UK: Taxation of companies' foreign profits

The Treasury issued a consultation document in June 2007 inviting comment on the proposed reform of the UK's controlled foreign company (CFC) regime. The paper proposes a new income-based system for controlled companies (CC).

Current CFC regime

Broadly a company is a CFC if it is resident outside the UK in a territory subject to a lower level of tax than the UK and is controlled by a person resident in the UK. If this is the case then Revenue and Customs may assess the UK resident company for tax on those income profits of the CFC which can be apportioned to that UK company, provided the profits which can be apportioned are at least 25% of the CFC's total profits. This prevents UK companies from diverting profits to subsidiaries set up in tax havens. There are a number of exemptions to this rule for example if the CFC pursues an acceptable distribution policy or is engaged in exempt activities.

New exemption to CFC regime – Cadbury Schweppes case

More recently a new exemption has been added to the CFC regime in the form of the introduction of a new section 751A Income and Corporation Taxes Act 1988. This section exempts certain profits from the CFC charge if the CFC has a business establishment in an European Economic Area (EEA) territory. This new exemption arose as a result of the judgement of the European Court of Justice (ECJ) in the Cadbury Schweppes Case (C-196/04). The ECJ held that the UK CFC rules do restrict the freedom of establishment protected by the European Community (EC) Treaty. This restriction may be justified, however, where CFC rules prevent the creation of wholly artificial arrangements aimed to escape tax.

Reform of the CFC rules - The CC regime

The June consultation document was, in part, a response to the Cadbury Schweppes case. It is proposed that the new controlled company rules apply to UK subsidiaries as well as foreign companies, hence, it is proposed, the new CFC regime will be a controlled company (CC) regime rather than a CFC regime.

Foreign dividend exemption

In conjunction with the new CC regime, the consultation document proposes an exemption, from UK corporation tax, for foreign dividends. In other words, the exemption would apply to dividends received in the UK from the profits of companies to which the controlled company rules apply. This exemption would be in place of the current method of taxing foreign dividends, but allowing credit for underlying tax.

CC regime gateway test and trigger

The aim of the proposed CC regime remains the prevention of the artificial location of profits. Most small businesses will be excluded from the CC rules by a gateway test (as is the case with the current CFC rules where there is an exemption for profits not exceeding £50,000).
The trigger for the application of the CC rules will be reduced to 10% (the CFC rules currently apply a 25% test) such that if 10% or more of the profits of a CC can be apportioned to a UK resident company then that UK company has to pay a sum equal to corporation tax at the appropriate rate on those apportioned profits.

Income caught by CC regime

It is proposed that the new CC regime will be self-assessed and capture income either as deemed dividend income or (like the current CFC rules) apportionment income.
The CC rules will target passive (investment) income primarily (such as dividends, interest and royalties), but also active income which is in substance passive (for example income derived from intangible assets). Unlike the current CFC rules, it is proposed that capital gains will also be caught (for example where passive income has been converted into a capital asset).

Exemptions

There will be exemptions though for income from genuine active finance business, certain intra group interest, participation dividends and income from intra-group transactions in the same country.

Jane Dodd, (jane.dodd@herbertsmith.com), London