as companies resident outside the UK subject to a lower effective rate of tax than they would be in the UK and controlled by UK residents. Residence will continue to be determined on the same principles as used for other UK tax purposes. Lower level of tax. The test currently asks whether the tax paid on the CFC s profits (ignoring capital gains) is less than 75% of the tax it would have paid if it were resident in the UK. Like the calculation of the CFC charge itself, this involves computing the CFC s chargeable profits as if it were UK-resident. The government has rejected suggestions that an accounting measure of profits might be used instead, but is open to discussion on how the computation might be simplified. The threshold will be maintained at 75%. 6 Capital gains are subject to a separate, narrower anti-avoidance rule. That is not being amended, although its compatibility with European Union law has been challenged by the European Commission. -7-

8 Control. The consultation document has put the definition of control into play. The current definition is a broad but mechanical one which looks at voting control and (since 2008) economic rights. It also treats certain large shareholdings in joint ventures as equivalent to control. The document suggests that the government is motivated by a desire to simplify the rules, rather than concerns about avoidance. The document puts forward three options: a principles-based approach; an accounting standards approach; and a more mechanical approach (similar to the current rules). The government is also looking to ensure that the rules deal appropriately with special types of entity, like protected cell companies ( PCCs ) and joint venture companies. PCCs, in particular, allow a taxpayer to obtain exclusive control of defined assets held in a corporate envelope, while arguing that it does not have control for CFC purposes. Finally, a concern has been raised that the breadth of the existing definition could mean that banks have control as a result of simply lending money. The government intends to address this. LOW PROFITS EXEMPTION Background CFCs with low profits pose little risk to the UK tax base. There has therefore long been a de minimis exemption for CFCs with chargeable profits below 50,000. The Finance Act 2011 introduced a further small profits exemption for CFCs with profits of up to 200,000 calculated on an accounts basis, subject to anti-avoidance rules. Proposal The consultation document builds on this new exemption. It puts forward three options: to retain the 200,000 limit with no additional conditions; to increase the limit to 500,000, but add a separate limit on investment income, perhaps to 50,000 or 10% of total income; to amend the limit to increase in line with the group s size (possibly by reference to a low percentage of total group turnover), subject to a minimum of 200,000 and a maximum of 1 million. The measure of profits would be the accounting profit with adjustments similar to those required for the small profits exemption introduced in the Finance Act There would be a targeted anti-avoidance rule ( TAAR ) to prevent exploitation of the exemption, for example by fragmentation of profits. -8-

9 The government is also seeking views on whether to retain the de minimis exemption. EXCLUDED COUNTRIES EXEMPTION Background The government recognises that carrying out a chargeable profits computation is not straightforward. The current CFC legislation provides an excluded countries exemption as a simpler proxy for the lower level of tax test. CFCs in certain jurisdictions (the excluded countries ) are or may be exempted from the CFC rules. For many companies this removes the need to carry out a computation. Proposal The new regime will have a similar exemption. The government is considering whether a jurisdiction should have a main rate of corporate tax no less than 75% of the UK rate as a threshold condition for excluded country status. But a similar main rate is not enough on its own: the tax base may be defined differently. There might also be specific low tax regimes for particular types of company or income. This may lead the UK to impose conditions on the application of the exemption to CFCs in some or all territories, as it has in the existing Excluded Countries Regulations. These conditions would be of two types: General conditions. These would prevent the exemption from applying to the proportion of the CFC s total income that arises from: transactions with the UK; investments; or the CFC s branches in lower-tax territories. Specific conditions. These would identify specific tax breaks in the territory and exclude those breaks from the exemption. As is the case with the existing Excluded Countries Regulations, a list of specific conditions would need to be updated regularly, causing some uncertainty and bringing resource costs for HMRC. The government has proposed a range of options of varying degrees of generosity, both in the categories to be covered by the exemption and in the conditions (general or specific) to be applied to them. The government proposes a targeted anti-avoidance rule to stop the exemption from being exploited in tax planning structures. The exemption will also need adapting for banking and insurance businesses. TEMPORARY PERIOD EXEMPTION Background The third low-risk category consists of companies of which UK residents gain control after a takeover or group reorganisation. -9-

