Taxation

The New UK CFC Rules – A Brief Overview

By David J Kidd, Citroen Wells

After a long period of consultation, the UK controlled foreign company (CFC) rules have been substantially overhauled. The new legislation applies for accounting periods beginning after 1st January 2013. This means that implementation at a detailed compliance level is now beginning for the first time for many UK companies. Thus a brief overview of the essential elements of the new rules may be of interest.

General

At a high policy and consultation level, the UK government wished to target the CFC legislation more closely towards its intended target, the diversion of UK profits abroad, and the general consensus is that in this respect the new rules are an improvement. The idea is that the new rules are supposed to pick up a nexus with the UK, and insofar as profits are not so connected, the expectation is that they should not be caught. Insofar as the UK is considered a congenial jurisdiction for a corporate group to have its headquarters, this development reduces the hindrance the previous CFC rules may have posed. In fact for a foreign group wishing to re-domicile to the UK, its foreign corporate profits are less likely to become a UK issue under the new rules.

Compliance with detailed rules

So far, so good at the policy level. However, it is not possible for directors to make a straightforward judgement “We are not diverting profits from the UK, therefore we will not report any CFC issues.” There are detailed rules to be followed. The rules prescribe five exemptions, each with their own sub-conditions, and then a so-called “gateway” mechanism to identify diverted profits. Passing through the “gateway” is a bad thing, it means some profits may be taxed in the UK, even if they are made and held abroad. What one has to try and ensure is that one or more of the five exemptions are met, and if that fails to ensure no profits pass through the “gateway”.

In terms of detailed compliance to support the filing position there needs to be a considered position as to any of the exemptions on which one is relying or reliance on the “gateway” to exclude profits from charge. Even if one gets the right result hoped for, there are still specific disclosure requirements in the Company Tax Return. Some of the exemptions still require a Company Tax Return report, whilst others do not.

Exemptions

The new exemptions are as follows:

  1. The Exempt Period Exemption – this is essentially a limited exemption for foreign companies becoming CFC’s for the first time, typically where a non-UK subsidiary or a new sub-group is acquired. The aim of the exemption is to allow a new CFC a period of time to organise or re-organise its business so that a CFC charge does not arise.
  2. Excluded Territories Exemption – this applies to exempt CFCs resident in certain territories, subject to conditions. Its purpose is to exempt those CFCs which constitute a low risk of UK profit diversion partly on account of their territory of residence but also by looking at the type of income the CFC can receive and any amounts it may receive from intellectual property. A list of excluded territories is set out in Regulations. For example, Germany, France, and the United States are on the list, but Poland, Estonia and Lithuania are not. The fact there is no automatic exclusion for companies established in the EU points to the possibility that the CFC legislation is not fully compliant in this regard with EU law.
  3. The Low Profits Exemption – this applies if the accounting profits are no more than £500,000, and non-trading income included therein is no more than £50,000. In deciding the level of profits UK accounting standards must be applied and other adjustments made – eg for transfer pricing and capital gains -, so substantial re-computation of the foreign subsidiaries profit may be necessary in order to determine that the exemption applies.
  4. The Low Profit Margin Exemption – this applies if the CFC’s accounting profits are no more than 10% of its relevant operating expenditure. It is essentially aimed at those CFCs that perform relatively low value added functions outside the UK, such as back-office functions, local marketing and distribution operations, or call or data processing centres, but is not limited to such operations.
  5. The Tax Exemption – this applies where the local tax amount is at least 75% of the corresponding UK tax. It requires comparison of the actual tax paid in the territory of residence with what tax would have been paid on a UK tax measure of those profits, applying various adjustments and assumptions. It may, of course, not always be clear without considerable information gathering and adjustments that the CFC’s local tax amount is 75% or more.


Exempt activities exemption gone

Those familiar with the old CFC rules will note that the hitherto applicable exempt activities test has gone. The purpose of this now repealed rule was to exclude companies simply because of the nature of activities overseas. It covered a wide range of trading activities. This exemption is now no longer in point. Re-thinking the position through is necessary in order, as may well be feasible, to achieve the same result under one of the new exemptions, but it cannot be taken for granted.

“Gateway charges”

If no exemption can be established to apply, a CFC charge will potentially apply. A significant change, however, from the old legislation is that the charge will apply only to the extent that particular profits are identified by the legislation as being within scope. This process of identifying the extent of chargeable profits is called applying “gateway tests”. The profits that pass these tests are considered to have been artificially diverted from the UK.

Example 1:Significant people functions in UK

As an illustrative example, profits would pass such a test (ie be chargeable) where they are earned by a CFC in respect of assets it owns or risks it bears, where the majority of the key management functions (“significant people function or a key entrepreneurial risk-taking function”) in relation to those assets or risks is undertaken by UK connected persons and where the arrangements giving rise to those profits would not occur if the key management function undertaken in the UK were to be undertaken by third parties.

Alternatively part of the profits may not come into charge if the CFC meets certain conditions (eg as regards local business premises, the amount of income derived from the UK, and the extent of management undertaken in the UK).

Example 2: Non-trading finance profits with UK connection

Another example of a test giving rise to a charge is where non-trading finance profits are earned from lending to other group members and third parties where the funding is provided from the UK or to the extent key management functions are undertaken by UK persons.

Concepts such as “significant people functions” are new in UK tax legislation. Traditionally a greater legal precision was the norm in prescribing occasions of tax charge. However, it is expected that over time a settled practice will emerge. The UK’s tax authorities have prepared published guidance, and are prepared in appropriate cases to give clearance on these matters.


David J Kidd
Citroen Wells, London, United Kingdom
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published: November 2014

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