Corporate tax reform: CFCs, IP tax and foreign branch profits (full update)

Practical Law UK Legal Update 1-504-1151 (Approx. 9 pages)

Corporate tax reform: CFCs, IP tax and foreign branch profits (full update)

by PLC Tax

Background

In the June 2010 Budget, the government announced a "roadmap for corporate tax reform", with further details to follow in the autumn. The reform is to be based on the government's view that a broad tax base, a low corporate tax rate and a more territorial approach will make the UK's tax system more competitive. The elements of the road map announced in the June 2010 Budget were:

Capital allowances: reduction in rates of writing down allowances and the amount of the annual investment allowance from 2012.
Corporation tax rates reduced from 2011-12, with the main rate reducing by 1% each year from 28% in 2010-11 to 24% in 2014-15.
Reform of the controlled foreign company (CFC) rules and the rules for taxing the profits of foreign branches.
Review of the taxation of intellectual property (IP) and the research and development (R&D) tax credits regime.
Simplification of the chargeable gains rules for groups.

(See Legal update, June 2010 Budget: key business tax announcements: A roadmap for corporate tax reform.)

Shortly after the Budget, the government published further details of its proposals for:

Interim changes to the CFC rules (see Practice note, oreign profits of companies: tax reform: Interim changes to the CFC rules: 2011).
Reform of the taxation of overseas branches (see Practice note, Foreign profits of companies: tax reform: Summer 2010: consultation document proposes exemption for overseas branch profits).

This government's work in this area builds on measures introduced by the previous government as part of its review of the taxation of foreign profits, particularly the common corporation tax regime for dividends which introduced a series of broad exemptions for UK and overseas source dividends with effect from 1 July 2009. For further background on the foreign profits tax reform so far, see Practice note, Foreign profits of companies: tax reform.

In the June Budget, the government also announced a new approach to making tax policy, based on increased predictability, stability and simplicity, improved scrutiny of proposals and greater transparency in the development of law and policy, see Legal update, June 2010 Budget: key business tax announcements: A new approach to making tax policy.

Corporate tax reform: 29 November 2010 proposals

On 29 November 2010, the government published its proposals for the reform of corporation tax in a document called "Corporate Tax Reform: delivering a more competitive system". This measure, the only tax element of the Chancellor's autumn statement, includes an outline of the government's plans for reform of corporation tax over the next five years (the corporate tax road map) and proposals for both full and interim reform of the CFC rules and reform of the rules for taxing foreign branch profits and IP.

In this update, we have summarised the key proposals and their implications. We have also published a series of more detailed updates, which explain and analyse the substantive proposals in relation to CFCs, foreign branches and IP in more detail:

Corporate tax road map

The government has set out its plans to reform the corporate tax system over the next five years, given its aim of making the UK the most competitive corporate tax regime in the G20. Along with the foreign profits and IP tax reforms (see below), this includes:

Confirmation that the government is committed to low rates of corporate tax with fewer reliefs and allowances (which has clear implications for the ongoing tax reliefs review, see Legal update, Office of Tax Simplification announces tax reliefs review) and to focusing the UK's corporate tax system more on profits from UK activities than on attributing the worldwide income of a group to the UK.
Confirmation of the gradual reduction of the main rate of corporation tax, reduction of the small companies' rate and reductions in capital allowances announced in the June 2010 Budget (see Background).
A timetable for consultation on, and introduction of, corporate tax reforms planned for the next three years.
A more strategic approach to the risk of tax avoidance with a view to reducing complexity and the need for frequent legislative changes. A "protocol" setting out the circumstances in which the government will consider introducing immediate anti-avoidance legislation will be published on 9 December 2010 (see Legal update, HM Treasury announces tax avoidance clamp-down). This may indicate that the government is reconsidering its published approach to the introduction of retrospective anti-avoidance legislation in relation to income tax, PAYE and NICs avoidance in employee remuneration arrangements.
An interim review of small business tax and IR35, which will be published by the Office of Tax Simplification (OTS) at Budget 2011, together with the OTS' recommendations on the tax reliefs review.
Commitment that corporate tax reform should aim for a tax system that is stable, simple, fair and able to keep pace with changes in business practice. The government also intends to apply these principles to reforms in other tax areas, such as personal taxes and environmental taxes. This could include the promised review of the taxation of non-domiciliaries, an area of concern for many large multinationals (see Legal update, June 2010 Budget: key business tax announcements: Non-dom rules to be reviewed).