10 Under the old regime, HMRC would sometimes give period of grace clearances in these circumstances on the basis of the motive test exemption. The interim improvements of Finance Act 2011 introduced a separate temporary exemption lasting up to three years. Anti-avoidance rules have the effect of making this a partial exemption. Proposal The temporary period exemption will be similar in scope and structure to the Finance Act 2011 temporary exemption. Any period of grace clearances already given will continue to run for the time envisaged, as will any temporary exemptions under the Finance Act TERRITORIAL BUSINESS EXEMPTIONS Background The territorial business exemptions are a step up in complexity. They are a remodelled version of the old exempt activities test and the two limited UK connection exemptions introduced as part of the interim improvements to the CFC regime. The government does not intend them to exempt investment activities, captive insurance, or any exploitation of intellectual property which in its view artificially diverts profits from the UK. Overview A CFC would have to pass a local management test to benefit from the TBEs. The government proposes three exemptions, with fairly mechanical conditions: Exemption 1: CFCs coming within a profits rate safe harbour; Exemption 2: CFCs carrying on a manufacturing trade; Exemption 3: CFCs carrying on commercial activities. The exemptions will cover investment (including finance) income only so far as it is incidental to the rest of the CFC s business, in order to prevent swamping. Local Management Condition Each exemption would be subject to a local management condition. This would require the CFC to be controlled and managed by sufficient staff of the necessary expertise and seniority. 7 The government intends to give further consideration to the treatment of CFCs managed by individuals based in a different jurisdiction, for example, where activities are managed regionally. The document suggests that the local management condition for Exemption 1 might be simpler than for the other two exemptions. 7 A lower hurdle than the effective management condition for the exempt activities test. -10-

11 Exemption 1: profits rate safe harbour This exemption would apply to a CFC which makes a low level of profits by reference to its cost base. The government would rather set a single profit rate than a series of sector-specific profit rates. The document puts forward a maximum profit of 10% of operating expenses less the cost of goods acquired for resale and related party business expenditure. Dividends that would be exempt from UK tax would be excluded from profits. 8 Exemption 2: manufacturers The second exemption would be for CFCs which are not substantially involved in activities other than manufacturing. There would be no restriction on transactions with the UK. CFCs holding intellectual property would only qualify for the exemption if they do not act as an IP hub and use only local IP : IP developed in-house including to a limited degree elsewhere in the group; IP developed by third parties that is integral to the CFC s trade; or IP acquired by or licensed to the CFC where needed for the CFC s local manufacturing. Exemption 3: commercial activities Scope. The third exemption is broader in scope and more complex. 9 activities: It would apply to the following trading and certain business activities between the CFC and other foreign companies; trading and certain business activities between a CFC and UK persons, where there is no artificial diversion of profits from the UK; and trading activities involving the exploitation of foreign IP which do not pose a significant risk to the UK tax base. IP. Where the CFC exploits IP, the exemption will only apply if: the IP has not been transferred from the UK within the last six years (or earlier in some cases); no more than 50% of the CFC s expenditure on IP goes to related parties in the UK; and no more than 20% of the CFC s gross income from IP exploitation is from the UK. Local substance. As well as meeting the local management test, the CFC would have to meet a further establishment requirement The tests are modelled on elements of the trading companies with limited UK connection exemption introduced by the Finance Act Like Exemption 1, it is heavily based on elements of the new limited UK connection exemptions. Presumably this will be close to the business establishment condition for the current exempt activities exemption. -11-

12 Interaction with investment activities. The commercial activities TBE will not apply if the CFC is engaged substantially (perhaps around 20%) in certain investment activities: holding and managing shares and securities of companies outside the group; and leasing, other than: long-term leasing of property outside the UK to unrelated tenants; and operating leasing of large capital assets to non-uk lessees, provided no capital allowances have been claimed on the asset in the UK. 11 UK income and costs. The document states that the provision of goods or services to or from the UK could provide scope for avoidance. The concern seems to be that risk is allocated to the CFC so as to prevent the transfer pricing rules from applying. The government is considering two measures to deal with this: a targeted anti-avoidance rule; or a limit on income from the UK or expenses in the UK. Other points Holding companies. The document proposes that holding companies which hold only trading companies and receive almost all their income from within their territory of residence will also be exempt as part of the TBEs. In any event, where dividends would fall within the UK dividend exemption, they would not give rise to a CFC charge. Principles-based alternative. The government is also considering a principles-based TBE as an alternative to the three mechanical exemptions. Such an exemption might exclude profits from arrangements where there has been a separation of risk and/or intangibles originating from the UK, resulting in an artificial diversion of UK profit. This approach would bring the TBE closer to the general purpose exemption: it would be intended to serve as a more straightforward alternative to the GPE, not to replace it. SECTOR-SPECIFIC EXEMPTIONS Background The current exempt activities test contains banking and insurance-specific rules within it. The government recognizes, however, that finance income is an integral part of insurance and banking business. 11 These two exclusions are a change from the old regime and new since the November 2010 consultation document. -12-

