UK Controlled Foreign Company Rules and Taxation of Non-UK Branches

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1 UK Controlled Foreign Company Rules and Taxation of Non-UK Branches UK Government Announces Further Consultation on Changes to the Controlled Foreign Company Rules and the Taxation of Non-UK Branches of UK Companies SUMMARY The UK Government has published further consultation documents regarding the reform of the UK Controlled Foreign Company rules; and a proposed exemption from tax in respect of the profits of non-uk branches of UK companies. The intention is that legislation will be introduced in respect of these proposals in the Finance Bill FURTHER REFORM OF UK OUTBOUND TAXATION RULES As promised in the June 2010 Budget Statement, the new UK Government has released consultation documents regarding (i) the next stage of the reform of the UK Controlled Foreign Company ( CFC ) rules; and (ii) exempting the profits of non-uk branches of UK-resident companies. The proposals regarding the CFC legislation are a staging post pending full reform of these rules, which is expected to have occurred by More detailed CFC reform proposals were published earlier in 2010 by the outgoing Government: see our client memorandum of 5 February, Before the final reform of the CFC rules is put in place in 2012, modest legislative changes will be made in the Finance Bill By contrast, the proposed reform of the taxation of non-uk branches should be in place by the summer of Comments are requested on the consultation documents by mid-october CONTROLLED FOREIGN COMPANY PROPOSALS The overall aim of the reforms of the CFC rules and the taxation of non-uk branches is to make the UK corporation tax system more territorial, subject to measures needed to limit erosion of the UK tax base. New York Washington, D.C. Los Angeles Palo Alto London Paris Frankfurt Tokyo Hong Kong Beijing Melbourne Sydney

2 The changes proposed to the CFC legislation between now and 2011 are modest but are in keeping with this aim of greater territoriality. In particular, the UK Government has indicated that the CFC rules will be clarified so that restructurings of UK-controlled groups, involving the transfer, from one non-uk entity to another, of non-uk businesses that conduct most of their activity with unrelated parties, will be exempt from CFC taxation. In some situations, this may already be the case because, typically, the UK CFC rules do not tax capital gains. Specific mention is made of a proposal to exempt from CFC taxation an intra-group reorganisation where non-uk-source intellectual property is transferred from a company resident in one non-uk jurisdiction to a company resident in another such jurisdiction. Furthermore, proposals have been made to assist UK-controlled groups engaging in commerciallymotivated acquisitions of non-uk companies, where those acquired companies would otherwise be subject to the CFC rules. Under current practice, there is some scope for avoiding an immediate CFC charge where a UK-controlled group acquires one or more subsidiaries in low-tax jurisdictions, from an unrelated non-uk-controlled transferor. In particular, CFC taxation is postponed for a grace period once the non-uk companies have been acquired by the UK-controlled group. However, there have been significant problems in applying this practice. The grace period concept is to be extended so that it applies to a wider range of acquisition transactions (e.g. a corporate group migrating to the UK) and also applies for a longer period than currently, at least where the acquired non-uk subsidiaries have no ongoing impact on the UK tax base. The UK CFC rules continue to generate controversy: only recently, the UK tax authorities agreed a large settlement of CFC liabilities with Vodafone plc following protracted litigation (much of it relating to the impact of European Community law on the UK CFC legislation). Hence, the final reformed rules are eagerly awaited. THE PROPOSED REFORM OF THE TAXATION OF NON-UK BRANCHES Historically, like the U.S., the UK has taxed the profits of non-uk branches of UK companies, while giving a foreign tax credit for non-uk taxes on those profits. Likewise, losses from such branches can be set against other profits of the UK company and (subject to certain restrictions which have been called into question under European Community law) against profits of certain UK-taxpaying affiliates of that UK company. There is no specific provision for the clawback of branch losses used in this way when the branch becomes profitable although it is expected that when this occurs, the branch will be able, under the relevant non-uk tax rules, to use its losses to reduce the local tax charge. That in turn limits the UK foreign tax credit in respect of those profits and hence increases the overall UK tax charge once the non- UK branch becomes profitable. Partly because of concerns regarding the compatibility of the current rules with European Community law, an exemption regime for the profits of non-uk branches of UK companies is proposed for 2011, subject to safeguards to ensure that income is not diverted from the UK to low-taxed non-uk branches. -2-

3 ATTRIBUTING PROFITS AND CAPITAL TO THE NON-UK BRANCH The consultation document requests input on two possible methods of attributing profit to the non-uk branch of a UK-resident company. One approach applies in particular where the branch is located in a jurisdiction which has a double tax treaty with the UK, and follows the profit attribution method in the Business Profits article of the relevant tax treaty. This is normally, though not invariably, based on the notion of treating the branch as an independent enterprise dealing at arm s length with other parts of the entity to which it belongs. However, there are variations within the UK s wide treaty network. This approach has the merit of ensuring that the UK will only exempt the amount of tax which the treaty partner taxes and vice-versa. It may be that defining this amount of taxable profit will require competent authority discussions between the UK and its treaty partner. This introduces an element of uncertainty. Partly for that reason, an alternative approach has been suggested whereby profits should be attributed to non-uk branches of UK companies by adapting the existing UK rules (largely based on OECD principles) whereby profit is attributed to the UK branches of non-uk-resident companies. However, double taxation or double non-taxation could result if the profit attributed to a non-uk branch, using these rules, were not the same as the profits taxed by the territory of the branch. This mismatch issue could become more acute because of 2010 changes to the Business Profits article in the OECD Model Treaty. Part of the process of attributing profit to a non-uk branch involves attributing equity capital to that branch (and to that extent disallowing the financing costs of that branch), in accordance with the principles which treat the branch as if it were an independent enterprise dealing at arm s length with the remainder of the UK company of which it forms part. This is likely to be a significant issue for non-uk branches of UK banks and UK insurance companies. Comment is invited on two alternative methods of attributing capital to such branches. One would involve taking the actual capital of the UK company concerned and then attributing it to the branch by reference to the risk-weighting of the assets attributed to the branch i.e. assets created in the branch or the risk relating to which is managed in the branch, by, for example, hedging. The other method (which has significant similarities with the first method) would involve attributing equity capital to the branch on the basis that it is a fictional independent enterprise, dealing at arm s length with the remainder of the UK company. The consultation document expresses a clear preference for the first attribution method (the so-called capital allocation method), on the basis that this minimises the compliance burden and dovetails with the UK regulatory regime already applying to UK banks and insurance companies. Furthermore, it avoids the risk of attributing to the non-uk branch more assets than are in fact held by the UK company. CHARGEABLE GAINS OF NON-UK BRANCHES The consultation document questions whether the exemption for non-uk branches should extend to their chargeable gains as well as their income. Exempting such gains would be logical bearing in mind that non-uk-resident subsidiaries are not subject to tax on their chargeable gains (whether or not they fall -3-

