Analysis of New Law UK CORPORATE TAX REFORM. Nikol Davies *

Transcription

1 70 Analysis of New Law UK CORPORATE TAX REFORM Nikol Davies * INTRODUCTION The long anticipated consultation document for corporate tax reform was published by the government on 29 November The document outlines the intended changes to the corporate tax system over the next 5 years to deliver a more competitive and stable tax system. The document deals with the treatment of intellectual property rights (IP), the much criticised controlled foreign companies (CFC) rules and the foreign branch profits exemption. In addition, draft legislation was published for inclusion in the Finance Bill 2011 on 9 December 2010 in relation to the interim CFC proposals and the foreign branch profits exemption. The main principles behind the roadmap are to prioritise rate reductions over broadening tax reliefs (with the main rate of corporation tax reduced to 24% by April 2014). In addition, there is a move towards a more territorial corporate tax system focusing more on profits from UK activities with the aim of simplifying the tax legislation, avoiding unnecessary changes and complexity. The detailed proposals include: the introduction of a Patent Box regime which is an optional regime involving a 10% tax rate for profits arising from patents on or after 1 April 2013 where the patents are first commercialised after 29 November Although this represents a higher effective tax rate than in some other territories, given the non-tax benefits of locating IP in the UK, we expect that this regime will be of benefit to groups with a patent pipeline, in particular in the pharmaceutical and high-tech industries; an outline of the interim improvements to the CFC regime which are intended * Partner, Private Client, Tax and Incentives, Taylor Wessing LLP.

2 Vol 18 No UK Corporate Tax Reform 71 to include further exemptions from the CFC rules in respect of foreign to foreign activities providing little risk of erosion of the UK tax base or in cases where IP-rich CFCs have minimal UK connection. The proposals also provide for an extension to the period of grace upon a migration of a group into the UK or an acquisition of a foreign subsidiary by a UK group, as well as an increase in the de minimis threshold to 200,000 where a group company is large. The interim improvements introduce welcome exemptions to the CFC regime but do not sufficiently address the situation of IP-rich CFCs with some UK connection; and an outline of the full reform to the CFC regime, in particular focusing on CFCs holding monetary assets or IP. In essence, the rules retain the entity based regime but are focused on profits that have been artificially diverted from the UK. There will be a welcome partial finance company exemption and an exemption for interest which is ancillary to a trading activity. Where the CFC has IP-related profits, there will be a focus on high-risk entities which generate excessive profits with only profits artificially diverted from the UK within the CFC charge. This area requires further development and the intended reform has, to date, received a mixed reaction; the introduction of a foreign branch exemption regime which would allow a UK company to elect irrevocably to exempt permanently from UK corporation tax profits arising in all that company s foreign branches. We expect that this foreign branch exemption could be of benefit to UK companies with profitable overseas branches or with branches holding assets standing at a gain. Such companies should begin to consider whether they would benefit from opting into the exemption regime. A positive outcome of the consultation process is that the government is not proposing to impose a form of earn-out charge on any transfer of UK intellectual property rights. In a further welcome move, the government has confirmed its intention not to pursue significant changes to the UK s regime for interest. Consequently, interest will continue to be deductible as a normal business expense (irrespective of where the proceeds of a loan are put to use). Nevertheless, the government will continue to review this area where it perceives there to be any avoidance risk. The government has also announced the establishment of a group to consider whether a general anti-avoidance rule would be effective in the UK. Given that the group is to complete its study by 31 October 2011, it is unlikely that any legislation will be drafted before 2013.