13 Overview The government therefore proposes to separate the exemptions for these two sectors from the TBEs. It is open, however, to continuing with the previous approach, if presented with evidence that insurance or banking activities are combined with other trading activities in the same CFC. Insurance exemption Conditions. The CFC would have to: have insurance as its predominant activity (around 80% rather than the current regime s 50%); meet residence, establishment and local management requirements similar to those for the TBEs; be part of an insurance group (in other words, not a captive insurer); and derive less than 50% of its gross trading receipts from the UK. The government also intends to introduce a capitalisation test for some or all cases. Operation. The current exemption applies where most of the CFC s gross trading receipts come from third parties. The new exemption would apply to business with third parties and also to foreign-to-foreign activity within the group. Banking exemption Design issues. The document notes that the banking sector raises specific risks for a CFC regime: although capital adequacy is subject to regulation and scrutiny, capital can easily be transferred between banking entities, so there is a risk that a CFC would hold more capital than it needs; and not much activity may be required to generate profits. Conditions. The CFC would have to: have banking as its predominant activity (around 80% rather than the current regime s 50%); fulfil residence, establishment and local management requirements designed to reflect the issues referred to above; meet a capitalisation test. The document proposes that the capitalisation test should be similar to the test under the current regime, which provides for a 15% capital ratio. The ratio, what goes into the calculation and how often the ratio is tested are all open for discussion. The current regime ignores lending to connected parties in the UK. The government is prepared to maintain that position or exempt lending to non-uk connected parties, but not both. -13-

14 FINANCE COMPANY PARTIAL EXEMPTION Background As first announced in the November 2010 consultation document, the government intends to introduce a finance company partial exemption ( FCPE ) for income from lending to non-uk group companies. The group will be treated broadly as if the CFC is financed by a minimum 1:3 mix of intra-group debt from the UK and equity. (The November consultation document proposed 1:2; the change to 1:3 was announced in Budget 2011.) If a CFC is wholly equity-funded, 25% of its profits would be apportioned to its UK parent. This would give an effective UK corporation tax rate of 5.75% when the main rate comes down to 23%, from 1 April This partial exemption is a compromise. It reflects the lack of UK streaming or interest allocation rules where a UK parent borrows to equity-fund a non-uk affiliate conducting group financing activity. 12 Scope As a general matter, the FCPE would apply only to income from lending to non-uk group companies, not upstream lending or deposits with third parties. However, the government is open to the idea of allowing the exemption to cover upstream loans in particular commercial situations, for example, where there are temporary obstacles to payment of a dividend, or where the loan forms part of group treasury management policies or is necessary to comply with bank restrictions imposed by legal or regulatory requirements. Insurance and banking. The government is concerned that it is difficult to separate monetary assets which support the trading operations of finance companies from those that support the capital structure of their business. It is therefore inclined not to allow insurance and banking companies to benefit from the FCPE. Treasury activities. Profits of group treasury companies arising from the provision of treasury services are likely to be exempt under the GPE. However, where a CFC carries out both treasury and finance company activities, the government considers that only the FCPE should apply to this combined activity. Mixed finance and trading. The government is still considering whether, and if so how, the FCPE should apply to companies carrying out a mix of finance activities and trading. Much will depend on which structure the government adopts for the FCPE. (The options are set out on the following page.) The simple option would demand restructuring of the mixed activity company so that the non-finance activities are located in a separate group company in order to qualify for the FCPE (in which case the government may include transitional rules to allow time for such restructuring). The more flexible options could be designed to apply to intra-group finance income held in mixed activity companies. 12 The UK government decided not to introduce such a restriction with the dividend exemption. Instead, it brought in the UK s worldwide debt cap rules. -14-

