UK Tax Flash. Reform of the UK CFC Rules: The Next Chapter.

27 January 2010 UK Tax Flash. Reform of the UK CFC Rules: The Next Chapter. The long-awaited discussion document on the reform of the UK s controlled foreign company rules has at last been published by HM Treasury. Whilst the proposals represent a significant improvement on the income-based controlled companies regime put forward in 2007 and shed some light on the way the Government proposes to deal with the most difficult areas of monetary assets and IP, there is little in the way of detail. It is clear that much more work is needed if legislation implementing the new regime is to be included in Finance Bill 2011 as intended. Contents Framework of the New Regime... 1 Monetary Assets... 3 IP... 4 How Does the UK Stack- Up?... 4 Next Steps... 5 Framework of the New Regime After months of consultation, the overall mechanics of the new regime seem broadly to be a moderated version of those employed within the existing CFC rules. The Government has rejected an income stream or purpose test approach, and the new rules will also operate on an entity basis. However, where the rules apply to a particular CFC, it is envisaged that only those profits which represent an artificial diversion of UK profits will trigger a tax charge in the controlling UK company. Fortunately, the original idea of extending the rules to cover controlled UK companies has been axed, as has the suggestion that certain capital gains be caught. Under the latest proposals, capital gains will continue to be wholly excluded. The working assumption is that the regime will operate on an exemption basis, i.e. that a foreign subsidiary s income profits will be apportioned to its parent unless it falls within one of a number of exemptions, although the discussion document notes that this approach may change once further work has been done on the activities and income that should be brought within the scope of the regime. So, what companies or activities would benefit from an exemption? Excluded Countries: The Government is considering the introduction of a new exclusion in place of the existing lower level of tax test. This would exclude companies operating in jurisdictions with (i) similar statutory rates and (ii) similar tax bases, to the UK. The document 1 UK Tax Flash Reform of the UK CFC Rules: The Next Chapter

notes that a test of this nature may also do away with the need for a white list. Whether this is an improvement on the current position will depend on the detail of the new test. If it is too tightly drawn, it may require detailed foreign tax advice to confirm its application which could actually increase compliance costs. Trading Activities: The discussion document envisages a more generous exclusion for trading activities which would also extend to intra-group transactions provided that they do not pose a risk to the UK tax base. There would, however, be less scope for the artificial location of non-trading profits within a trading company than under the current rules. The application of the rules to offshore group treasury operations and the active management of intellectual property is considered in more detail in the document and is discussed below. De Minimis: The discussion document identifies that the existing de minimis threshold of 50,000 needs to be increased although the appropriate amount is still under consideration. Motive Test: Taxpayers have, for a long time, felt that the requirements of the CFC motive test are unduly restrictive. In its place, the Government is proposing a new test intended to cover subsidiaries which are properly established overseas and not engaged in activities intended to artificially divert UK profit. The overseas subsidiary would be given the opportunity to demonstrate the non-tax related commercial rationale for any specified transaction and/or its role or purpose as a member of the group as a whole. There is insufficient detail in the discussion document to establish whether this will go far enough to satisfy the criteria put forward by the ECJ in Cadbury Schweppes and so effectively EU-proof the new regime. The Government is also considering including some flexibility within the rules so that subsidiaries would be exempt or partially exempt in circumstances where the technical conditions for exemption are narrowly missed or where a one-off commercial transaction results in an exemption being failed Helpfully, the discussion document suggests that the regime may be suspended for a period of time following the acquisition from a third party of a new sub-group which has no previous connection, through ownership or material transactions, with the UK. The discussion document acknowledges that the current rules apply too broadly in some cases, for example to reinsurance subsidiaries managing non-uk risks and property subsidiaries holding non-uk property, which do not constitute the artificial diversion of profits from the UK. Exemption for these and similar activities remains under consideration. As mentioned above, much of the document focuses on the particular issues arising in connection with monetary assets, i.e. instruments that give rise to interest like returns including cash and debt and their equivalents and IP. 2 UK Tax Flash Reform of the UK CFC Rules: The Next Chapter