3 72 The Journal of International Tax, Trust and Corporate Planning Vol 18 No PATENT BOX REGIME The government recognises that a large part of the value of multinational businesses is based on their ability to exploit intangible assets and IP and, therefore, its taxation impacts on the ability to attract and encourage further innovation in the UK. A preferential regime is to be introduced for patents (the Patent Box ) to encourage businesses to retain and exploit patents in the UK. The new Patent Box regime will be elective and: will apply only to IP in the form of patents first commercialised after 29 November 2010 (with more detailed qualification and transitional rules to be discussed during the consultation); will provide for a 10% tax rate to apply to profits arising from patents from 1 April The 10% rate is to apply to both royalty income and embedded income included in the price of patented products. Identifying such embedded income is recognised as being complex and the government favours a formulaic approach; will apply to net patent income after associated expenses (including pre-commercialisation expenses) rather than to gross income. However, the government is committed to retaining the full rate relief for the additional deduction available under the research and development (R&D) tax credit regime. The consultation process is intended to develop fully these proposals; and discourage artificial tax avoidance behaviours and the purely passive holding of IP. The government is considering ways to prevent abuse including linking the amount of income which can be attributed to the Patent Box to the level of ongoing R&D or associated manufacturing activity. A new Patent Box working group will be established to take the consultation forward. The Patent Box is likely to be very beneficial for pharmaceutical companies (although disappointing for other sectors that hold IP in the form of trademarks or brands). Indeed, GlaxoSmithKline recently confirmed it is investing up to 500 million in the UK in expanding manufacturing capacity and in a new venture capital fund. Unfortunately, the government has ruled out extending the preferential regime to other forms of IP on the grounds that it would be too expensive. The decision to focus only on patents has been criticised and the 10% tax rate is still higher than that offered in other European territories with preferential regimes. The Institute of

4 Vol 18 No UK Corporate Tax Reform 73 Fiscal Studies has questioned the benefit of a Patent Box in its Briefing Note 112, noting that while the Patent Box should increase the UK s share of new patent holdings, tax revenues from patents would be likely to fall substantially and a significant amount of real activity would need to accompany patent income in order to offset the loss in tax revenues. RESEARCH AND DEVELOPMENT CREDITS The government is committed to ensuring R&D credits continue to be effective in encouraging innovation by UK companies. R&D schemes comprise the small and medium-sized enterprise scheme, the large company scheme and the Vaccine Research Relief scheme. The government notes that since their introduction, the schemes have supported nearly 52 billion of R&D activity by UK companies. Independent research was commissioned by Her Majesty s Revenue & Customs (HMRC) as to the impact of the schemes on the decision-making processes of companies. It was concluded that the schemes are perceived to increase the overall amount of R&D companies undertake, although they have little effect on decisions to conduct particular projects. The Dyson Review published in March 2010 made two specific proposals as regards R&D credits: (1) to refocus the R&D credit scheme on high-tech companies, small businesses and start-ups and to increase the credit to 200% when finances allow; and (2) to improve the ease with which the R&D credits can be claimed. The report suggested simplifying the claims process, allowing the external audits of claims or the pre-agreement of projects or activities with companies. As regards the first proposal, the government does not intend to restrict qualification for R&D tax credits to specific sectors as the schemes are intended to remedy a market failure that exists for companies across the economy. The government will, however, examine the extent to which the relief is appropriately targeted at those costs most closely linked to genuinely innovative activity. Currently relief is available for expenditure on staff, materials, power and software development. The government will consider views on what costs should be brought in, including whether expenditure on developing internal use software should be included.