15 Local substance To qualify for the FCPE, the CFC must have a territory of residence in which it is established and locally managed. However, the government recognises that finance companies may not necessarily require employees located in the company s territory of residence. Operation The government recognises that businesses would like the FCPE to be easy to operate but also that multinational businesses tend to be complex. The consultation document outlines one simple design option and three flexible alternatives. Simple option. One quarter of the CFC s chargeable profits would be apportioned to the UK. This option would apply only to wholly equity-funded CFCs that lend only to other overseas group companies whose profits are not themselves subject to a CFC apportionment. Option A. There would be a complex series of adjustments to the chargeable profits computation, using one quarter of an adjusted income figure. Lending between non-uk finance companies within the group would be disregarded. Option B. A group would be allowed to elect to disregard 75% of intra-group finance income and 75% of the corresponding finance expense in the borrower. Option C. 25% of the chargeable finance profits of the CFC would be apportioned. The government recognises that the simple option would be inflexible and might require businesses to restructure their existing finance arrangements to qualify (although transitional rules could be brought in to allow time for restructuring). The government therefore favours one of the more flexible options. Neither the simple option nor Option C takes full account of any debt funding. The government plans to include a TAAR. Its targets will include groups trying to bring interest on deposits with third parties within the rules. Full exemption The government intends to explore whether there is a case for providing a full exemption for overseas finance income in certain situations and in what circumstances it might apply. One such situation might be where a group makes the substantial majority of its genuine commercial profits overseas, these profits are reinvested overseas and the UK members of the group have no net borrowing costs. GENERAL PURPOSE EXEMPTION Background The GPE is intended to offer a flexible exemption when other exemptions are not available. It would exempt CFC profits that have not been artificially diverted from the UK for tax reasons, reflecting the -15-

16 move to a more territorial corporate tax regime. Although it works differently, the government sees this as fulfilling the same function as the current motive test. Hopefully, it will prove much easier to rely on it in practice than has been the case with the motive test. It is the GPE that is intended to make the new regime compliant with EU law. Operation A CFC must be established in a territory of residence with sufficient local management in order to qualify for the GPE. A CFC s profits are exempt under the GPE if: they are commensurate with the CFC s activity ; or to the extent that they exceed the profits commensurate with the CFC s activity being excess profits they are not: UK diverted profits ; or non-incidental investment income. The consultation document summarises this in a diagram: Profits commensurate with the CFC s activity are those profits that would accrue to the CFC under uncontrolled conditions : that is, if the CFC were an independent entity dealing at arm s length rather than a member of a group. Determining what those profits are is a two-step process. First, the group must determine what assets and risks the CFC would be likely to own and bear under uncontrolled conditions. The government suggests using the principles in Article 7 of the OECD Model Tax Convention and the OECD s 2010 Report on the Attribution of Profits to Permanent Establishments -16-

17 to do this. When applying these principles, the CFC and any group entity developing, managing or using the asset would be treated as parts of a single entity. On this: Where a CFC s existing and established staff perform sufficient day-to-day active decision-making and other core functions related to its assets and risks, then this is likely to be an indication that the associated profits arising in the CFC are those that would arise under uncontrolled conditions. There may be situations, for example where the transfer of staff forms part of the arrangements under which the assets and risks are themselves transferred, which may not have happened under uncontrolled conditions, where management by the CFC s staff may not therefore necessarily be determinative. 13 The first sentence is surprisingly weak ( likely to be an indication ), since the OECD Report explicitly attributes assets and risks on the basis of significant people functions. 14 The second also diverges from the standard OECD approach. The OECD s Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations contains a chapter on business restructurings. This states that tax authorities should start from the transactions actually undertaken by the associated enterprises and nonrecognition of the actual transaction or arrangement should be limited to exceptional cases. 15 The examples given in the consultation document show that this proposed licence to ignore transactions is aimed in particular at groups moving IP offshore to reduce taxes. The income generated by the IP transferred would be subject to a CFC charge. However, the transfer itself may give rise to an exit charge to UK corporation tax. The government is consulting on options for relief against such a double charge. The consultation document also acknowledges that IP may have a limited life: if the activity of generating new replacement IP is transferred to the new non-uk jurisdiction, that may provide a justification for reducing the CFC charge over time. It appears though the consultation document is not clear on this that investment is not to be considered part of the CFC s activity for these purposes. It is questionable whether this is reconcilable with EU law. Second, the group must determine the profits attributable to those assets and risks. The document envisages that this would also be done on Article 7 principles. The resulting number would be the profits commensurate with the CFC s activity. UK diverted profits are those profits that would have accrued in the UK under uncontrolled conditions, and have therefore been artificially diverted from the UK. There is no longer a default assumption that a CFC s profits would have arisen in the UK. The government proposes that these UK diverted profits would be calculated using the same principles used to calculate profits that are Paragraph See paragraphs 15 and following of the Report. See Chapter IX Part IV, in particular paragraphs and