Recognising the importance of stability, the government does not intend to make any other major corporate tax reforms in 2010, 2011 or 2012, subject to the need to prevent revenue loss through avoidance and the need to respond to wider events, such as legislative or regulatory developments. The document also confirms that the government has no intention of making significant changes to the tax deductibility of interest and remains committed to interest being relieved as a normal business expense, regardless of the use to which the loan is put, subject to the need to prevent tax avoidance.

Controlled foreign companies: overhaul

The key features of the proposed new CFC rules are:

Retention of an entity-based CFC regime, but imposing a charge only on the profits of the CFC that have been artificially diverted from the UK.
The focus on CFCs perceived as the greatest risk to the UK tax base, targeting CFCs with significant monetary assets and IP.
Introduction of a partial finance company exemption, where the extent to which the finance income of the CFC is exempt will depend on the debt-to-equity ratio of the CFC. The government will consider the case for a minimum debt-to-equity ratio of 1:2. Therefore, if the finance company is fully equity funded 66.6% per cent of the CFC’s finance income would be excluded from the CFC charge. When the UK main rate of corporation tax reduces to 24% (in 2014), the finance income would be taxed at an effective rate of 8% (that is, 33.4% of its finance income would attract the CFC charge at the corporation tax rate of 24%).
The finance company exemption should also apply to excess cash held by trading companies in low tax jurisdictions. Incidental or ancillary amounts of interest will not attract a CFC charge, but cash in excess of this will be treated as if it were held in a finance company and be subject to the debt-to-equity ratio and vulnerable to the CFC charge.
The day-to-day management of the monetary assets of a group by a company that only makes a small margin, is not regarded as posing a significant risk to the UK’s tax base. It is proposed to exempt such activities from the new CFC rules.
A new approach to dealing with CFCs with IP, which centres on identifying a "high risk" CFC, determining whether it has earned excessive profits in relation to the activities it has undertaken and, if it has, imposing a CFC charge on the proportion of the excess profits representing profits artificially diverted from the UK. This approach focuses on IP:
- developed in the UK, which is transferred to a low tax country. The government wishes to impose a CFC charge on profits that are attributable to UK activity;
- held offshore but effectively managed in the UK. The government’s position is that if activity that increases the value of IP takes place in the UK, but most of the profits arise in a low tax country, it is likely that UK profit has been artificially diverted; or
- where UK funding is used to invest in IP held in an overseas subsidiary resident in a low tax country, but a return on that investment is not received in the UK. The government sees investment IP as analogous to a monetary asset. Therefore, if a CFC owns investment IP and has been equity funded from the UK, the government expects that the UK funder would receive a return on its investment and it wishes to apply a debt to equity ratio, similar to the approach adopted for monetary assets. A UK CFC charge would only apply if the CFC is equity funded in excess of the ratio.

Further details on full CFC reform will be published for consultation in spring 2011. Draft legislation will be published in autumn 2011 for inclusion in the Finance Bill 2012.

For more detail on the full CFC reform proposals published on 29 November 2010, see Legal update, Full CFC reform proposals (corporate tax reform).