5 74 The Journal of International Tax, Trust and Corporate Planning Vol 18 No CONTROLLED FOREIGN COMPANIES INTERIM IMPROVEMENTS The corporate tax reform document sets out in detail the package of proposals the government intends to introduce in Finance Bill 2011 to provide improvements to the CFC regime prior to full reform to take effect in Draft legislation was published on 9 December 2010 (together with other draft clauses of the Finance Bill 2011) which was broadly consistent with the document and further consultations have since taken place. The proposals reflect the outcome of working group sessions between government and businesses to develop the proposals. The interim improvements are designed to implement an initial set of changes consistent with the direction the government has set for full reform. Where applicable, the CFC regime can operate to attribute to a UK parent company the profits of its lower-taxed foreign subsidiaries. It is well known that this regime reduces the competitiveness of the UK as regards attracting holding companies to the UK, and a number of large multinationals have migrated their holding companies out of the UK over the past few years. The principal interim changes involve exemptions for CFCs which carry on a range of foreign to foreign activities involving transactions wholly or partly with other group companies in circumstances where there is little or no risk of erosion of the UK tax base. In particular this involves: The introduction of a new exemption for a CFC aimed at UK multinationals whose CFCs are involved in the provision or consumption of intra-group goods and services (eg as part of a supply chain) where the transactions do not involve the UK or do so only to a limited extent. The following conditions will need to be satisfied for the exemption to apply: the CFC must have a business establishment in its territory of residence, the CFC must conduct trading activities. This means that its non-exempt activities must comprise less than a substantial part of the CFC s business. The draft legislation does not define substantial for this purpose, although the corporate tax reform document contemplated a 10% threshold, the amount of finance income and relevant IP income must be less than 5% of the total gross income. Relevant IP income for this purpose excludes income arising to the CFC from the exploitation of IP which is licensed to an unrelated third party. In circumstances where the finance income of the CFC exceeds this 5%

6 Vol 18 No UK Corporate Tax Reform 75 limit but the other conditions are met, the excess would be apportioned to the UK. Further discussions are to take place in relation to situations where the finance income is an integral part of the trading activities. The group can assess the profits to be apportioned through an application to HMRC. However, if the relevant IP income exceeds this 5% limit, this exemption would not be available; and there must be minimal connection with the UK. This minimal UK business connection condition will be treated as met in full where no more than 10% of the CFC s gross income or expenditure arises from a UK connection. Where more than 50% of the CFC s business income and expenses arise from a UK connection, the CFC will not be able to apply for this exemption. Where the proportion of transactions of the CFC with the UK is between 10% and 50%, a CFC charge may arise unless the CFC falls within a safe harbour. The draft legislation indicates that the safe harbour would be satisfied where the CFC s profits for the period do not exceed 10% of the CFC s staffing costs for directors and employees resident in the CFC territory and where the CFC is effectively managed in its territory. This requires sufficient individuals working outside the UK with the competence and authority to undertake substantially all of the CFC s business. Where the safe harbour conditions are not met, application can be made to HMRC to agree a reduced CFC charge. Another new exemption is to be introduced for a CFC which has a business establishment in its territory of residence but with its main business being IP exploitation. This limited exemption is to allow multinationals holding foreign IP in circumstances that do not pose a risk to the UK tax base to fall outside the CFC rules. It requires that: the IP exploited has a minimal UK connection. This will depend on whether the IP has been held in the UK within the preceding 10 years and whether activities in relation to the creation, development, maintenance or enhancement of the IP have been carried on by related persons who are tax resident in the UK; and the CFC itself has minimal UK business connection. Consideration is to be given to the receipts arising from the UK in respect of sales in the UK, expenses incurred on R&D that have been undertaken by related parties

7 76 The Journal of International Tax, Trust and Corporate Planning Vol 18 No in the UK and the nature and extent of any related party equity funding coming from the UK. There is no indication of any acceptable level of equity funding in this regard. If the CFC meets the above conditions and there is minimal finance income, then the CFC would be exempt from the CFC rules. To the extent that the CFC meets the above conditions but finance income exceeds 5% of gross income, the excess income would be apportioned to the UK and the CFC charge would need to be agreed through an application to HMRC. A statutory extension to the period of grace will be introduced. Consequently, there will be an exemption for up to 3 years from the application of the CFC rules where foreign subsidiaries, as a consequence of a reorganisation or a change to their ownership, come within the scope of the CFC regime for the first time. Currently, the government accepts that acquisition of overseas companies will satisfy the motive test up to the end of the first full accounting period following the accounting period in which the acquisition occurs. However, it is recognised that this may not give multinationals sufficient time to restructure. This statutory period of grace is also to be extended to apply to non-uk headed groups that are considering a migration of the group or the regional headquarters to the UK. This period of grace will end earlier if there is a relevant change in the business of the CFC. This is to be measured by reference to whether there is a reduction in UK tax as a result of transactions referable to non-exempt (typically investment) activities of the CFC or where there is an increase in any upstream loan from a foreign subsidiary to the UK. There is to be an increase to the de minimis limit (so that groups with at least one large member will be able to have CFCs qualifying for exemption if chargeable profits do not exceed 200,000 for a 12-month period). In another welcome development, profits of the CFC will be measured by reference to accounting profits (rather than requiring UK tax law to be applied to the CFC s accounts to determine the profits for this purpose) and it will exclude capital gains and losses. (However, anti-avoidance provisions are to be introduced to avoid manipulation by requiring transfer pricing adjustments to be made (subject to a 50,000 de minimis) and by introducing rules to prevent schemes which would involve profit fragmentation in order to benefit from this exemption.) Small and medium-sized businesses will, however, continue to be subject to the 50,000 de minimis. Other than a widely expected delay to the withdrawal of the holding company exemption until 2012, all other amendments are intended to have effect in relation to accounting periods of CFCs beginning on or after 1 April 2011.