Monetary Assets The discussion document proposes different treatment for traditional treasury operations, including the day-to-day management of groups monetary assets and finance companies which may be involved in wider financial transactions including long-term structured debt advanced to group companies. Whilst the Government is proposing a welcome exemption from the rules for group treasury companies, finance companies are more problematic. The Government perceives there to be a greater risk of the artificial diversion of UK profits where finance companies are financed through UK capital on which the UK does not earn a return. In those circumstances, the Government is proposing that the finance company s debt:equity ratio will determine the application of the CFC rules. Where the UK parent holds equity in the finance company in excess of the permitted ratio, this would be deemed to be interest-bearing debt, with the UK parent being taxed on the deemed interest. In addition to the difficulties with this approach identified in the discussion document where, for example, local legal requirements specify minimum levels of equity funding, this test is likely to be problematic to apply in practice, particularly in relation to subsubsidiaries of a UK parent. One of the main factors which has led groups to relocate outside the UK has been the impact of the CFC rules on non-uk financing structures. Getting the finance company exemption right will be vital if the CFC regime is not to penalise groups which hold foreign subsidiaries from the UK. While we understand the Government s concern that there could be tax avoidance where UK sourced funds are used to subscribe excessive amounts of share capital in a finance company, we do not think that focusing on the debt:equity ratio of a finance company held by a foreign intermediate parent is the correct approach. Further refinement of this proposal will be needed to produce an appropriate balance. The discussion document notes that any finance company exemption would likely be combined with a requirement that the company make no loans to the UK or that any interest received by the finance company from the UK would not be eligible for exemption. Companies which undertake both traditional treasury operations and the broader activities of a finance company, will be treated in the same way as pure finance companies under these proposals. Where cash is held by overseas trading subsidiaries rather than a specific treasury or finance company, the discussion document proposes that this should not give rise to a CFC exposure for those, otherwise good, companies provided that the level of interest earned is only incidental or ancillary to their trading profits. If the interest goes beyond the level of incidental or ancillary, the excess will be subject to a CFC charge. 3 UK Tax Flash Reform of the UK CFC Rules: The Next Chapter

The Government is of the view that specific rules are likely to be needed for banking and insurance groups and commits to engaging with the financial sector to ensure that the proposals recognise the different role played by monetary assets within these groups. IP One of the more controversial proposals in the discussion document, and the one that has generated the early publicity, is the suggestion that where IP is transferred outside the UK at an early stage so that its value cannot be accurately assessed, an additional tax charge, much like an earn-out, could arise. The document envisages that the additional charge would be applied for a finite period where the price at the time of transfer is difficult to calculate and the value of the IP has increased significantly following the transfer from the UK. Where IP is held outside the UK, the discussion document draws a distinction between IP which is actively managed and IP which is effectively held as an investment. The discussion document sets out a series of factors which might be relevant in determining whether IP is actively managed, such as the negotiation of IP licensing agreements, obtaining legal protection for the IP and so on. For IP which is actively managed, the key question is whether that management is undertaken offshore or in the UK. Where there is no UK involvement or it is only minimal, it is proposed that an exemption would be available. Where, however, the management takes place in the UK, a charge would arise under the CFC rules. In circumstances where the IP is not actively managed, the discussion document envisages that a charge would only arise where there has been an artificial erosion of the UK tax base, for example, where the IP investment is equity funded by the UK. The debt:equity approach proposed in relation to finance companies is one of the options being considered here. Once again, we do not think that this would be the correct approach where the IP holding company is held from outside the UK and the source of the funds used to finance it is not the UK: the discussion document helpfully hints that exemption may be available in these circumstances. Although the Government has been involved in long-running discussions with representatives of IP-rich businesses, there is again an acknowledgment of the work that still needs to be done, specifically in providing clarity as to the interaction between the CFC rules and transfer pricing legislation and consideration of the impact of the new patent box regime announced in the 2009 Pre-Budget Report. How Does the UK Stack-Up? We have come a long way since the first consultation paper on the reform of the UK s taxation of foreign profits was published in the summer of 2007 and there can be no doubt that these latest proposals are a significant improvement on the widely-criticised controlled companies regime put 4 UK Tax Flash Reform of the UK CFC Rules: The Next Chapter

