Government proposals to simplify tax rules while promoting the
interests of business are always welcome, and this is especially
true of the proposed reforms to the United Kingdom's Controlled
Foreign Company ("CFC") legislation. The Government has
released the final legislation as part of the Finance Bill 2012
after much discussion and consultation. The new regime will apply
to accounting periods of CFCs beginning on or after 1 January
2013.
In this Commentary, we provide a summary of the history
of the CFC rules and discuss the proposed changes. We also consider
the opportunities that the new legislation presents for
multinational businesses.
The new regime will allow some UK multinational companies that are
currently taxed under the CFC regime to fall outside the scope of
the new rules. For companies looking to expand into the UK or
considering an expansion into Europe through the UK, the new CFC
regime should make the UK a more attractive place for such
businesses.
History of the CFC Rules
The UK introduced CFC rules in 1984 in response to a perceived increase in tax deferral and artificial diversion of profits to lower-tax jurisdictions following the relaxation of UK exchange controls. Such rules are a common feature of many tax systems that seek to bring profits accumulated outside the jurisdiction within the charge to tax. For example, the rules contained in Chapter 1, Subchapter N, Part III, Subpart F of the US Internal Revenue Code seek to bring the income of US CFCs within the scope of US tax.
Current CFC Rules (for accounting periods beginning before 1 January 2013)
Under the current UK rules, where a company is a CFC and does
not fall within one of the specified exemptions, all the profits of
that CFC may be apportioned among its participators (broadly, its
shareholders).
A company is a CFC where the following three criteria are met: (i)
the company is not resident in the UK; (ii) the company is
controlled by UK residents; and (iii) the company pays a lower
level of taxation (i.e., less than 75 percent of the tax that would
have been paid had the company been resident in the UK).
A CFC can fall outside the scope of the rules and therefore avoid
an apportionment of its profits if it satisfies any one of the
following five statutory exemptions. These exemptions are parallel
tests, in that they may be applied in any order.
The exemptions exclude CFCs that: (i) have profits below the de
minimis limit1; (ii) operate an acceptable
distribution policy2; (iii) carry on certain exempt
activities3; (iv) are resident in certain excluded
countries4; or (v) do not have a tax avoidance
motive5.
Where the exemptions do not apply, any UK corporate participator
whose apportionment is 25 percent or more of the CFC's profits
(including apportionments made to persons connected or associated)
will be subject to UK corporation tax, with an allowance made for
any foreign taxes paid by the CFC.
Challenges to the CFC Rules
The decisions of the European Court of Justice ("ECJ") in
the Cadbury Schweppes6 case and the Court of
Appeal of England and Wales ("Court of Appeal") in the
Vodafone 27 case have left the validity of the
current CFC rules in doubt. Accordingly, in addition to introducing
a simpler, more business-friendly set of rules, the new CFC regime
is also intended to be European Union law compliant.
In the Cadbury Schweppes case, the ECJ was asked to rule
on whether the UK's CFC rules were an infringement of the
freedom of establishment principle. The ECJ ultimately held that
Cadbury Schweppes had not engaged in an abuse of the freedom of
establishment principle by establishing subsidiaries in lower-tax
jurisdictions but that the CFC rules did hinder the freedom of
establishment. Importantly, however, the ECJ ruled that the
restriction on the freedom of establishment imposed by the UK's
CFC rules could be justified where it was both in the public
interest and proportionate. The UK had argued that such a
restriction could be justified on the grounds that it was in the
public interest to prevent tax avoidance; however, this was
rejected by the ECJ, which instead held that the CFC rules could be
justified only where the rules related to "wholly artificial
arrangements...".
That position was further compounded by the decision of the High
Court of England and Wales ("High Court") in the
Vodafone 2 case, which stated that the CFC rules should
not apply to companies with subsidiaries in European Union
("EU") or European Economic Area ("EEA") Member
States, owing to incompatibilities with the Treaty establishing the
European Community. The Court of Appeal overturned the decision of
the High Court, instead deciding that the CFC rules could apply to
subsidiaries in EU/EEA Member States subject to the implied
exception that the rules did not apply to companies carrying on
"genuine economic activities."
New CFC Rules (for accounting periods beginning on or after 1 January 2013)
In broad terms, the new CFC rules have moved towards an
"all out unless in" approach that facilitates intra-group
activities and offers businesses the flexibility to self-assess
their obligations under the new CFC rules.
The new rules are intended to reflect the decision of the Court of
Appeal in the Vodafone 2 case by subjecting overseas
profits to UK tax only where there is an artificial reduction of UK
tax. In addition, the CFC charge will be proportionate, by
targeting only those profits that have been artificially diverted
away from the UK, rather than applying to all profits of the CFC
which are caught (subject to exceptions) under the current
regime.
The new rules introduce a "gateway test" and safe
harbours, reframe the exemptions as entity level exemptions and
provide a specific exemption for finance companies. Broadly, the
criteria for establishing whether a company is a CFC have been
retained, although the requirement that a lower level of taxation
is paid by the company has been removed from the CFC test and
included as an entity exemption.
The Gateway Test. One of the most significant
changes to be introduced under the new regime is the "gateway
test" which defines those profits that are to fall within the
scope of the regime. This differentiation of profit streams
represents a significant improvement on the current regime and
provides the initial mechanism for the new "all out unless
in" approach. In addition, the gateway test will serve to
exclude a significant proportion of entities from the scope of the
CFC rules, even before the other exemptions need be
considered.
