UK: Controlled Foreign Companies

Last Updated: 21 July 2009
Article by Rosemary Blundell

The objective of the controlled foreign companies (CFC) legislation is to tax profits which have been diverted from the UK into an overseas 'controlled' company, subject to a range of exemptions, including where HMRC accept the activities are genuine (the 'exempt activities test'), and where the territory is on a white list (an 'excluded country'). However, successful challenges in the European Court of Justice have prompted a reform of the UK's CFC rules (although HMRC has just won the Vodafone 2 case at the Court of Appeal – see separate article).

The CFC reforms in Finance Bill 2009 are only temporary measures pending more sweeping changes to come – likely to be in 2011. The current proposals are limited to the abolition of the acceptable distribution policy (ADP) and the non-local holding company exemptions in the exempt activities test. Both changes are significant, but the repeal of the non- local holding company exemptions may have a significant impact on tiered group structures. There is two year transitional period for exempt international and superior holding companies, but given the conditions which must be met, groups must not assume they will be able to benefit from this. It is good news however that the exemption for local holding companies will now be retained. The changes apply from 1 July 2009 and there are transitional rules dealing with straddling accounting periods.

Key points to note are:

  • The acceptable distribution policy (ADP) exemption will be repealed for accounting periods beginning on or after 1 July 2009. It will still be possible to pay an ADP in respect of all accounting periods (including the first portion of the straddling period) ending before 1 July 2009. Where a CFC pays an ADP on or after 1 July 2009, it will not be exempt from tax under the distribution exemption.
  • The non-local holding company exemptions are abolished from 1 July 2009 (subject to transitional rules), but the local holding company exemption will now be retained.
  • A two-year transitional period to 1 July 2011 is available for 'qualifying holding companies' (QHC) which meet certain additional tests in order to allow groups time to restructure. Qualifying holding companies therefore cease being exempt under the IHC or SHC exemptions from 1 July 2011.
  • In order to be a 'qualifying holding company' the holding company must have been an exempt holding company throughout its last accounting period to end before 1 July 2009 (not including the deemed AP where an AP straddles 1 July 2009). In other words, it must have qualified as an exempt international or superior holding company. If a QHC satisfies certain additional requirements in the two year transitional period as regards its income and ownership, it will continue to be exempt.

It follows that the holding company's last accounting period before 1 July 2009 will be critical in determining whether the two year period of grace is available or not. Groups therefore need to be reviewing their overseas non-local holding companies to establish whether they meet the exempt activities test or not. This is not as easy as it might sound owing to the complexity of the CFC rules, for example, subjectivity in the 'main business test' and income tracing rules. In particular, any investment income of trading companies can have a detrimental impact on holding companies higher in the group structure meeting the exempt activities test – and the way the rules work mean this impact is magnified as you progress upwards through the tiers of holding companies. However, this is only the starting point, the next challenge is to ensure that the two year transitional exemption continues to be met, so groups need to be reviewing their holding companies to make sure they continue to be exempt. If they do not, then their income will be taxable in the UK. Although their dividend income will, in most cases, be exempt under the distribution exemption, their non-dividend income will be taxable. Furthermore, in calculating the CFC's apportionable profits, it will be necessary to apply the whole range of UK legislation, including transfer pricing, loan relationships and anti-avoidance, to name but a few. This in itself will also add to compliance costs.

Professional advice should be taken before any action is taken.

Mazars LLP accept no responsibility for any action which any individual or business may take or not take based on their reading of this article.

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