slaughter and may UK holding companies and CFC reform William Watson

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1 slaughter and may Article October 2011 William Watson There is one issue which has dominated the UK s corporate tax system for some time now: as the song has it, Should I stay or should I go?. Many UK groups were asking themselves this question just a few years ago and a surprising number decided it was time to leave. This did not go unnoticed by the authorities. The UK s Coalition Government, elected in 2010, has said that it aims to make the UK s corporate tax regime the most competitive in the G20. This article seeks to explain the exodus and then assess the response, with particular reference to the UK as a location for holding companies and the proposed reform of the controlled foreign company (CFC) regime. Some History The UK s corporation tax system has had a number of beneficial features for many years. Most tax practitioners would put at the top of the list the absence of dividend withholding tax and a comparatively liberal regime for interest deductions. The particular attraction of the latter for multinational groups is that there is no rule which automatically restricts these simply because the debt is funding overseas operations or the capitalisation of overseas subsidiaries. (Nor has there ever been such a rule. So no change was needed following the landmark judgment of the European Court of Justice (ECJ) in the Bosal case (C-168/01, 2003) and, by contrast to countries such as The Netherlands, the UK s tax revenues do not suffer from a Bosal gap.) To that one can add what is probably the most extensive tax treaty network in the world, which among other things means that withholding tax is not generally a problem in relation to interest either. A Technical Note published by Her Majesty s Revenue & Customs (HMRC) on 1 August 2011 threatened a fundamental attack on the efficacy of this network, as it provided for the introduction of a motive test which would allow HMRC to override treaty protections. Happily, this remarkable proposal was withdrawn barely a month later. A long-standing hole in the system was then plugged in 2002, with the enactment of a participation exemption for share disposals. The exemption is more complex then some foreign equivalents (particularly in its insistence on trading status before and after the disposal), but in most cases it does the job. In other respects, too, the UK s rules for the taxation of standard M&A transactions are reasonably simple and generally satisfactory. Last but not least, it is probably fair to say that taxpayers in the UK face a little less uncertainty when planning their affairs than their counterparts in many other major jurisdictions. A line of cases dating back to Ramsay v IRC (1980) allows the courts to treat a substantially preordained series of transactions as a single composite transaction and tax the result accordingly, on the basis of a purposive interpretation of the relevant legislation. But this judicial doctrine does not go as far as the nuclear options available to revenue authorities elsewhere. Notable examples include the economic substance principle in the US, the general anti-avoidance rules that have been adopted in other common law countries and the concept of abus de droit that is applied in one form or another by the

2 ECJ and by courts in civil law jurisdictions. (Though the possibility of a GAAR is another current focus of attention in the UK: a GAAR committee is scheduled to deliver its report before the publication of this article.) Set against this array of advantages, there have been three main drawbacks of the tax system for UK holding companies and their shareholders: no participation exemption for foreign dividends (or business income); stamp duty on share transfers, which is something of a historical relic; and a CFC regime which, while not as fierce as the subpart F rules in the US, scores maximum points for complexity and can bring within the corporation tax net activities that have no real UK connection. The Netherlands and the UK. It proved possible to retain a FTSE listing for this entity, even though its tax residence and head office were located in The Netherlands. The combination of full listing in London with tax residence overseas was alluring. Over the next few years, upwards of 20 listed (though considerably smaller) UK groups introduced new holding companies resident outside the UK. The most common choice was a company incorporated in Jersey but resident in Ireland; other groups opted for Luxembourg, The Netherlands, Switzerland (a member of the European Free Trade Association and so to a degree protected from discrimination by other European countries) or, in the insurance sector, Bermuda. Rumblings of Discontent That was the position half a dozen years ago: some legitimate grounds for complaint, but overall a regime which compared fairly well to the corporate tax systems of other major economies. However, a number of developments made UK groups begin to question whether the UK was such a good place to be from a tax perspective. A gradual tightening of the CFC noose was followed in 2007 by a proposal for a drastic shift in the direction of the US rules, but without the valuable deferral mechanisms available to US groups that have substantial overseas revenues; this threatened to bring almost all passive income earned abroad within the scope of the CFC regime unless it was taxed at something close to the UK rate. At the same time there was a general move towards lower corporate tax rates around the world, coupled with a determination on the part of HMRC to raise the effective tax rate for UK groups. But a transaction undertaken for quite different reasons may also have had an impact. In response to various market pressures, the structure of the Shell Group was streamlined in 2005 by the introduction of a single parent company sitting above what had for nearly 100 years been twin holding companies in A New Direction Following publication of its CFC proposals in 2007, HMRC was faced by barely concealed threats from several major UK multinationals to join the tax émigrés. Adopting a fortress UK approach involving a version of the draconian anti-inversion rules in the US did not seem to be a plausible option, if only because of the risk that the ECJ would intervene. Whatever the reason, there appears to have been a change of heart in 2008, led by the UK Treasury but with the acquiescence and in some cases enthusiastic support of senior personnel in HMRC. Instead of pushing for an increased tax take from a potentially dwindling number of major UK corporate groups, it does now seem to be accepted that UK PLC would be better served by a corporate tax system which aims to increase the number of taxpayers. (With the benefit of hindsight, many tax practitioners would say that the period in fact marked a significant shift in the approach to tax cases taken by the ECJ, confronted no doubt by exasperated governments across the continent. The notion that there should be a balanced allocation of taxing powers, first appearing in Marks & Spencer at the end of 2005 (C-446/03), has allowed the Court to deliver a series of much less taxpayer-friendly judgments in subsequent cases. 02 SLAUGHTER AND MAY

