Controlled Foreign Companies (CFC) Reform - a guide to the legislation

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1 16 December 2011 Controlled Foreign Companies (CFC) Reform - a guide to the legislation Key points The policy aims and the broad scope of the revised proposals are welcomed but the legislation is complex and will require detailed consideration by most UK group with foreign subsidiaries. Draft legislation published 6 December for inclusion in Finance Bill New CFC regime expected to be effective for accounting periods commencing on or after Royal Assent to Finance Bill 2012, although this is still under consideration. Major changes to the framework of the CFC rules; instead of the current all-or-nothing approach there will be a two stage process involving (i) identifying in-scope profits of CFCs (which could be nil) and/or (ii) considering entity-by-entity exemptions. Wide ranging partial exemption for intra-group lending by CFCs with CFC pickup applying to only one quarter of the related profits. All groups with foreign subsidiaries controlled from the UK will need to give consideration to these rules in terms of both reviewing the treatment of current arrangements and ensuring their compliance processes facilitate accurate filing positions going forwards. Comments on draft legislation invited by 10 February 2012 Overview The proposed regime is more explicitly targeted at profits artificially diverted from the UK, and the charge will be proportionate as opposed to all or nothing. This is welcome, as is the pragmatic approach to financing companies. The legislation is, however, undeniably complex and will require a fresh review of the activities of foreign subsidiaries in most cases. In practice, taxpayers will need to consider whether a detailed functional analysis in relation to the assets and risks in their foreign companies is necessary in order to self-assess on the basis of the so-called gateway in the new rules. If it can be concluded that there is no significant UK activity in relation to the assets and risks in the foreign companies then most business profits will be outside the scope of the CFC rules, and finance profits will potentially benefit from the new partial exemption. The CFC rules The CFC rules essentially seek to impose additional UK tax in relation to the profits of certain lowtaxed offshore companies controlled from the UK. Definition of a CFC A CFC will be defined as any non-uk resident company controlled by UK resident persons. Unlike the current rules this definition does not make reference to the level of tax payable by the CFC; instead the lower level of tax test will become one of the separate entity level exemptions that can be applied.

2 Control will be defined by reference to a mechanical test, as in the current rules, covering both control of the affairs of the CFC and economic control over the CFC s income and assets. The existing 40% tests covering certain joint ventures will be retained. As a new measure, there will also be control where a person is the parent of the CFC for the purposes of accounting consolidation under FRS2. It is also proposed that there will be an anti-avoidance rule that will deem a company to be a CFC where it would be one but for arrangements with a main purpose of securing that it is not a CFC. Accordingly, practically all non-uk subsidiaries of UK companies will be CFCs within the scope of the rules. The proposed legislation also includes a provision to treat certain cell companies, or parts thereof, as non-uk companies (and so potential CFCs). Chargeable profits and the gateway rule The draft legislation sets out a standard approach in relation to each CFC which can be summarised as follows (but noting that if an entity level exemption is considered to apply then there is no need to complete the determination of chargeable profits; similarly if the chargeable profits are determined to be nil then there is no need to consider the entity level exemptions). determine whether an entity level exemption applies to the CFC; determine the chargeable profits (this will include only certain categories of profits, as discussed below); apportion the chargeable profits, and related creditable tax, amongst those persons who have relevant interests in the CFC Under the current rules, the chargeable profits of a CFC are essentially all of its profits, computed on UK tax principles, but excluding chargeable gains. Under the new regime, only certain categories of profits will be included. Chargeable gains will remain excluded. The categories of in-scope chargeable profits are set out in Chapters 8-12 of the draft legislation. Chapter 13 then sets out amounts that are to be excluded in any event. It is possible that some profits would fall within more than one of the chapters, but it seems intended that they would only count once towards chargeable profits. This approach of only including certain categories of profits is referred to by the Government as a gateway. Broadly speaking, the intended effect of this should be to limit the in-scope profits to (i) business profits that are attributable to activities in the UK and arise in a CFC through arrangements lacking any substantial non-tax value, that would have not been entered into by independent companies, (ii) certain finance profits and (iii) certain captive insurance profits. Chapter 8 profits: profits attributable to UK SPFs The first category of in-scope profits is those attributable to significant people functions or key entrepreneurial risk taking functions (together SPFs ) carried out in the UK. In effect the rules are seeking to identify, and potentially tax, those profits in the CFC relating to assets and risks that have been separated from SPFs that are in fact undertaken in the UK. The legislation requires an analysis based on principles in the OECD Report on the Attribution of Profits to Permanent Establishments. The taxpayer must identify the assets and risks owned or borne by the CFC, and, to the extent that any UK SPFs are relevant to the ownership or management of these, the taxpayer must determine the extent to which under the OECD principles the assets and risks would be attributed to a notional permanent establishment in the UK. The taxpayer must then re-determine the CFC s profits assuming that those assets and risks allocated to the notional UK permanent establishment are not owned or borne by the CFC (effectively leaving a non-uk connected level of profit). The excess of the CFC s profits over this amount is included as the Chapter 8 profits unless specifically excluded by the further rules below. Exclusion 1: minority of UK SPFs profits are excluded from Chapter 8 profits if the SPFs relevant