8 Vol 18 No UK Corporate Tax Reform 77 HMRC will also consider how its published guidance could provide greater certainty on the availability of motive test exemption in the case of trading US limited liability companies and similar entities. CONTROLLED FOREIGN COMPANY RULES FULL REFORM The government proposes to reform fully the CFC rules contained in the corporate tax reform document. The response to this reform has been mixed and is described as lacking real ambition and as merely building on the reforms previously announced by the former Labour Government. The government considers that CFC rules are necessary to protect against artificial diversion of UK profits to low tax jurisdictions and, therefore, a CFC regime will remain. The new rules, to commence in 2012, are intended to focus on taxing the profits from UK activity (rather than attributing the worldwide income of a group to the UK) in order to enhance the competitiveness of the UK. The full CFC reform proposals focus primarily on the two most difficult areas involving monetary assets and IP. The government will publish further details on the new CFC rules in spring 2011 with draft legislation in autumn New CFC working groups will be established under the headings monetary assets, IP, insurance, banking and property. The principal proposals set out in the document are: the retention of an entity based approach but the CFC charge applying only to the proportion of overseas profits that have been artificially diverted from the UK. A number of exemptions will be retained and specific rules will address banking, insurance and property sectors; and in the context of monetary assets (which comprise assets such as cash and debts and their equivalents), the government is concerned about diversion of profits out of the UK through upstream loans from an entity in a low tax jurisdiction to a UK entity or through a UK company taking out debt to equity-fund a low-tax offshore investment. The proposed solutions, which represent welcome developments in this area, are: that companies involved in financing the activities of the multinational group could benefit from a partial finance company exemption. This exemption would consider the finance company s debt-to-equity ratio and apply a CFC

9 78 The Journal of International Tax, Trust and Corporate Planning Vol 18 No charge to the extent that the company has excess equity. If the CFC is appropriately funded (in terms of the mix of debt and equity), then it would qualify for exemption. Where the equity exceeds the appropriate level, a proportional CFC charge would arise. The government is considering a minimum debt to equity ratio of 1:2 (so that, if the CFC is fully equity funded, 66% of overseas finance income will still be excluded from a CFC charge). Subject to targeted anti-avoidance rules, this would result in a highly favourable effective tax rate on finance income of less than 9% (falling to 8% when the main rate of corporation tax reduces to 24%). A proposed exemption for any incidental or ancillary interest income arising within trading companies, and a proposed extension of the finance company exemption to excess cash held in trading companies. In the latter case, this would involve applying a debt:equity ratio to that part of the company where there is excess cash in the same way as for a finance company. In relation to companies with treasury activities which only make a small return, the government would like to exempt such activities and will be considering this further. For CFCs which have IP-related profits and which present the highest potential risk, the new rules are intended to target artificially diverted UK profit. The government is concerned that in certain structures and transactions, the transfer pricing rules may not protect UK revenues by ensuring appropriate allocation of profits to the UK. Nevertheless, the government intends to ensure that a double tax charge on profits due to any overlap between CFC rules and transfer pricing rules will not arise. The rule for IP-rich CFCs is less developed than the proposals relating to monetary assets. Consequently, the government intends to consult further in this area; in particular where IP has been developed crossborder and/or where IP has a significant connection to the UK. The intention behind the proposals is to exclude certain CFCs which pose little or no risk to the UK tax base, such as trading CFCs which have incidental or ancillary amounts of IP income with a UK connection or where only a small amount of profit arises on IP with a UK connection below a certain de minimis level. The government is not attracted to introducing an active management exemption for IP-rich CFCs. Nevertheless, the government does not want to discourage groups holding foreign IP from sub-contracting activities back to the UK and, in circumstances where they do not represent a high risk to the UK tax base, it is intended that these arrangements fall outside the CFC rules.