18 commensurate with the CFC s activity. Profits associated with assets and risks that would probably be attributed to UK members of the group under uncontrolled conditions would be UK diverted profits. Accordingly, the attribution exercise would ask both whether the underlying assets or risks would be owned by the CFC under uncontrolled conditions, and if not whether they would be owned by UK or non-uk members of the group. Non-incidental investment income is likely to be defined in the same way as for the territorial business exemptions. HMRC accepts that in many circumstances all of a CFC s profits may be exempt. The group may be able to show that all of the CFC s profits are commensurate with its activities without making a chargeable profits calculation. APPLICATION TO FOREIGN BRANCHES Background As well as interim improvements to the CFC regime, the Finance Act 2011 introduced an optional exemption for the profits of foreign branches of UK-resident companies. This included an anti-diversion rule a mini-cfc regime with a small profits exemption and motive test exemption. Proposal The government intends to align the tax treatment of exempt foreign branches with that of foreign subsidiaries as far as possible. There are, however, some differences: the low profits exemption would apply by reference to the profits of the branch, which would be calculated on a UK tax, rather than an accounting, basis; the capitalisation tests for the sector-specific exemptions, however, may be applied to the company as a whole; the government is inclined not to extend the finance company partial exemption to branches; and the consultation document suggests that the GPE should be applied by first seeing whether the profits of the company as a whole are commensurate with its activities, and then identifying whether any excess profits are attributable to the branch. CONCLUSIONS Process Detail. Although the consultation document runs to some 110 pages, there is a lot of detail still to come. To take just one example, the third territorial business exemption is to cover trading and certain business activities : we are not told what these business activities are or might be, or even what policy considerations will inform the decision. -18-

19 Timing. It follows that the government will have its work cut out to consider responses to the consultation and publish draft legislation this autumn. The most important influence on timing is likely to be the reception the proposals get. If business welcomes them, as seems quite likely, the government is likely to push ahead. Pluses Sophistication. The question of when profits are artificially diverted from the UK has bedevilled the consultation process. The new consultation document takes a more nuanced approach than the government had adopted in earlier documents. The decision not to class overseas property rental and big-ticket operating leases as investment (which would otherwise disqualify a CFC from the TBE for commercial activities ) will be helpful for taxpayers. Pragmatism. The finance company partial exemption has been on the table for some time now, but it remains a pragmatic way of dealing with an asset as mobile as money. The government s willingness to consider a full exemption in some cases is also encouraging. Flexibility. The current system of full but narrow exemptions can impose an excessive penalty on some structures. Wider partial exemptions offer UK-headed groups more flexibility to organise their businesses as they see fit. How flexible the new regime turns out to be will be affected by where the government comes out on some of the outstanding questions after the consultation. For example, incidental finance income may be defined as a proportion of the CFC s income or by reference to the facts and circumstances at the time. Certainty. The current system of full exemptions creates a cliff-edge effect: getting the analysis wrong and losing an exemption has disproportionate consequences. The move to partial exemptions where the effect is proportionate to the cause will reduce the consequences of uncertainty. Minuses Uncertainty. Transfer pricing is one of the least certain areas of tax law, so the use of transfer pricing techniques to arrive at the exempt profits figures under the GPE is a recipe for uncertainty. Similarly, if what is incidental is defined by reference to facts and circumstances, with no safe harbour, that will be another source of potential disputes with HMRC. Complexity. On the evidence of the consultation document, it is difficult to see the new regime being simpler than the old. Groups may find themselves applying different exemptions to different income streams from a single CFC. The number of references to targeted anti-avoidance rules is also indicative. The government proposes to include TAARs in the low profits exemption, excluded countries exemption, temporary period exemption, commercial activities TBE and finance company partial exemption. Compliance burden. Complexity gives rise to compliance costs. So does applying transfer pricing techniques. This may be a particular issue for consumer goods businesses and other users of IP. -19-

20 Other points EU compliance. There has been justified scepticism as to whether the new regime as proposed in the consultation document would comply with EU law. The consultation process. The process may be slow and tortuous, but one cannot fault the willingness of HM Treasury and HMRC to engage with business to get to a workable regime. And, as one in-house tax expert noted after the government s retreat from an income-based regime, No one said it was easy. * * * Copyright Sullivan & Cromwell LLP

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