3 to the assets or risks in the CFC are only partly UK SPFs, and the profits attributable to the UK SPFs are not more than half of the total profits in the CFC in relation to those assets or risks. Exclusion 2: substantial non-tax value profits are excluded from Chapter 8 profits if the non-tax value is a substantial proportion of the excess net economic value to the group resulting from the assets or risks being in the CFC rather than the UK. Substantial is not defined in the legislation, but the accompanying commentary refers to a general expectation that substantial would mean at least 20% of the total. Exclusion 3: arrangements which independent companies would have entered into profits are excluded from the Chapter 8 profits if, in the case where UK SPFs relevant to the CFC s assets and risks are carried on by connected companies in the UK, it is reasonable to suppose that if they were not so carried on, the CFC would enter into identical arrangements with unconnected companies. The reference to identical suggests that this condition is strict and it may be difficult to evidence. Exclusion 4: trading income safe harbour all trading profits are excluded from the Chapter 8 profits if five safe harbour conditions are met. These are, broadly: (i) the CFC has business premises in its territory of residence (ii) no more than 20% of the CFC s trading income derives from UK residents or UK branches (iii) UK related management expenditure is not more than 20% of the total related management expenditure (iv) the CFC s profits do not include significant profits from exploiting IP transferred from related persons in the UK in the prior 6 years and (v) no more than 20% of the CFC s trading income arises from goods exported from the UK (but excluding goods actually exported from the UK into the CFC s territory of residence). In practice, the inclusion of a limit on the trading income means that the trading safe harbour may not be as widely applicable as hoped, particularly for overseas companies that sell into the market. The basic concept of Chapter 8 profits is relatively easy to understand (i.e. profits related to activities in the UK) and in some cases, where foreign subsidiaries are highly autonomous, it may be possible to quite quickly conclude that there are no such profits. However it can be seen that in many scenarios the application of the rules will require a detailed functional analysis of which assets and risks are owned by the CFC, where the related people functions are carried out, and what profit is attributable to them. In the case of a globalised business where there is some central oversight on a business line or divisional basis the analysis of precisely which SPFs are the most significant in relation to the CFC s assets and risks could become a detailed piece of work in its own right. Some of this may already have been done in relation to transfer pricing policy but inevitably this would need to be revisited by reference to the specific requirements proposed here. Chapter 9 profits: non-trading finance profits Non-trading finance profits (e.g. interest income) are included in chargeable profits if the related SPFs are carried on in the UK, or they arise from funds that directly or indirectly derived from the UK (e.g. through a capital contribution), or they relate to loans to UK residents or branches where it is reasonable to suppose that the main reasons for such loan include a tax-related reason. It is worth noting that where a CFC with financing income is largely autonomous from UK SPFs e.g. where the group s treasury function is based offshore and where the CFC s capital does not derive from the UK, then it appears that profits arising from lending to non-uk persons could be fully outside of the scope of the CFC charge. This will be a welcome development, although the determination of where SPFs are exercised may not be easy where there is a degree of oversight of intra-group lending that is not undertaken in the CFC itself. Chapter 9 does not appear to include items such as debt factoring or leasing which share some characteristics with financing activity. However the profits from such activities could be within the scope of Chapter 8 as set out above. Where financing profits are in scope, they may well benefit from the partial exemption discussed below.