10 Vol 18 No UK Corporate Tax Reform 79 Therefore, the proposed approach in relation to CFCs with IP-related profits involves a two-step process, assessing the extent to which excessive profits have arisen in such CFCs and the proportion of profits which represent artificially diverted UK profits. This two-step approach is as follows: Step 1: involves identifying the high-risk entities that hold IP with a substantial UK connection. This definition could include situations where: IP has been transferred from the UK within the last 10 years; a significant amount of activity to maintain and/or generate the IP value is undertaken in the UK; and UK funds are used to invest in IP that is held offshore as an investment but the UK does not receive a return on that investment. Step 2: involves assessing whether excessive profits have arisen and what proportion of profits represent artificially diverted profits. Where IP is held by a CFC (otherwise than as an offshore investment): a low-risk entity could be removed by applying a safe harbour test which is referable to the return earned in the CFC. Responses are sought as to how to determine an appropriate safe harbour return; where the CFC has failed the safe harbour test, profits would be allocated in determining whether excessive profits have arisen. Factors relevant in this context would include the level of substance in the CFC (ie the expertise and number of employees), the actual activity undertaken offshore, how much finance income is generated, how the entity is funded and, if the IP has been transferred from the UK, how long ago. If there are no excessive profits, then the CFC would be exempt; in the event of excessive profits, it would be necessary to identify the proportion of any excessive profits that are artificially diverted UK profits. Where several territories are involved in developing the IP, only the proportion of profits relating to the UK activity would give rise to a CFC charge. A just and reasonable basis of apportionment would be applied to excessive profits. Profits could be allocated based on costs incurred or sales made. A CFC charge would then arise on the excessive profits artificially diverted from the UK. In situations where the IP is held as an offshore investment, the CFC would be treated as analogous to a finance company. If equity funded, a UK tax charge

11 80 The Journal of International Tax, Trust and Corporate Planning Vol 18 No would apply to the proportion of profits that represents the return on that investment. In this regard, it is envisaged that a similar debt:equity ratio test would apply as with monetary assets. In addition, the government is considering, as part of the full reform, a number of other proposals discussed in the working groups including inserting a white list of high-tax jurisdictions and considering the lower level of taxation threshold for the application of the CFC rules. FOREIGN BRANCH EXEMPTION The government has set out further details regarding the proposed exemption for foreign branch profits as part of a positive move to improve the UK s competitiveness by making company taxation more territorial and to align the tax treatment of foreign subsidiaries and branches. The changes to the treatment of foreign branches have also been motivated by the introduction of the EU Solvency II Directive, 1 and the government is working with the life insurance industry to develop a new basis of taxation from 2013 onwards. The conclusions set out in the document are the outcome of working group meetings and consultation discussions. Draft legislation has been published on 9 December 2010 to be included in the Finance Bill A Technical Note was published on 20 December 2010 and the government will also publish draft guidance regarding the rules to prevent artificial diversion of profits to exempt branches. While the changes are welcome, there is a concern that some of the proposals may not be EU compliant. In summary the principal reforms are: the introduction of an opt-in exemption regime for foreign branch taxation such that companies within the regime will not be taxable on foreign branch profits (or any investment income effectively connected to the branch) but will also not receive relief in respect of foreign branch losses; that an irrevocable election will be available to UK resident companies who can elect for all their foreign branches to be permanently exempt from UK corporation tax. The election will apply to all present and future branches of the relevant company and for all accounting periods beginning after the 1 Directive 2009/138/EC of the European Parliament and of the Council of 25 November 2009 on the taking-up and pursuit of the business of Insurance and Reinsurance (Solvency II) OJ L 335/1.