Controlled foreign companies: interim reform

Key features of the proposals are:

An exemption for CFCs carrying on intra-group trading activities where there is minimal UK connection and little risk that UK profits have been artificially diverted. This exemption, which is to apply regardless of the proportion of the CFC's transactions taking place with group companies, is aimed at UK multinationals whose CFCs are involved in the provision or consumption of intra-group goods and services (for example, as part of a supply chain) where these transactions do not involve the UK (or do so only to a limited extent). Incidental finance and IP income will not prevent this exemption from applying.
An exemption for CFCs whose main business is IP exploitation where the IP and the CFC have minimal connection with the UK and the CFC's finance income is no more than 5% of its gross income.
A maximum three-year exemption for certain foreign subsidiaries that enter the CFC regime for the first time. The exemption will cover both acquisitions from third parties and certain types of group reorganisations (such as where a non-UK headed group sets up a regional holding company in the UK, which brings that company's subsidiaries within the UK CFC rules). Similarly, the exemption will apply to groups migrating into the UK.
Extension of the existing de minimis exemption. Currently, a CFC can qualify for exemption if its chargeable profits do not exceed £50,000 in a 12-month accounting period. The government proposes to increase the limit for groups that include large companies (falling outside the EU definition of a small or medium-sized enterprise (SME)) to £200,000. For SMEs, the limit will remain at £50,000.
Deferring the withdrawal of the existing exemption for certain holding companies. The Finance Act 2009 included transitional rules for superior and non-local holding companies to ensure that they could continue to qualify for exemption under the exempt activities test for the period to July 2011. The government will extend these transitional rules for an additional 12 months to ensure that the exemption remains available until the completion of full CFC reform in 2012.

Draft legislation effecting these changes, to be included in the Finance Bill 2011, is to be published on 9 December 2010. Comments are invited by 9 February 2011.

For more detail on the CFC interim reforms published on 29 November 2010, see Legal update, CFC interim improvements proposals (corporate tax reform).

Intellectual property and R&D

The government published details of its plans for the reform of the taxation of innovation and intellectual property. There are two main strands to the reform: introduction of a 10% corporation tax rate on patent income (the patent box) and possible reform of the reliefs available for expenditure on research and development.

Key features of the patent box:

A 10% corporation tax rate applicable to net income arising from patents, where the recipient elects.
Effective from 1 April 2013.
Applicable to income from patents first commercialised after 29 November 2010.
Available for royalty income from patents and "embedded" income included in the price of patented products.

The government intends to publish further details for consultation in spring 2011. Draft legislation will be published in autumn 2011, for inclusion in the Finance Bill 2012.

The government is also seeking views on ways to target better the existing R&D tax credit schemes. This includes:

Whether there are any changes to the structure of the schemes that would significantly improve their impact in stimulating investment in R&D.
Whether additional costs should be eligible for relief and, conversely, whether any items should be excluded.
Whether the existing definition of R&D (taken from accounting standards) is effective. If not, whether there should be a statutory definition.

Comments on both consultations are invited by 22 February 2010.

For more detail on these proposals published on 29 November 2010, see Legal update, Research and development and IP tax consultation (corporate tax reform).

Foreign branches

Following consultation, the government plans to introduce an opt-in exemption from UK tax for foreign branches. Key features are as follows:

The regime will be elective. The election will be irrevocable and, once a company has opted in, the regime will apply to all of a company's branches, present and future. If a company elects, the profit or loss of each foreign branch will be deducted from the company's worldwide profit calculation to reach a net amount subject to UK corporation tax.
The exemption will apply to accounting periods beginning on or after a specified date in 2011. Once the regime takes effect, a company will be able to opt in and the regime will apply from the beginning of the next accounting period, subject to transitional rules.
Companies within the regime will not be entitled to relief for their foreign branch losses. Transitional rules will mean that a company's branch profits will only become exempt once the tax losses of the branch in the six years immediately preceding the making of the election have been matched by profits. This period will be extended to six years before the introduction of the new regime if "very large" branch losses are made during that period (the figure of £50 million is mentioned)
With the exception of branches of small companies in non-treaty countries, the exemption will apply to branches in all jurisdictions.
The government has offered to exempt branch chargeable gains, although this was not a priority for business.
Since the profit diversion risk that exists for foreign subsidiaries will also apply to exempt branches, the government has logically decided to apply CFC-style rules to exempt branches. In due course, the reformed CFC rules will instead apply to exempt branches so taxpayers will have to follow CFC developments to understand what the future holds for the branch exemption.

