UK: Taxation Of Foreign Profits Of Companies

Last Updated: 25 November 2008
Article by Deloitte Tax Group

Most Read Contributor in UK, August 2017

Today's announcement on foreign profits reform brings a welcome resolution to over two years of debate on the introduction of an exemption from UK corporation tax for overseas dividends. The announcement of reforms which are to be introduced into law in Finance Bill 2009 represent significant changes to how the UK taxes international activity. However, it also opens a further round of consultation on the future of the UK's Controlled Foreign Company (CFC) rules which, for some businesses, have been the most controversial part of the consultation process to date.

Summary Of The Announcement

At a very high level, the reform package announced today will introduce an exemption for foreign dividends (subject to certain restrictions) received by large and medium businesses. It is not clear yet from what date this will apply. This will be accompanied by the abolition of the outdated Treasury Consent requirements and their replacement with a post-transaction reporting requirement for high-risk transactions with a value of more than £100m. These two reforms are intended as the 'good news' parts of the package. The 'bad news' parts of the package are;

  • the introduction of a worldwide cap on the amount of interest which can be deducted for tax purposes in the UK,
  • an extension to the current anti-avoidance rules for loan relationships and
  • the restriction of some of the current exemptions which take overseas subsidiaries outside the scope of the current CFC rules.

The Cost Of Reform

HM Treasury's estimated cost of the foreign profits reform (published in the Pre-Budget Report) is zero in 2008/09, +£75m (ie income to HMT) in 2009/10, +£25m (ie income to HMT) in 2010/11 and a cost to HMT in 2011/12 of £275m. The declining cost profile of the overall package is interesting, although there is no detail as to how this breaks down between the various elements of the reform package. However, this profile does indicate that over time HM Treasury expect this package to represent a cost to the Exchequer.

Future Reform: CFC

A wider reform of the CFC rules (which was originally suggested as part of this reform package) has been deferred. This will still be taken forward but will follow its own timetable, although it is not expected this will be concluded in time for Finance Bill 2010. In an open letter from the Financial Secretary to the Treasury to the CBI and Hundred Group, it is stated that the intention of this reform will be to modernise the rules, which will aim to protect against artificial diversion of profit from the UK. This letter also indicates that a new CFC system should not tax profits genuinely earned in overseas subsidiaries. This is stated to be consistent with a "move towards a more territorial system of taxing foreign subsidiaries".

In terms of process for future CFC reform there is no indication of what we can expect, but a consultation or discussion document on options for reform is likely to be the next step. This announcement suggests that the Treasury have listened to the concerns of business and representative bodies over the proposals put forward for CFC reform in the 2007 Discussion Document (the income based controlled companies rules) along with the calls which have been made not to rush this critical piece of reform. Therefore, separating CFC reform from the wider package seems sensible in terms of process as this allows dividend exemption to be introduced without further delay, whilst further work on policy options for the future of CFC are worked through.

A Territorial System?

Whilst the statement of the expected future intention of CFC is reassuring, the continued uncertainty over timetable and the outcome of this reform may be unsettling for some businesses. The outline of the income based controlled companies rules, suggested in the 2007 Discussion Document, was regarded by many as an attempt to broaden the scope of the current CFC rules, bringing more offshore activities within the UK tax net. In today's open letter to the CBI and Hundred Group, the Financial Secretary to the Treasury acknowledges that there has been speculation the Government is seeking to increase the scope of the CFC rules and goes on to say that this is not the case.

Of course, full consultation on CFC reform will take time so this leaves us with the question of whether there will be tensions in how the current CFC regime is operated by HMRC during the period between now and the introduction of future reform. The current system does tax situations where profits are genuinely earned in overseas subsidiaries where there has been no diversion of profit from the UK, and the motive test, which many may expect would apply in such situations, is often denied by HMRC. This tension could very easily be managed if HMRC were to revise their position on the motive test to provide clear and public guidance that under current rules, profits that are genuinely earned in overseas subsidiaries will be CFC exempt. This would be a very positive move in demonstrating the Treasury is serious about its stated intention and would help relieve the pressure on the CFC position of UK groups who are competing with companies located in more favourable tax jurisdictions.

Shorter Term CFC Issues

Today's announcement includes the abolition of some of the current avenues available for offshore subsidiaries to qualify as exempt CFCs. These changes may, depending on their detail, adversely impact some very common commercial arrangements.

The first, the Acceptable Distribution Policy (ADP) exemption, allows a CFC to be exempt if it distributes at least 90% of its profits back to the UK via a taxable dividend within 18 months of the end of the accounting period. The introduction of dividend exemption means this CFC exemption no longer makes sense and in fact, even if it were not abolished it simply would not be effective any more as the requirement for the dividend to be subject to UK tax would not be met under a dividend exemption system.

The second change is the proposed abolition of the holding company tests contained within the exempt activities CFC exemption, subject to a 24 month transition period (the full details of which are yet to be published) which is announced to allow groups time to unwind holding company structures. This is more controversial. By proposing to abolish the holding company tests, the Government is ignoring the fact that many groups have holding companies which are used for normal commercial purposes. For example, a holding company may be used to provide services to other companies within the same territory which, under the current rules, could be exempt from a CFC apportionment. Holding companies are also used for cash pooling and financing within the same territory. In many normal acquisition scenarios a holding company may be used as a bid vehicle and may provide finance. All of these situations which may escape the ambit of the current CFC rules in a straightforward manner are likely to be impacted by the proposed abolition of these tests. This means that affected companies will need to consider whether any of the alternative CFC exemptions may be available to them or suffer a CFC apportionment which, even if it does not increase the total tax cost (because of relief for overseas taxes already suffered) it will increase their compliance burdens.

Who Is Likely To Be Affected?

The different elements of the reform package announced are likely to impact different sectors in different ways. The impact on specific taxpayers will of course depend on the circumstances of each group but we would broadly expect the impact to be as follows:

  • UK outbound groups - should benefit from dividend exemption. The interest cap proposals are likely to negatively impact groups with upstream loans where external debt is borrowed wholly in the UK.
  • Inbound groups - many will not benefit from exemption but could be adversely impacted by the interest cap proposals. Even if this does not result in additional tax cost it is likely to be a compliance cost, depending on the detail of the rules.
  • Cash rich groups/groups required to hold liquid assets in their business are likely to be adversely impacted by the debt cap depending on how the net consolidated interest position of the group is calculated and how much of their external debt is located in the UK (if interest on UK debt remains deductible in spite of the cap).
  • Private Equity & Fund structures - it is unclear whether the typical sorts of investment structures used by these groups are likely to be impacted by the interest proposals. This is likely to depend on how the consolidated group accounts for shareholder investment and whether this is regarded as external debt.

Whether groups will benefit from the overall package of reform will depend on how significant a benefit they believe dividend exemption offers them and whether the impact of the interest cap is a price they are willing to pay.

Next Steps

Today's announcement states that draft legislation containing the detailed proposals will be published in the coming weeks for consultation. The intention is for the final form of the legislation to be introduced in Finance Bill 2009. No timetable has been suggested for wider CFC reform, but as this is unlikely to be complete before 2010, which is widely expected to be an election year, it is unclear how this will impact the prospects for CFC reform.

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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