4 within the CFC rules). However, exempting chargeable gains on non-uk branch assets raises complications e.g. the need for transitional rules to retain UK taxing rights over unrealised gains on existing branch assets; and the need to ensure assets used partly by the non-uk branch and partly by other parts of the same UK company are dealt with appropriately. ANTI-AVOIDANCE Given that enterprises engaged in international shipping and air transport operations are typically taxed (under double tax treaties and equivalent arrangements) only in their jurisdiction of residence, the consultation document proposes that the non-uk profits of UK companies conducting such operations from branches in treaty jurisdictions should not be UK-exempt, because this would otherwise lead to double non-taxation. The UK is also keen to avoid the branch exemption regime being used to set up low-taxed branches in other jurisdictions which are UK tax-exempt. This element of the proposals will require further refinement as the broader reform of the CFC rules continues. In essence, it is proposed that profits which would have been subject to CFC taxation if earned by a non-uk-resident subsidiary should not be exempt from UK tax if earned by a non-uk branch (although credit relief for any non-uk tax would remain). Several ways of achieving this are proposed:- the non-uk branch exemption could be limited by reference to the CFC rules; or an anti-avoidance rule could limit branch exemption in a way that reflects the principles of the CFC rules without applying them directly; or the profits of the relevant branch could be exempted from UK tax but then the CFC rules would apply to that branch as if it were a non-uk-resident subsidiary. The last-mentioned approach is more complicated but it may target more closely those profits of the non- UK branch which have been artificially diverted from the UK. Further anti-avoidance issues are raised in the consultation document. In particular:- The question is raised whether branch exemption should be given to non-uk branches which are not located in jurisdictions with which the UK has a double tax treaty. If exemption were denied in such cases, this would be out of line with the exemption for dividends from non-uk resident companies, which usually applies irrespective of whether the paying company is resident in a treaty jurisdiction. The primary beneficiaries of the non-uk branch exemption regime are expected to be the banking, insurance and oil and gas sectors, but the consultation document also notes the possibility of smaller UK companies using non-uk branches. The UK Government is reluctant to extend branch exemption to a non-uk branch of a small company which is not located in a treaty jurisdiction, because of the scope that such an exemption would offer for individual tax avoidance. Whether a company is small for these purposes is likely to be determined by reference to EU legislation used elsewhere to determine these issues. The consultation document also suggests that there should be a more generic anti-avoidance rule -4-

5 where small companies seek to use the non-uk branch exemption. This would avoid having to apply to such companies a variant of the CFC rules. LOSS RELIEF The existing treatment of the losses of non-uk branches was described earlier. In the oil and gas sector, this treatment has been beneficial in relation to the costs of abortive exploration activity by non-uk branches. Consequently, there is some concern that any tax exemption for non-uk branches does not lead to losses from such branches being denied UK tax relief. A number of alternative solutions are proposed. The first is that it would be possible to elect out of the non-uk branch exemption (just as it is possible to elect out of the exemption from corporation tax in respect of dividends). Follow-on questions are whether any such election should be irrevocable, and/or whether it should bind not only the company with the non-uk branch but also its affiliates. Two other alternatives would consist of clawing back loss relief given in respect of a tax-exempt non-uk branch, rather than denying any relief for such branch losses outright. The first clawback mechanism would tax the profits of a non-uk branch to the extent necessary to reverse any loss relief previously given in the UK, but this UK tax would itself be reduced by a credit for any non-uk tax on the branch profits. The alternative is for non-uk branch profits to be taxed to the extent necessary to reverse any loss relief previously given in the UK, without allowing any credit for non-uk tax on the branch profit. Lastly, proposals have been put forward for dealing with the transitional position of UK companies which are carrying forward losses when the non-uk branch exemption regime comes into force, to the extent that those losses are derived from the activities of that branch. The UK Government wants restrictions to ensure that the exemption regime does not make those carried-forward losses more valuable because they no longer have to be set against taxable profits of the non-uk branch and can be used more readily elsewhere within the UK group. Similarly, a rule may be introduced to permit clawback of certain non-uk branch losses used prior to the introduction of the non-uk branch exemption. OTHER ISSUES If the non-uk branch exemption is introduced for UK companies, it will be interesting to see whether the UK s treaty partners will wish to modify double tax treaties so as to limit benefits where income or gain accrues to the non-uk branch of a UK company which is more favourably taxed than the other operations of that UK company. * * * Copyright Sullivan & Cromwell LLP

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