UK: CFC Reform Consultation (Tax Newsletter, Summer 2011)

Last Updated: 11 November 2011
Article by John Watson, Alexander Cox, Paul Miller, Richard Palmer and Simon Swann

The Treasury has published the most detailed proposals yet for the reform of the controlled foreign company (CFC) rules. The Treasury indicated at a recent open day that the new rules would be expected to apply to accounting periods of companies commencing on or after Royal Assent to the Finance Act 2012 (July/August 2012).

The proposed new CFC rules are to operate in a similar way to the existing regime; by identifying low taxed foreign companies controlled from the UK and then applying a number of exemptions. While the new exemptions have clear parallels with those currently in operation, they will be refocused on key areas of risk (mainly IP and monetary assets) and - most importantly - will adopt a proportionate approach such that a CFC charge will only arise on the proportion of profits in a given entity deemed to have been artificially diverted. In particular, the "general purpose" exemption for CFCs that can demonstrate no artificial diversion takes the place of the old motive test, but without a default assumption that profits would have arisen in the UK.

While there are likely to be many cases at the margins where it will be difficult to determine the extent to which profits should be attributable to the UK, it is helpful that the structure of the regime is similar to the existing rules and a non-statutory clearance procedure is proposed to give certainty in borderline cases.

Defining a CFC

The Treasury is looking at a number of options on how best to define "control" in this context:

  • by principle, i.e. that, in substance, the person has economic rights or actual control over the assets or income of the company;
  • by relying on the rules for group consolidation used for accounting purposes; or
  • using similar rules to the present ones, i.e. the ability to ensure that an overseas company's affairs are conducted in accordance with the wishes of a UK person.

As currently, only an entity with profits taxed at a lower effective rate than if it were resident in the UK will be caught (clearly, this decreases as the UK corporation tax rate reduces over the next few years). It is intended to retain the "lower level of tax" test threshold at 75 per cent of the UK corporation tax that would have been suffered, and companies would not be obliged to apply this test if it is easier to claim one of the exemptions instead.


The exemptions exclude from the regime those CFCs which appear to pose a low risk to the UK tax base and the main exceptions are set out below:

Low profits exemption. Effectively a de minimis, the options suggested are a £500,000 threshold with further limits on investment income, permitting a certain percentage of turnover or retaining the existing £200,000 limit.

Excluded countries exemption. Equivalent to the "white list", this operates as a proxy for performing a "lower level of tax" calculation. It would apply to CFCs meeting certain conditions, including a local management condition, and located in jurisdictions with tax regimes with broadly similar rates and bases to the UK. The scope of this exemption has not yet been further clarified.

Temporary period exemption for up to three years where an overseas subsidiary comes within the scope of the CFC regime as a consequence of a reorganisation or change to UK ownership, as per the amendments recently enacted in the Finance Act 2011.

Territorial business exemptions (TBEs) designed to be a safe harbour for genuine overseas trading operations. This would comprise three separate exemptions for CFCs:

  • with low operating margins;
  • carrying on manufacturing trades (other than those involving an IP hub); and
  • carrying on commercial activities where there is a low risk of artificial diversion of profits from the UK. Around 20 per cent of the CFC's activities will be permitted to be certain investment activities such as holding and managing shares and securities other than those of group companies, and some leasing.

Incidental finance income from the working capital needs of the business would be exempt, but because the CFC charge will now be calculated on a mixed entity/income stream approach on a proportionate basis, it will no longer be possible to "swamp" finance income with trading income.

It is proposed that there would be a local management condition for the TBEs such that the CFC must be controlled and managed by sufficient staff of the necessary expertise and seniority.

Finance company partial exemption for overseas financing that would lead to an effective rate of 5.75 per cent on profits from overseas intra-group finance income by the year 2014, i.e. a quarter of what would normally be payable. This equates to a deemed 1:3 debt:equity ratio on an assumed wholly equity funded finance company. This would also apply to finance income that represents the structural surplus cash reinvested within a group to the extent that it exceeds amounts incidental to the CFC's business.

The Government would prefer this to be calculated on an apportionment basis under which the CFC would undertake a UK chargeable profits calculation, rather than an imputation basis deeming excess equity funding to be a loan from the UK. The details of the interaction between this apportionment and debt cap rules is currently unclear.

The Government is also considering a full exemption in limited circumstances.

General purpose exemption. This will consider the facts and circumstances of a CFC to assess whether profits are commensurate with the CFC's own activities or have been artificially diverted. It is proposed that assets and risk would be attributed to the CFC in a similar manner to the OECD guidelines on attributing profits to permanent establishments. Indicators of profits which had been artificially diverted would include (i) transaction diversion, e.g. a transaction giving rise to a UK deduction that would not have arisen had the transaction been at arm's length and (ii) diversion through transfer of assets, e.g. the separation of an intangible asset, previously in the UK, from the active decision-making regarding the risks inherent in the asset ownership.

This exemption would have to be considered for CFCs with high-risk IP, but could also be used as a fall-back either where a CFC falls within none of the previous exemptions (most likely to be available where another exemption is failed only marginally) or where only a proportion of its income is otherwise exempt, e.g. under the partial exemption for finance companies. The Government intends to publish guidance on the operation of this exemption. Concern was expressed at the open day that the complexity of the other exemptions would lead to widespread reliance upon this exemption.

Sector-specific rules will apply to leasing companies, insurers and banks where monetary assets are an intrinsic part of their trade. Please speak to your usual Ashurst contact if you would like more detailed information on these at this stage.

Specific rules for IP

The TBEs can be used to exempt CFCs involved in the exploitation of IP that do not pose a significant risk to the UK tax base. This will cover:

  • IP income related to the holding and exploitation of foreign IP which has not been transferred from the UK, nor has significant economic connection with the UK;
  • local IP that is integral to a genuine overseas manufacturing trade; and
  • IP royalty income that is incidental/ancillary to the trade.

More complex cases, where IP has been transferred out of the UK within the last six years or there is a significant UK connection such as the effective management or development of the IP in the UK, will need to be dealt with by the general purpose exemption.

The consultation document contains a long list of factors to consider in determining whether the profits arising in a CFC following the transfer to it of UK IP are artificially diverted. These include:

  • insufficient genuine commercial substance in the transferee;
  • UK IP is transferred without the transfer of the functions needed to continue to develop/exploit the IP;
  • significant sales in the UK;
  • value-adding activities connected with the IP are performed in the UK rather than the CFC's territory of residence;
  • in the case of a brand, it is geographically sensitive and its integral value is in the UK; and
  • the UK borrows to fund third party acquisitions of IP by the CFC.

Foreign branches

The Finance Act 2011 contains an opt-in exemption for the taxation of foreign branches of UK companies. To ensure that tax treatment of exempt foreign branches is aligned with that of foreign subsidiaries as far as possible, the new CFC rules provide that, when a company elects into exemption, it must consider whether any of its branches are subject to a lower level of tax and, if so, whether those branches meet any of the CFC exemptions. If a CFC exemption is met, the branch profits will be exempt but, otherwise, the branch profits (or an appropriate proportion) will remain chargeable to UK tax.

Credit relief will be available for any foreign tax paid on profits which are subject to UK tax.

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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