3 But it was not quite so clear at the time. In any event the Advocate General s recent opinion concerning the Dutch exit charge, in National Grid Indus BV (C-371/10), suggests that the specific issue of corporate migration may still favour the taxpayer.) Three consequences of the change in approach are particularly evident. First, the decision has been taken to make a historic shift to the territorial taxation of UK companies (though not UK individuals). This is shown most obviously in the introduction of a participation exemption for foreign dividends and a regime which allows UK companies to make an irrevocable election that the profits (and losses) of foreign branches should not be taken into account for corporation tax purposes; these developments were covered in our introductory articles for, respectively, the 2010 and 2011 editions of this guide. The second consequence of the new approach is a logical complement to the first. The Government announced in 2009 that it would start again with the process of CFC reform, abandoning the idea that all passive income should in principle be caught. The latest step along this path was the publication in June 2011 of a long consultation document setting out in some considerable detail the basis for a revised set of rules which would target only foreign subsidiaries earning income that had been artificially diverted from the UK. This document is discussed further below. Finally, the new Coalition Government reduced the headline rate of corporation tax from 28% to 26% and has committed itself to further reductions of 1% per year for the next three years, reaching 23% in 2014/15. This is a direct response to global trends and will produce the lowest rate of corporation tax in the G7. (Or so says the Government, blithely ignoring the possibility that other countries may follow suit.) In Western Europe, the most enthusiastic exponents of this approach to corporate taxation have to date been Ireland and the Benelux countries. And there are other UK developments which appear to have been inspired by their example. From April 2013, there is to be a patent box in place which will apply a special 10% rate of corporation tax to UK profits that are attributable to qualifying patents. There will also be a partial exemption for the net interest receipts of finance company subsidiaries (again, see below), provided that the payer of the interest is not a UK member of the group such that it is the UK tax base which is being eroded. Presumably the Government has concluded that this is compatible with the EC Treaty, notwithstanding the European Commission s successful campaign against Belgian Coordination Centres and, more recently, the interest box in The Netherlands. Two other changes are worth noting. On the practical side, there can be no doubt that HMRC has attempted to foster a spirit of collaboration in its dealings with large businesses, facilitating contemporaneous discussion of and, where necessary, clearance for transactions. The other change is much less welcome, but can also be seen as shifting the balance of advantage towards UK holding companies for UK businesses. Owing to the comparatively light restrictions on interest deductibility, it has for many years been easy enough for overseas multinationals to secure a low effective tax rate for their UK operations by introducing substantial quantities of debt, so long as this complied with the arm s-length principle at the heart of the UK s thin capitalisation code. The use of a hybrid instrument or entity might then allow debt deductions in the UK to be combined with equity treatment in the parent jurisdiction. The initial attack on such hybrid funding schemes came in 2005, but from HMRC s perspective had only partial success in discouraging what it saw as excessive debt funding of UK subsidiaries by foreign parent companies. So in 2009 they introduced the worldwide debt cap, which operates whether or not there is any element of hybridity. The principle is, broadly, that interest costs in the UK should not exceed interest costs for the worldwide group; in other words, the target is what HMRC describes as debt-dumping. The debt cap erodes a potentially significant tax benefit that has been available only to foreign owners of UK businesses. 03 SLAUGHTER AND MAY

