The discussion document proposes replacing the existing tax and credit regime for foreign dividends with a new exemption for most foreign dividends received by large or medium-sized companies from subsidiaries in which they have at least a 10% shareholding (the participation exemption) (see box “Taxation of foreign dividends: current rules”). A simplified credit system will continue to apply for small companies.

To prevent avoidance, some foreign dividends, such as dividends that do not attract credit for foreign tax under the current rules, will fall outside the participation exemption. In addition, a new CC regime will be introduced to deal with certain foreign profits that are not distributed (see “Controlled companies” below).

“The move to an exemption system is very welcome,” says Michael Hardwick, a partner at Linklaters LLP. “Companies will no longer have to compute rates of foreign tax on their dividends and this will give rise to a significant compliance saving.”

The ability to repatriate profits of foreign subsidiaries free of corporation tax will generally make subsidiaries more tax-efficient than branches for doing business abroad, as foreign branch profits remain taxable. While agreeing that the move to exemption is generally to be welcomed, Tony Beare, a partner at Slaughter and May, questions the wisdom of deferring consideration of the taxation of branches: “It seems to me that the issues raised by overseas branches are so inextricably linked with those raised by overseas subsidiaries that the area should have been addressed in the discussion document.”

For shareholdings below 10%, three options are put forward for discussion:

The discussion document proposes replacing the existing controlled foreign company (CFC) rules with a modified CC regime (see box “Controlled foreign companies: current rules”).

Application. Subject to various exemptions, including for most small companies, the proposed CC rules will apply to all companies controlled to a significant extent by individuals or companies resident in the UK (controlling parent companies). This addresses concerns about whether the CFC rules comply with EC law by bringing UK resident CCs within the scope of the rules, along with CCs resident in countries excluded from the existing CFC rules.

Control. The threshold for control will be reduced from 25% to 10% to align the CC rules with the participation exemption (see above). The definition of control will be modernised to deal with non-corporate holding vehicles. This will expand the scope of the rules to encompass much smaller shareholdings than before. “One big question is the impact on joint ventures and consortia that were established under the old rules,” notes Dominic Stuttaford, a partner at Norton Rose.

Income and gains. Controlling parent companies will be subject to corporation tax on their proportionate share of the CC’s “passive” income, such as dividends, interest, royalties and rents, as calculated under UK GAAP (generally accepted accounting principles). Certain capital gains and active income will also be caught. This means that groups will need to be able to track the income and gains of their CCs by source. However, the discussion document indicates that the government believes businesses already have these systems in place.

Compensation. To avoid double taxation, credit will be given for any foreign tax paid. There will also be a system of compensating adjustments for UK tax so that the overall tax bill for UK CCs does not increase. This is expected to work rather like the existing regime for transfer pricing, which was extended to apply to UK/UK transactions with effect from 1 April 2004 to address similar concerns about compliance with EC law (for background, see feature article “UK-UK transfer pricing on loans: is fiscal neutrality a myth?”, www.practicallaw.com/6-103-2422). There is some anecdotal evidence that this method has not been without its difficulties in practice, and it seems likely that wholly domestic groups will take a disproportionate share of the increased compliance burden.

Participation dividends flowing within the controlled group will be exempt. In practice, this means that companies will be able to earn and repatriate profits in their foreign subsidiaries, even those resident in tax havens, without paying corporation tax at any stage. Perhaps unsurprisingly, the discussion document invites comments on whether the reforms as a whole will require any targeted anti-avoidance measures, such as a specific anti-diversion rule.

“There remains quite a lot of detail still to fill in, and the detail is going to be very important in establishing how the proposed CC rules will work in practice,” concludes Hardwick. “Practitioners will want to give the draft legislation very careful scrutiny.”

Multinationals generally will have been relieved to see confirmation that the government proposes no wide-ranging changes to the existing generous interest relief regime provided for in the Finance Act 1996, and this will no doubt colour their response to the proposed new anti-avoidance measures.

Cap on interest deductions. The amount of interest that can be claimed as a deduction by UK members of a multinational group will be capped by reference to the group’s total consolidated external finance costs, to prevent companies loading a disproportionate amount of debt into the UK sub-group.

“Capping interest at the amount of interest on external group borrowings has the potential to cause problems in fairly innocent situations, such as a merger of two groups with different borrowing policies,” says Hardwick. Beare agrees that the limitation might be considered a little too inflexible: “There may be circumstances where the activities of the members of the UK resident group justify a different level of gearing, either higher or lower, than that of the worldwide group.”

Wider general rules. The existing rules that disallow tax deductions in relation to loans and derivatives that have a tax avoidance purpose (paragraph 13, Schedule 9, Finance Act 1996 and paragraph 23, Schedule 26, Finance Act 2002) will be widened to include:

“These changes show that HMRC is broadly happy with the way the anti-avoidance rules work for them in relation to interest relief, despite the lack of decided cases in this area,” notes Stuttaford.

The discussion document proposes the repeal of the Treasury consent rules (section 765, Income and Corporation Taxes Act 1998). These unpopular rules, breach of which is a criminal offence, impose a disproportionate compliance burden on companies.

They require UK companies with foreign subsidiaries to obtain Treasury consent before carrying out certain transactions involving those subsidiaries, such as transferring shares in them, unless the transaction is a movement of capital within the EEA.

“The abolition of Treasury consent is long overdue and the only disappointing feature is that the timing of abolition has been tied to the new package,” says Beare. However, at least the delay will give businesses the chance to test whether the Treasury can justify the proposal to introduce a reporting requirement in the Treasury consent rules’ place.

The closing date for comments on the discussion document is 14 September 2007. Further consultation on the detailed provisions will follow before legislation is brought forward in the Finance Bill 2009.