Originally published 29th November 2010
INTRODUCTION
The Government published today a document 'Corporate Tax Reform: Delivering a More Competitive System'. This takes forward proposals for reform of the taxation of CFCs and foreign branches and also includes proposals on taxation of IP (Patent Box Regime) and R&D tax credits.
1. NEW CFC REGIME
The wider reform of the CFC rules is still expected to be included in Finance Bill 2012. The new rules will operate on an entity by entity basis, with a number of exemptions; only overseas profits which have been artificially diverted from the UK will be subject to a CFC charge.
The document focuses on the difficult areas of monetary assets and intellectual property.
Monetary Assets
The proposal is to exempt finance companies from a CFC charge where the company is appropriately funded with a mix of debt and equity. The proposed minimum debt:equity ratio is 1:2 which, for a 100% equity funded CFC, effectively excludes 66% of overseas financing income from the scope of a CFC charge. This would give an effective tax rate of less than 9% in 2012, falling to 8% when the main UK CT rate reduces to 24%.
Anti-avoidance rules will be included to prevent groups recycling money to the UK to obtain a tax advantage and artificially diverting UK profits. This is presumably designed to target upstream loans but it is unclear whether this might be defined more widely, for example, to prevent loan receivables transferred from the UK from using the exemption.
Swamping finance income in trading companies will no longer be possible as any interest income that is not ancillary or incidental to an entity's trading income will be treated as if it had arisen in a finance company and the same debt:equity ratio will be applied to that part of the company.
It would appear that a full exemption for treasury companies may not be taken forward, as many businesses often have higher risk financing activities alongside normal treasury operations. Further discussion is proposed on this point, particularly whether these "mixed" entities should be treated in the same way as a finance company.
Separate proposals will be published in spring 2011 for banks and insurance companies.
Intellectual Property
The areas where the Government believes CFC protection is required in respect of intellectual property are where:
- IP, which has been developed in the UK, is transferred to a low tax jurisdiction;
- IP is held offshore but is effectively managed in the UK; and
- the IP has been funded by the UK and the UK does not receive a return on that investment.
The proposed CFC rules will require the following assessment to be undertaken:
- Identify entities which hold IP with a substantial UK
connection which will include:
- IP which was transferred from the UK in the last 10 years;
- IP where significant amounts of activity to maintain or generate the IP are undertaken in the UK; and
- IP which is held as an offshore investment.
- If there is IP with a substantial UK connection, assess whether
excessive profits have arisen.
The Government is proposing that a new methodology (with some safe harbours) is developed which seeks to identify "excessive profits" based on factors such as substance, activity, funding structure and the time since the IP was transferred from the UK. The detail of this new methodology is far from clear but the Government does not accept that internationally accepted transfer pricing principles are sufficient. Any additional calculations are likely to be highly complex and will be subject to substantial debate. - Finally, if there are excessive profits, assess whether these
have been artificially diverted from the UK.
The proposal is that the "excessive profits" that the IP company generates should be shared amongst jurisdictions (including the UK) where relevant on a just and reasonable basis. - "Investment IP" will be treated as if it were a
monetary asset.
For investment IP, rather than trying to trace how offshore IP is funded, the Government is proposing the same approach as with monetary assets (ie there will be a deemed UK charge based on an imposed debt:equity ratio of 1:2, which results in the IP income being taxed at 8-9%). We assume that this will be available as a backstop for more active companies if this gives a better result than the calculations in steps 1-3.
Although this could represent a more targeted approach, it has the potential to be extremely complex and requires a new concept of 'excessive profits' to be defined. There is no comment as to how the proposals will operate in an EU context.
Two proposals from the previous January 2010 discussion document have been excluded from the consultation following discussions with business. These are the proposed "earn-out" charge when IP leaves the UK and the "actively managed exemption" which has been dropped due to fears that this would force economic activity out of the UK.
Comments are invited by 22 February 2011.
2. CFC INTERIM IMPROVEMENTS
Further details on the interim improvements to the existing CFC regime have been published for consultation and will be legislated in Finance Bill 2011. Draft legislation is expected on 9 December. Four main changes are proposed:
Intra-Group Activities
A new exemption is proposed for companies with intra-group transactions which meet the following conditions:
- the CFC must have a business establishment in its territory of residence;
- the CFC's business does not include to a substantial extent investment business (substantial is likely to be defined as more than 10%);
- less than 5% of the CFC's gross income is in the form of finance income or income from IP; and
- no more than 10% of the CFC's gross income or expenditure arises from a UK connection.