4 Chapter 10 profits: trading finance profits Trading finance profits (typically in a banking, insurance or other financial business) are included in chargeable profits if they arise from over-capitalisation or excess free assets as compared with what would be expected in an uncontrolled scenario. The Government acknowledges that these concepts will continue to be refined with the relevant sectors. Chapter 11 profits: captive insurance business Broadly, the profits of a CFC carrying on insurance business will be chargeable profits if they derive from an insurance contract with a UK resident. However where the CFC is resident in the EEA then profits deriving from the UK are excluded if there is a significant reason other than UK tax for the insured person entering the relevant contract. It appears therefore that captive insurance companies insuring only non-uk company risks may fall fully outside the scope of the CFC charge (although of course if SPFs are exercised in the UK, then Chapter 8 could bring the profits partly or fully back in scope). Chapter 12 profits: solo consolidation This is a specific rule for certain regulated financial companies that are subject to a solo consolidation waiver. The excess profits of such companies over the amount that would be attributed to it if it were a permanent establishment of the UK parent is included in chargeable profits. Such companies are also ineligible for the main entity-level exemptions. Chapter 13: general exclusions from chargeable profits Certain amounts are to be excluded from chargeable profits even where they would otherwise be within Chapters These include: profits of a property business incidental non-trading finance profits where non-trading finance profits are no more than 5% of the total trading / property business profits of the CFC incidental non-trading finance profits where they arise from the investment of funds for the purposes of a trade or property business of the CFC which does not itself give rise to Chapter 8-12 profits (albeit with some specific exclusions) incidental non-trading finance profits of holding companies where they represent no more than 5% of the company s exempt distribution income (i.e. broadly, its dividend income). Entity level exemptions As under the current rules it is proposed that there will be a number of entity-level exemptions available. The taxpayer will have the option of assessing that exemptions apply rather than computing chargeable profits if it prefers. Where a CFC satisfies an entity-level exemption then no CFC charge will be imposed in relation to any of its profits (whether or not they would be inscope chargeable profits as defined). Low Profits exemption A full exemption will be available for CFCs whose accounting profits do not exceed 50,000 for an accounting period, and for CFCs whose accounting profits do not exceed 500,000 and whose profits representing non-trading income do not exceed 50,000. The limits are for 12 month periods and so are adjusted accordingly for shorter accounting periods. Accounting profits are to be computed under generally accepted accounting practice (UK, IAS or local) but ignoring capital gains and losses and exempt dividend income. Importantly, transfer pricing rules need to be applied in computing accounting profits and there are certain other specific inclusions in relation to trusts and partnerships.

5 There is an alternative exemption which applies the same limits to assumed taxable total profits (i.e. on UK tax principles). There is an anti-avoidance provision aimed at denying the exemption in certain perceived avoidance scenarios. Low Profit Margin exemption This exemption will be available where a CFC s accounting profits do not exceed 10% of its relevant operating expenditure. Any deduction for interest expense is to be ignored. Unlike in earlier proposals, the cost of goods purchased for resale can be included in the cost base if they are imported into the CFC territory of residence, but expenditure payable to a related person is excluded. The limitation on related-party expenditure will preclude this exemption in many cases, but it may still be helpful for, say, intra-group service providers whose expenses are incurred locally. Excluded Territories Exemption CFCs resident in specified territories (broadly intended to be those with a headline tax rate of more than 75 per cent of the UK main corporation tax rate) will be exempt provided that their total income within certain categories does not exceed 10% of the company s pre-tax profits for the accounting period (or 50,000 if greater). Those categories will generally cover income which is exempt from tax or subject to a reduced rate of tax in the territory of residence. There are detailed rules setting out Categories A-D for this purpose. In addition the exemption will be denied where significant IP has been transferred to the CFC from the UK in the prior 6 years. As with the current Excluded Countries rules, the exemption will also be denied where the CFC is involved in certain tax avoidance arrangements. The relatively long list of potentially excluded territories is welcome. However the detailed provisions in relation to Categories A-D appear complex and potentially onerous for taxpayers to apply. As with the current rules this is exacerbated by the fact that the Category A-D income is essentially gross and this is compared to a net profit number. Tax Exemption A CFC will be exempt if the local tax amount payable in relation to the CFC s profits in its territory of residence for an accounting period is at least 75% of the corresponding UK tax that would be payable. This is similar to the lower level of tax test used to define a CFC under the current rules. Other entity level exemptions It should be noted that the draft legislation does not include any continuation of the current temporary period exemption for newly acquired CFCs. However the Government has confirmed its intention to offer some kind of time-limited exemption within the new regime, and this is still under consideration. It should also be noted that the draft legislation does not include any direct equivalent to the current motive test. Finance company partial exemption Chapter 17 in the draft legislation deals with the much awaited finance company partial exemption. This operates by providing an overriding exclusion from a CFC s chargeable profits of three-quarters of its qualifying loan relationship profits. This will apply only where a claim is made by the company on whom the CFC charge would otherwise be made. Details of the claim mechanism are not yet included but this may be an attempt to preclude taxpayers seeking to avoid any CFC pickup on financing activity and using the partial exemption as a mere fall-back position.