12 Vol 18 No UK Corporate Tax Reform 81 accounting period in which the election is made. The profit or loss of each foreign branch would be deducted from the UK company s worldwide profit to give a net amount subject to UK corporation tax. There will be no transition possible from the exemption regime back to worldwide taxation of foreign branch profits; that exempt profits will be defined by reference to individual treaties and, if there is no treaty in the territory, the profits will be determined by applying the OECD model treaty published in July Where a treaty applies, the existing UK measure of branch profits will represent the exempt amount; that the opt-in exemption will not be available to a company whose business is wholly or mainly investment business; that in relation to certain sectors such as banking and insurance, provisions will be incorporated to avoid the over-attribution of capital to the exempt branch; that the opt-in exemption for large and medium companies will be extended to branches in all countries and territories (including those with which the UK has no tax treaty), but the exemption will not extend to branches of small companies in territories without a double tax treaty containing a non-discrimination clause. This exclusion from the exemption of such branches of small companies is due to the government s concern of a loss of tax through diversion of personal income; that the exemption will extend to chargeable gains. Any gain (which is or was taxable in the host state) would be exempt from UK corporation tax and any loss would not be available in the UK. The attribution of chargeable gains and losses to exempt branches is to follow the principles of the relevant tax treaty and if there is no treaty, by reference to the OECD model treaty. The government are considering whether anti-avoidance rules are needed and have indicated, in the Technical Note, that the exemption is not extend to chargeable gains arising to a close company; and that there will be a transitional rule where foreign branch losses have already benefitted from reliefs. When a company with foreign branch losses opts into exemption, the company s branch profits will become exempt as soon as the tax losses of those branches in the immediately preceding 6 years have been matched by profits (except in the case of very large losses exceeding 50 million within the past 6 years where the loss must be carried forward until the aggregate of all losses made in foreign branches has been matched with profits in the foreign branches).

13 82 The Journal of International Tax, Trust and Corporate Planning Vol 18 No The new regime is to be available for accounting periods commencing on or after a specified date in It will not apply to international air transport and shipping. Anti-avoidance The corporate tax reform document and the Technical Note indicate that there will also be rules introduced to avoid companies maximising exempt profits, for example, by requiring companies to claim capital allowances so as to reduce the measure of profits arising in the branch. Legislation in this regard has not as yet been drafted. Similarly, rules are to be introduced to protect the UK tax base against artificial diversion of profits (including in the identified areas of leasing and transfers between connected companies), although draft legislation relating to these measures has also not been published. Where a company opts into the exemption regime, each of its branches will be potentially subject to anti-diversion rules. If a branch does not comply with these rules in any one year, profits arising from the branch in that year will be subject to corporation tax with credit for foreign taxes in the usual way. For the interim period (before full CFC reform), there is to be a CFC-type regime introduced for foreign branches with various exemptions available, including a de minimis exemption and the motive test. As part of the full CFC reforms in 2012, the CFC rules will be changed so as to apply equally to foreign subsidiaries and exempt foreign branches. CONCLUSION In conclusion, while the corporate tax reform represents a welcome clarification of the intended regime for the taxation of foreign profits, there is still much work to be done and consultations will continue to take place to develop fully the permanent CFC and Patent Box regimes. Nikol Davies Partner, Private Client, Tax and Incentives Taylor Wessing LLP 5 New Street Square London EC4A 3TW N.Davies@taylorwessing.com