forward in round one of this process. The existing CFC rules and the uncertainty surrounding the reform process has been widely regarded as a strike against the UK s status as a holding company jurisdiction. From the limited information available in the discussion document, the latest proposals appear to be a step in the right direction although, as always, the devil is in the detail and there is a lot of that still to come. If these proposals are enacted in a form that does not prejudice foreign financing or IP holding structures would companies still look to leave the UK? The UK has no withholding tax on outbound dividends and the substantial shareholdings exemption and exemption for UK and foreign dividends provide a relatively generous participation exemption. Although the new debt cap regime adds unwelcome additional compliance, the impact of those rules does not appear to be as significant as first feared. Once you take account of the UK s extensive double tax treaty network and non-tax factors such as eligibility for the FTSE, the picture in the UK is encouraging. In addition, some of the more negative aspects of the UK s tax environment, the frequently changing law, the often aggressive stance of HMRC and higher personal tax rates, may well become more prevalent in other popular jurisdictions in light of the difficult global financial conditions. In the short term, uncertainty concerning the steps the Government will inevitably have to take at some stage to plug the huge budget deficit is likely to be a significant factor against the attractiveness of the UK. Next Steps The consultation period runs until 20 April 2010 with a stakeholder event planned for late February. This would be followed later in the year by consultation on draft legislation. The discussion document envisages that legislation implementing the new regime will form part of Finance Bill 2011 although this will obviously depend to some extent on the outcome of the election. The discussion document can be viewed by clicking here. 5 UK Tax Flash Reform of the UK CFC Rules: The Next Chapter

Contacts For further information please contact: Mark Kingstone Partner (+44) 20 7456 5714 mark.kingstone@linklaters.com Ian Bowler Partner (+44) 20 7456 5696 ian.bowler@linklaters.com Jonathan Richards Partner (+44) 20 7456 5695 jonathan.richards@linklaters.com Michael Hardwick Consultant (+44) 20 7456 5658 michael.hardwick@linklaters.com Author: Michael Hardwick This publication is intended merely to highlight issues and not to be comprehensive, nor to provide legal advice. Should you have any questions on issues reported here or on other areas of law, please contact one of your regular contacts, or contact the editors. Linklaters LLP. All Rights reserved 2010 Linklaters LLP is a limited liability partnership registered in England and Wales with registered number OC326345. The term partner in relation to Linklaters LLP is used to refer to a member of Linklaters LLP or an employee or consultant of Linklaters LLP or any of its affiliated firms or entities with equivalent standing and qualifications. A list of the names of the members of Linklaters LLP together with a list of those non-members who are designated as partners and their professional qualifications is open to inspection at its registered office, One Silk Street, London EC2Y 8HQ or on www.linklaters.com and such persons are either solicitors, registered foreign lawyers or European lawyers. We currently hold your contact details, which we use to send you newsletters such as this and for other marketing and business communications. We use your contact details for our own internal purposes only. This information is available to our offices worldwide and to those of our associated firms. If any of your details are incorrect or have recently changed, or if you no longer wish to receive this newsletter or other marketing communications, please let us know by emailing us at marketing.database@linklaters.com. One Silk Street London EC2Y 8HQ Telephone (+44) 20 7456 2000 Facsimile (+44) 20 7456 2222 Linklaters.com 6 UK Tax Flash Reform of the UK CFC Rules: The Next Chapter