The UK’s new Controlled Foreign Company (CFC) legislation is effective for all accounting periods beginning on or after 1 January 2013. This represents a timely wholesale revision of the rules as over the last few years there has been numerous revision to the rules in reaction to various recent Court of Justice of the European Union cases.
- The definition of a CFC has changed – companies with positions agreed under the old laws must update their clearances
- The new rules provide for the CFC charges (effectively UK tax) to apply to some or all of the CFC’s profits
- Foreign branches which are exempt from UK tax are within the scope of the new rules
- There is a finance company exemption which is a potentially important new element
The definition of a CFC and control
The definition of control has been widened to include that where a person is a parent of the CFC for the purposes of accounting consolidation under FRS 2. However, the focus has moved away from defining the entity as a CFC towards identifying relevant profits.
There are still exemptions that operate at the entity level, for example:
- The initial period exemption – a CFC is exempt for the 12 months after the company first becomes a CFC (but potentially not if there is a subsequent reorganisation). The 12 month period can be extended by agreement with HMRC
- The low profits exemption – this exemption applies where the accounting profits of the subsidiary are not more than £50,000 or not more than £500,000 provided non-trading income is not more than £50,000
- The low profits margin exemption – this exemption applies where accounting profits are less than 10% of defined operating expenditure
- The excluded territories exemption – similar to the previous “white list”, however, some jurisdictions have not made it onto the new list
If the entity is not excluded from being a CFC, it must be put through two gateway tests.
An initial gateway test prevents the entity from being a CFC if any of four conditions below are met:
- Motive and purpose of the structure
- No UK managed or controlled assets or risks
- If the entity is commercially effective
- Only non-trading and/or property business profits
However, these tests are quite subjective and it is considered that they will be difficult to meet conclusively in a large number of cases.
The second gateway test looks at profits. Firstly, there is a safe harbour which applies if there is a local presence with premises, no more than 20% of local income is derived from the UK, that UK management expenditure is no more than 20% of total relevant management expenditure, that no IP has been transferred to the CFC in a relevant fashion and no more than 20% of the CFC’s trading income derives from goods exported from the UK.
If the safe harbour does not apply, it is necessary to identify the ‘Significant People Functions’ in the UK. This is to be done using a functional analysis familiar from transfer pricing studies. The UK related activity is then deemed to be a hypothetical UK permanent establishment and profits are allocated to it using OECD principles.
If this allocation results in less than 50% of the CFC’s income being attributed to the UK permanent establishment, there is no further CFC charge. The charge will apply but to a reduced amount of profits if the non-tax value of the benefit of operating the CFC is greater than 20% of combined tax value and commercial, non-tax value. Otherwise, the CFC charge will apply to all profits of the deemed permanent establishment and they will be subject to UK corporation tax.
There are specific detailed rules relating to financing profits. However, one of the most interesting inclusions in the new rules is the Finance Company Exemption. This provides a minimum exemption from the CFC charge for 75% of the qualifying loan relationship profits. Once a route has been plotted through the technical details, it seems possible for the exemption to be used in debt push down structures so that overseas trading subsidiaries, in potentially high tax jurisdictions, can be financed from a low tax CFC finance company which suffers an effective UK tax rate equivalent to less than 25% of the full rate of UK corporation tax.
In an era of targeted anti-avoidance measures, such a freshly enacted relief appears to be worthy of note.