In February 2012, the new rules were further improved upon by the
inclusion of an "introductory" Gateway Chapter (Chapter
3) to the legislation. This chapter will reduce the compliance
burden by acting as a pre-gateway test enabling companies to test
whether the specific gateway chapters require consideration.
The substantive chapters of the gateway test then assess whether
any of the CFC's business and finance profits may be subject to
the CFC charge by determining whether there has been an artificial
diversion of profits from the UK.
One of the key tests of whether there has been an artificial
diversion of profits is whether there is a significant mismatch
between key business activities undertaken in the UK and the
profits arising from those activities allocated outside the UK. The
following three specific requirements must be satisfied in order to
establish whether this significant mismatch occurs: (i) the
majority of the profits from the assets or risks owned or borne by
the CFC are connected with the UK activity by reference to
"significant people functions" ("SPF") in the
UK8; (ii) the separation of assets or risks from
activities does not give rise to substantial non-tax value; and
(iii) the arrangement that creates this separation would not be
entered into between independent companies.
Safe Harbours. Specific profits of the CFC are
excluded from the CFC rules by the operation of various safe
harbours. This represents a significant departure from the approach
of the current regime which subjects all CFC profits to tax unless
an exemption is satisfied. Profits dealt with by safe harbours
include: profits from property businesses; incidental non-trading
finance profits; incidental non-trading finance profits derived
from the investment of funds held for the purposes of a trade or
property business where the profits of the trade would not
themselves fall within the CFC rules; and incidental non-trading
finance profits where a "substantial part" of the
CFC's businesses is holding shares and securities in its 51
percent subsidiaries.
Entity Level Exemptions. As an alternative to the
gateway test, companies can use the "entity level
exemptions" to fall outside the scope of the new CFC rules.
There are similarities between these exemptions and the various
exemptions that exist under the current rules. These exemptions are
targeted at CFCs which pose a low risk to the UK tax base. The
specific exemptions include a low profits exemption (similar to the
current de minimis rule), a low profit margin exemption for CFCs
whose accounting profits are 10 percent or less of their cost base
and related party expenditure, an excluded territories exemption
(similar to the current excluded countries test albeit subject to
certain conditions) and a temporary period of exemption of 12
months for companies that will be new to the UK CFC regime (for
example, either because they were acquired by a UK company or the
parent company has migrated to the UK), during which a foreign
subsidiary will be exempted from the CFC rules subject to the CFC
undertaking any restructuring necessary to ensure that no CFC
charge arises for subsequent periods.
Finance Company Exemption. The finance company
exemption is intended to allow multinational entities to manage
their intra-group financing arrangements more effectively. Under
the Finance Company Exemption, the profits of intra-group financing
companies will effectively be taxed at 25 percent of the normal
corporation tax rate, which will be 5.75 percent if the corporation
tax rate is reduced, as proposed, to 23 percent for 2014. This
exemption will work by considering the finance company's
debt-to-equity ratio and applying a CFC charge to the extent that
the company has excess equity.
The partial exemption has been extended to a full exemption in
situations where either the CFC charge that would arise from
partially exempt loan relationships is limited to the aggregate net
borrowing costs of the UK members of the group or the finance
profits arise from a qualifying loan (broadly, a loan made to a
connected foreign company) which is made without reliance on wider
group funds (for example, as a result of a rights issue).
The Bigger Picture
The proposed changes to the CFC rules demonstrate the UK
Government's desire to make the UK a more attractive place from
which multinational entities can conduct their operations. However,
they are but one of many aspects of the UK tax system that will go
towards achieving this goal.
The new CFC rules combined with the general exemption from
corporation tax on dividends received by UK companies, the absence
of withholding tax on dividends paid by UK companies, the option to
elect to exempt profits of overseas branches from corporation tax,
the corporation tax exemption with respect to disposals of shares
in subsidiaries in certain situations and the UK's extensive
tax treaty network—all of these factors make the UK an
attractive location for multinational entities considering
establishing or expanding their business operations in the UK and
worldwide.
Footnotes
1.CFCs with profits of less than £50,000 or, for
accounting periods beginning on or after 1 January 2011, less than
£200,000 are exempt from the CFC regime.
2.No CFC charge will arise where not less than 90 percent of the
CFC's profits are distributed for periods prior to 1 July
2009.
3.Entities which can satisfy a series of prescriptive conditions
to establish that their main purpose is not to reduce UK tax are
excluded from the CFC rules, although in practice, satisfying this
exemption can be difficult.
4.CFCs resident in certain jurisdictions will be exempted in whole
or in part from the CFC regime.
5.Through a series of sub-tests, this exemption provides a final
opportunity for CFCs to fall outside the CFC regime where the
previous objective tests have failed to exclude companies not set
up for the purposes of tax avoidance.
6.Cadbury Schweppes plc, Cadbury Schweppes Overseas Ltd v
Commissioners of Inland Revenue C‐196/04 [2006] ECR
I‑7995.
7.Vodafone 2 v The Commissioners of Her Majesty's Revenue
and Customs [2008] EWHC 1569 (Ch).
8.The principles for the identification of SPFs are set out in the
2010 OECD report on the Attribution of Profit to a Permanent
Establishment.
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.