The government will shortly publish draft legislation (to be included in the Finance Bill 2011) and guidance. Comments are invited by 9 February 2011.

For more detail on the foreign branch tax exemption proposals published on 29 November 2010, see Legal update, Foreign branch exemption detailed proposals (corporate tax reform).

Comment

There is a great deal to be welcomed in this document, both in terms of the substantive proposals and the way in which the government plans to go about introducing the changes. The publication of the road map and the assurances about deductibility of interest (assuming the government stands by its statements) do indeed suggest that we will have a more stable corporate tax regime for the next five years. The commitment to "extensive and timely consultation with business" over tax reforms is also welcome.

The document is explicit, however, that stability and simplicity in a tax system cannot always co-exist, for example, broad transitional rules offer stability but can lead to excessive complexity and the government expects business to be prepared to negotiate these trade-offs openly. There is also an indication that the government considers that business must take some responsibility for improving the administration of the tax system, in particular by considering the wider impact on the tax system when analysing particular tax arrangements and must share their views with HMRC where they believe the law is unclear or uncertain. This has echoes of the code of tax conduct for banks (see Legal update, Banks' tax code of practice: complying with the spirit, not just the letter, of the law, now adopted by the UK's 15 largest banks). It may even indicate that HMRC is considering extending the code of conduct to other large corporates.

As regards the specific legislative proposals:

CFC full reform. It is clear from the tenor of the document and the substance of the proposals that the government is listening to what business has to say, although it is keen to preserve the UK's tax base. The proposals on the operation of the CFC charge for thickly capitalised finance companies will be generally welcomed as they are in line with the effective rate of tax requested in the responses to the January 2010 document. The proposal for an earn-out charge in relation to intellectual property transferred to a CFC, which was a controversial element of the January 2010 proposals, has been dropped. However, it remains to be seen whether an acceptable debt-to-equity ratio for intellectual property will be advanced and how the subjective allocation of profits test for intellectual property will apply in practice. Although there is still much work to be done before the final form of the legislation materialises, it does appear that CFC reform is back on track.
CFC interim review. The interim changes will be welcomed by taxpayers. They will mean that more companies will fall outside the CFC rules and should ease the compliance burden on groups potentially affected by those rules. Further, they indicate that the government anticipates a collaborative approach to applying the changes, which will hopefully make application easier for groups. Obviously, it will be necessary to consider the details of the draft legislation to determine whether it give rises to any as yet undisclosed difficulties. In addition, these areas will be looked at again in the full reform of the CFC rules.
IP tax reform. The patent box proposal has generally been well-received, although some concern has been expressed that it will be too expensive in fiscal terms. Its exclusive focus on income from patents, rather than other forms of IP, such as trademarks and copyright, has also been criticised.
Foreign branch exemption. In designing the exemption, the government appears to have listened to the responses to the July 2010 document. For example, a number of businesses preferred a simple elective regime (without a potentially more complicated loss relief "claw-back") and that is what the government proposes. The application of the CFC rules to the branch exemption is logical. Once the exemption is in force, the profit diversion risk that exists for foreign subsidiaries will also apply to exempt branches so it makes sense to apply similar anti-avoidance rules. (Clearly, this means that developments in CFC reform will have a direct effect on the branch exemption so taxpayers will have to follow those developments, too.) The anti-avoidance rule and a duty on the company to minimise branch taxation should help to limit the cost of the exemption to the Exchequer, which has calculated that the exemption will cause an overall loss of tax revenue.

For more on business reactions to the proposals, see Legal update, Tax news round-up to 7 December 2010: Response to HM Treasury's plans for corporate tax reform.

Sources

(All published on 29 November 2010.)

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