UK: UK Tax Update: Proposed New ‘Patent Box’ Regime, Controlled Foreign Company (CFC) Reforms and Changes to the Tax Treatment of Overseas Branches

Last Updated: 3 December 2010
Article by Robert Gaut and Sarah Gabbai

As part of a wider package of reforms to the UK's corporate tax system aimed at becoming one of the most competitive tax systems in the G20, the UK Government plans to reform the tax treatment of profits from overseas subsidiaries and branches and to introduce a new 'Patent Box' regime. While UK companies have benefited from a participation exemption for most dividends from UK and overseas subsidiaries since 1 July 2009, the current tax rules for Controlled Foreign Companies (CFCs) are considered a major obstacle to doing business in the UK, particularly for UK multinationals with overseas operations. To address this concern, the UK Government continues to consult businesses on an extensive package of reforms to the existing tax rules for CFCs and overseas branches. The new changes to the tax treatment of overseas branches and certain interim CFC reforms are expected to appear in Finance Bill 2011, with the remaining CFC reforms due to appear in Finance Bill 2012. The Patent Box regime is expected to take effect from 1 April 2013.

'Patent Box' Regime

To encourage UK businesses to create and retain intellectual property (IP) and enhance the UK's status as a world leader in the field of patent exploitation and development, the UK Government plans to introduce a new 'Patent Box' regime with effect from 1 April 2013. Broadly, as of 1 April 2013, profits arising from eligible patents will be taxed at a rate of 10%.

All patents first commercialised after 29 November 2010 will be eligible for inclusion in the Patent Box. Income qualifying for the new 10% rate will include net royalty income and income embedded in the price of patented IP after deduction of pre-commercialisation and other associated expenses. The Government is also considering improvements to the existing tax credit regime for research & development (R&D) expenditure incurred during the IP creation and development phases.

CFC Reforms

Historically, the UK CFC rules were introduced to prevent UK companies from artificially diverting taxable profits to offshore subsidiaries based in low tax jurisdictions. Under the current rules, a UK parent of a CFC is taxed on an imputed share of the overseas subsidiary's profits unless one of a number of specific exemptions applies. Recent case law has confirmed that the current rules are compatible with EU law, provided that they are confined to wholly artificial arrangements and are not intended to catch genuine economic activities overseas. Nevertheless, the current rules continue to create uncertainty for UK multinationals with overseas subsidiaries. Because the UK Government recognizes that the current CFC rules are a major disincentive for such companies to continue doing business in the UK, it seeks to remedy this situation by reforming these rules, with a view to improving the UK's attractiveness as a place to do business without eroding the UK tax base.

As interim measures, the Government proposes to introduce new exemptions for commercially justified activities, such as overseas intra-group transactions that meet certain conditions and the overseas exploitation of IP with minimal or no UK connection. A temporary three-year exemption is also expected to be introduced for UK multinationals who acquire overseas subsidiaries as part of an M&A transaction or reorganisation. These measures are expected to appear in Finance Bill 2011.

The full reforms, which are expected to appear in Finance Bill 2012, intend to address what the UK Government perceives as significant risks to the UK tax base associated with the use of interest-bearing financial instruments and IP held offshore. For example, the UK Government intends to require CFCs to satisfy a debt-to-equity ratio test in order for the UK parent to benefit from a proposed new exemption for overseas finance companies. In addition, as part of a wider initiative to encourage the retention and development of IP in the UK, the UK Government intends to target any IP held offshore as an investment with no commercial return to the UK and any offshore IP effectively managed in the UK by making these activities fully taxable under the CFC rules.

Changes to the Tax Treatment of Overseas Branches

To ensure greater alignment between the UK tax treatment of dividends from overseas subsidiaries and profits from overseas branches, the UK Government also proposes to introduce in Finance Bill 2011 an irrevocable election regime to exempt overseas branch profits and gains of medium and large UK companies from UK corporation tax. Companies who elect for the exemption will not get relief for overseas branch losses. Currently, UK companies are subject to UK corporation tax on the profits of their overseas branches, with credit given for any foreign taxes paid in respect of those same profits under a relevant double tax treaty, while dividends from all subsidiaries (wherever located) are generally exempt from UK corporation tax. The UK Government proposes to extend the election regime to branches in all territories and countries, including those with which the UK has no double tax treaty.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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