 Controlled foreign companies consultation
HMRC and HM Treasury have issued a consultation document setting out proposed changes to the controlled foreign companies (CFC) legislation to be included in Finance Act 2012. The aim is for the rules to better reflect the way that businesses operate in a globalised economy and to focus the UK tax base on profits economically derived from UK activity, rather than from worldwide business.
The overall framework of the rules would stay as they are now and would continue to apply to companies that are resident outside of, but controlled from, the UK and subject to a lower level of tax in their territory of residence. However, it is possible that changes could be made to the definition of the terms ‘controlled’ and ‘lower level of tax’. It is proposed that a non-statutory clearance procedure will be introduced to give companies early certainty on their CFC exposure rather than having to self-assess.
The most significant reforms would be to the exemptions from the CFC regime. Some of the existing exemptions will be retained in an amended form and some new exemptions added with the intention that a CFC charge should only apply to the proportion of a company’s profits that have been artificially diverted from the UK.
The existing exemptions to be amended are:
· the low profits exemption, which might remain a fixed de-minimis test (but increased from its current level), or become a variable measure, depending on the size of the group concerned
· the excluded countries exemption (it is proposed that the list of countries will be overhauled and that multiple lists may be used, reflecting the different additional conditions which might need to be met for certain countries)
· the temporary period exemption, providing relief for up to three years where an overseas subsidiary comes within the scope of the CFC regime as a result of a reorganisation or change to UK ownership.
Brief details of the proposed new exemptions are set out below. There will also be specific rules for the insurance and banking sectors.
Territorial business exemptions (TBEs)
It is proposed that there will be three mechanical based exemptions, perhaps also accompanied by a principles based exemption, available where none of the other three exemptions apply. A local management condition may need to be met in relation to some or all of the exemptions, such that the CFC must be controlled and managed in the local territory of residence by staff of sufficient expertise and seniority.
Exemption 1 would apply to those companies with a low profit margin (a safe harbour of 10% of operating expenses is currently proposed).
Exemption 2 would apply to companies carrying on manufacturing activities (and not any other substantial activities). The company would only be able to use ‘local IP’ developed by its own staff, third parties integral to the CFC’s trade or acquired by, or licensed to, the CFC solely for its manufacturing activities.
Exemption 3 would apply to a CFC performing commercial activities where there is a low risk of artificial diversion of profits from the UK. It is proposed that IP exploitation activities would only qualify if:
· no more than 50% of the CFC’s business expenditure relating to IP is with related UK parties and
· no more than 20% of the CFC’s gross income involving IP exploitation is from the UK and
· there are no substantial activities relating to IP transferred from the UK within a certain period.
To be able to rely on any of these proposed exemptions, no more than 20% of the CFC’s business should consist of investment activities. These would include holding shares and securities (other than in group companies) and certain leasing arrangements. It should also have no more than an incidental amount of finance income.
Finance company rules
A partial exemption is proposed for a CFC lending to overseas group companies and realising more than an incidental amount of intra-group finance income. The exemption would not apply to finance income arising on upstream loans to UK group entities or monies held on deposit with third parties (unless these amounts are incidental). As with the TBEs, there may be a requirement for the CFC to be locally managed.
Various options have been put forward for calculating the proportion of the CFC’s profits that should be subject to UK tax but, in a worst case scenario, only one quarter would be caught, resulting in an effective UK tax rate on profits from overseas intra-group financing of 5.75% by the year 2014. Under some of the options proposed, a smaller proportion may be caught if the CFC’s debt:equity ratio is greater than 1:3.
General purpose exemption (GPE)
A GPE would replace the existing motive test and exempt profits that have not been artificially diverted from the UK, based on the facts and circumstances of the case. The exemption could only be applied to part of the company’s profits so that profits which have been artificially diverted, and are not covered by any of the other exemptions, would be subject to a CFC charge.
The consultation document is available at http://digbig.com/5begwt
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