6 This mechanism means that the CFC itself need not be a pure financing company to avail of the relief; it could have mixed activity. Qualifying loan relationships will be those loans where the ultimate debtor is a company connected with the CFC. Broadly speaking, there will be an exclusion, and so no partial exemption, for loan relationships where the borrower obtains UK tax deductions (i.e. loans to UK resident companies, loans to UK branches and loans to other CFCs where the CFC charge in relation to those other CFCs is being reduced by the related interest expense). There are various provisions aimed at precluding back to back loans from benefiting from the partial exemption where the funds are ultimately used to make external loans or deposits. In determining the qualifying loan relationship profits, it is necessary to include foreign exchange differences if relevant, as well as any corresponding foreign exchange differences on hedging instruments. The partial exemption will not be available to companies engaged in banking or insurance trades, although there is no general preclusion of the treatment for other companies within insurance or banking groups. The partial exemption will also not be available for loans to insurance or banking companies; so it cannot apply to surplus cash on bank deposit. There is a provision which appears to deny partial exemption for loans which are entered into for trading purposes in the hands of the borrower; this appears to be a very wide and probably unintended limitation and we expect it will be amended. It will be necessary for the CFC to have appropriate business premises in its territory of residence; however there are no particular rules around local management. The Government has stated that it continues to consider whether there is a case for full exemption in certain limited circumstances. In particular, it is also considering whether the total CFC charge in relation to finance profits under the partial exemption should be limited to the aggregate net borrowing costs of UK members of the group. It should also be noted that some intra-group financing activity might be totally excluded from chargeable profits through the gateway approach specifically that activity where the relevant people functions are not in the UK, the funds do not derive from the UK and the loans are not made to UK persons. Overall this is a welcome wide ranging and generous exemption that will be of interest to many groups. Other legislative provisions As with the current rules, there will be specific rules for determining the territory of residence of a CFC. The basic rule will be to look to the territory under the law of which the CFC is liable to tax by reason of domicile, residence or place of management. In computing chargeable profits within Chapters 8-12, UK tax principles are relevant i.e. the CFC is assumed to be a UK resident company for this purpose. As with the current rules there are detailed rules determining how a CFCs profits are to be apportioned between the companies with interests in the CFC. Where there have been avoidance arrangements aimed at securing that a company is not a CFC, the interests in the CFC will be determined by reference to what it is reasonable to suppose would have been the case absent those arrangements. The CFC charge applies only to profits apportioned to UK resident companies, and there will be no charge on a company that, together with its connected or associated persons, is apportioned less than 25% of the total of the CFC s chargeable profits. The apportionment will be on the basis of direct or indirect ownership of ordinary shares in cases where there are no other relevant interests in the CFC, or otherwise on a just and reasonable basis. The CFC charge will be charged and collected as if it were a sum of corporation tax. The UK company liable for the CFC charge will be entitle to utilise certain reliefs (e.g. group relief and certain losses) to reduce the sum payable, as under the current rules.

7 Other points The Government is undertaking further work in relation to the application of the rules, and in particular the gateway provisions, to insurance, banking and funds businesses. There are currently no specific rules around leasing businesses; the Government considers these should be dealt with in the same way as other businesses under the main rules. As previously announced it is intended that the new rules will also apply in relation to foreign branches of UK companies in cases where the new branch exemption is being sought. Next steps The Government has indicated that additional draft clauses will be made available in January 2012 in relation to items not yet included in the legislation; for example: detailed commencement and transitional provisions possibility of a temporary period exemption possibility of full exemption for certain intra-group financing additional considerations for banking, insurance and funds businesses, and potentially for leasing activities and holding companies. Comments on the draft legislation are invited by 10 February 2012 ahead of legislation in Finance Act Contacts Joanne Bentley jcbentley@deloitte.co.uk Tel: Bill Dodwell bdodwell@deloitte.co.uk Tel: Tim Haden thaden@deloitte.co.uk Tel: This Briefing is prepared by Deloitte LLP, a limited liability partnership. For further information on any of these developments, please ask your usual Deloitte contact. This Briefing is designed to keep readers abreast of current developments, but it is a general guide only and is not intended to be a comprehensive statement of the law. No liability is accepted for the opinions it contains, or for any errors or omissions. Deloitte LLP All rights reserved.