4 CFC Reform The new regime for the taxation of CFCs will not take effect until, at the earliest, enactment of the next Finance Bill in summer But the document published by HMRC and the UK Treasury in June 2011 contains considerable detail, providing a clear picture of the way in which the revised rules will operate. Here too, it is necessary to start with a little history. In the Cadbury Schweppes case (C-196/04, 2006), the ECJ was asked to decide whether the motive defence in the CFC regime was sufficient to make it compatible with the freedom of establishment enshrined in the EC Treaty. On the face of it, the regime is clearly incompatible with the Treaty freedoms: a UK company which establishes a subsidiary in another Member State may find itself subject to UK tax in a way that could not arise if the subsidiary was set up in the UK. As ever, the ECJ did not rule on the specifics of the case in front of it, which concerned an Irish financing structure that Cadbury was happy to concede it had put in place simply to reduce UK tax for the group. Nor did the Court focus on the wording of the motive defence, which was not of course intended to allow such activity. Instead, the judgment stated that CFC legislation was in principle permissible if it applied only to wholly artificial arrangements intended to circumvent national law. In addition, the taxpayer must be able to escape an apportionment under the legislation if it could show that the subsidiary is genuinely established in [its] state of establishment and that the relevant transactions reflect the services which were actually carried out in that state and were not devoid of economic purpose with regard to [the parent company s] activities. The UK legislation was amended following this judgment to exempt subsidiaries in EEA territories, but only for profits representing economic value that was created directly by qualifying work. It was plain to everyone but HMRC that this special exemption did not satisfy the test laid down in Cadbury and indeed the legislation was a subject of a formal challenge by the European Commission in May The current proposals for reform are a rather more serious attempt to meet the test set by the ECJ. The basic structure for the regime will be the same as at present: a UK company that controls a non-uk subsidiary can be taxed on its profits if those are subject to local tax in an amount that is less than 75% of the tax they would incur on UK principles, unless an exemption applies. Many of the exemptions will be similar too: a list of excluded countries, an exclusion for certain types of good activity (in particular, trading operations) and, in place of the motive defence, a general purpose exemption. This last category is key, providing the intended answer to Cadbury. Before moving on to that, though, there are several other aspects of the proposed regime that deserve attention. As already noted, there is to be a special partial exemption for CFCs that provide finance to other group members. So long as the recipients of the funds are not in the UK, the charge imputed to the UK parent will be only one quarter of the normal UK tax rate; so once this rate has reached 23%, in 2014, the profits of such a finance company will attract a charge in the UK at only 5.75%. It appears however that there will not be a similar provision for intellectual property, which is the other central cause of dispute in the CFC arena. Finally, there will be special rules for both banking and insurance activities. Cadbury and the New CFC regime HMRC believes that the new general purpose exemption (GPE) will suffice to make the revised rules compatible with the Treaty freedoms. The intention is that profits accruing to a CFC and falling outside the other exemptions will not be caught so long as they have not been artificially diverted from the UK. This is not in fact a new concept: HMRC argued in Cadbury that the motive defence had the same effect, or at least should be read as if it did. 04 SLAUGHTER AND MAY

5 The consultation document does not contain draft legislation, but the thrust of the GPE is clear enough. The CFC must be established in its jurisdiction with sufficient local management. Its profits will then be exempt if they would more likely than not accrue to the CFC if it was operating under uncontrolled conditions. In principle it will also be possible to rely on the GPE to protect what HMRC describes as excess profits, so long as there is no artificial diversion. It is at this point that the consultation document takes a surprising turn. It still regards the tax-driven diversion of profits from the UK as in itself sufficient basis for a CFC charge. HMRC no doubt appreciates that this will not really do: in Cadbury, the ECJ was quite clear that establishing operations in another Member State merely to take advantage of a lower tax rate was acceptable. So the main thrust of HMRC s defence here relies instead on a bold reading of ECJ case law, claiming that the ECJ laid down essentially the same test in Cadbury as it did in two later cases concerning thin capitalisation. HMRC considers that it is sufficient if the GPE operates whenever a CFC s profits are commensurate with its physical existence, staffing and activity, allowing an apportionment to the UK parent if and to the extent that they are not. A number of criticisms can be made of this conflation of the CFC and transfer pricing concepts. As one would expect, the ECJ appears to say in Cadbury that so long as the CFC is actually established in its jurisdiction and pursuing genuine economic activity there, there will be a proper exercise of the freedom of establishment and no CFC apportionment can be made. There is no separate requirement that its profit be commensurate with its degree of establishment or level of activity. A second difficulty relates specifically to intellectual property. Here, the consultation document says expressly that satisfying the arm s length principle will not suffice. More generally, the continued emphasis on tax motivation does not really fit with the judgment in Cadbury. The overall impression is of a brave but rather ambitious project. There is clearly a desire to have a single regime which gives HMRC adequate weaponry to use against CFCs in tax havens but is at the same time compatible with the Treaty freedoms. It may be that in this one respect the amendment made to the legislation in 2007 got it right, when it opted for a more generous rule applicable only to CFCs in EEA states. Nor can it be said that the new rules do much to reduce complexity, though it will help considerably if HMRC can devise a threshold test analogous to the successful gateway for the worldwide debt cap and thereby take most UK multinationals outside the regime altogether. It remains to be seen whether the new CFC regime really reflects a change of heart on the part of HMRC. The finance company partial exemption is a clear step forward; against that, HMRC seem determined to end the most commonly used technique in CFC planning, under which bad passive income is mixed in with and so sheltered by good active income in the same entity (a practice known as swamping ), and it is not clear that the proposed relaxation of some other aspects of the CFC code will fully compensate. Conclusion It seems unlikely that the Government will in fact manage to make the UK s corporate tax regime the most competitive in the G20, at least when measured in terms of effective tax rates rather than headline rates. But if the Government gets CFC reform right, the only clear defect in the system for a typical UK multinational will be a minor one, namely the continued imposition of stamp duty on share transfers. On that basis, if the UK s tax regime may not become a magnet it should at any rate cease to be a problem. UK PLC will of course wait to see the final package before reaching a view, but this piece can end on a positive note. The exodus appears to have ended and, for some, immigration is now a serious option. This article appeared in the 2012 edition of The International Comparative Legal Guide to: Corporate Tax; published by Global Legal Group Ltd, London. Slaughter and May 2011 This material is for general information only and is not intended to provide legal advice. For further information, please speak to your usual Slaughter and May contact. briefing.indd1011

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