This exemption represents a limited relaxation of the exempt activities test. It may be helpful for groups with, for example, intra-group service companies that do not have transactions with the UK, provided there is no intellectual property involved.
IP With No UK Connection
A limited exemption is proposed for CFCs, the main business of which is the exploitation of IP. This is helpful, but only where there is little or no involvement of the UK (which includes the IP not being held in the UK in the last 10 years).
Extension to 'Period of Grace'
HMRC guidance currently provides a temporary CFC exemption for certain companies that are acquired by UK groups following an acquisition or reorganisation, known as a 'period of grace'. The Government proposes that this practice is introduced as a statutory exemption and extended from 24 months to 3 years. The exemption will not be lost where a CFC restructures so long as the restructuring does not 'erode the UK tax base'.
De Minimis Exemption
The de minimis CFC exemption will be increased from £50,000 to £200,000 for large groups only. The basis of calculation will change from groups having to calculate the CFC's profits under UK taxation principles to being able to use their accounting profit with adjustments in line with the transfer pricing rules. There will also be anti-avoidance measures.
Other Matters
Transitional rules for superior and non-local holding companies introduced in FA 2009 will be extended until 2012.
3. INTELLECTUAL PROPERTY (PATENT BOX)
The Government's priority for reform of IP taxation is to support high value, successful commercialisation of IP with strong links to R&D and manufacturing in the UK . The Government's view is that brand names and trademarks have a weaker or more variable link to R&D and high-tech manufacturing - and a special regime for all IP would be expensive.
In line with earlier announcements, there will be a new tax regime for patents; a 10% tax rate on net profits will apply from 1 April 2013. Profits can arise from both patent royalty income and embedded income in the price of patented products. The Government will consult on the identification and quantification of embedded income. It currently favours a formulaic approach, which it believes will be simpler and provide greater certainty, rather than apply the arm's length principle. It is intended that the regime will apply to patents first commercialised, rather than first granted, after 29 November 2010. Although the document does not refer to the place of patent registration, it is thought likely that the regime will only apply to UK and EU patents. The Government is inviting comments by 22 February 2011; there will be further consultation in spring 2011.
4. RESEARCH AND DEVELOPMENT TAX CREDITS AND VACCINE RESEARCH RELIEF
As part of the IP review, the Government is also consulting on R&D tax credits for small and medium sized enterprises, the large company R&D scheme and vaccine research relief. As announced in the June 2010 Budget, the document considers the Dyson Review. This review raised concerns that the schemes may not be sufficiently well targeted and made two specific proposals: to refocus the schemes on high tech companies, small businesses and new start-ups and to improve the ease with which the R&D tax credit can be claimed. It is clear from the current document that the Government does not however intend to restrict R&D tax credits to specific sectors.
Areas for consultation include the definition of R&D, whether there should be a statutory definition of production, what costs should be eligible for relief, whether relief for internal use software should be limited or excluded and whether the claims process could be improved (eg by a pre-clearance procedure). The take up of vaccine research relief has been low; apparently only 10 claims have been made. Comments are therefore invited on whether there is a more effective way to support vaccine research. Again, responses are sought by 22 February 2011.
5. FOREIGN BRANCH TAXATION
Draft legislation and explanatory notes will be published on 9 December for inclusion in Finance Bill 2011 and the key features are expected to be as follows:
- An irrevocable opt-in regime will apply to the trading branches of most UK companies. Companies which opt in will not be able to take relief in respect of foreign branch losses. This all or nothing approach may mean that some companies may struggle to determine whether an election should be made.
- The exemption will generally apply to trading branches in all countries and territories, including those with which the UK has no tax treaty. However, it will not cover non-treaty branches of small companies.
- Chargeable gains will be exempt by reference to the relevant treaty or to the OECD model treaty.
- There will be transitional rules in order to effectively claw back relief already given for foreign branch losses. These rules will depend upon whether prior losses are 'large' (yet to be defined).
- When a company opts into the regime, each of its branches will potentially be subject to anti-diversion rules. Pending the wider CFC reform in 2012, the Government intends to include in Finance Bill 2011 a CFC-type regime for foreign branches, with a motive test, a lower level of taxation test and a de minimis level of profits as the available carve-outs.
Responses are invited by 9 February 2011.
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.
