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The government wants the proposals to be competitive for business while protecting the UK tax base. The new regime looks superficially similar to the old rules, but with a closer focus on profits ‘artificially diverted’ from the UK. Overall, the changes are likely to deliver some benefits, particularly for offshore financing activities, but the compliance burdens are likely to be heavy. There will be significant reliance on the new ‘General Purpose Exemption’, especially for IP. The complexity is, unfortunately, likely to discourage new inbound investors from choosing the UK as a European holding company location.

Heather SelfThe road to CFC reform is paved with good intentions. It is clear that the government wants to create an attractive regime, and hopes that the proposals will be competitive for business while protecting the UK tax base.

The consultation process has gone on for far too long, but has been an open and collaborative debate: the key question is whether what has now been produced will work in practice.

The reaction from big business is likely to be broadly positive, although with some reservations.

The overall tax burden should be no higher than under the current system, and the FinCo regime is a genuine step forward.

However, the compliance burdens, particularly in the early years, will be at least as heavy as they are now.

The approach of offering a menu of different exemptions means that a lot of work will need to be done to analyse the activities of each CFC within a group.

The complexity of the new regime is likely to be a disincentive for new inbound investors.

In particular, the lack of a clear and simple exemption for genuine EU activities will weigh heavily against the UK in the choice of a location for a European holding company.

This is a missed opportunity and does not sit well with the government’s message that the UK is ‘open for business’.


A CFC charge will arise on the proportion of profits of an individual entity that have been ‘artificially diverted’ from the UK.

This is a much more territorial approach than the current system, and sits alongside the dividend exemption introduced in 2009.

Reaction from David Smith and Philip Baker QC

However, the overall framework looks familiar, and in particular the definition of a CFC as a company which is controlled by UK residents, resident outside the UK and subject to a lower level of taxation is very similar to the current regime.

Having decided that a company is a CFC, there is then a menu of exemptions which are available to take the activities of genuinely commercial CFCs outside the regime.

Companies can choose to rely on whichever exemption best suits their circumstances, but many of those on offer require detailed examinations and calculations to be performed, and there seems to be a reluctance to move to a principles-based approach.

There is a generous partial exemption for finance companies (the FinCo regime), as announced at Budget 2011.

The rules for IP have clearly proved difficult to draft, and it is likely that the clearance mechanism will be needed in complex cases, which leaves a significant amount of discretion in the hands of HMRC.

Where a CFC charge arises, it will, as currently, be a notional charge on the UK water’s edge company.

However, note that it will only apply to the relevant proportion of the CFC’s profits, rather than the ‘all or nothing’ rule which applies at present.

The special rules for banking and insurance, and for foreign branches, are outside the scope of this article (but will be covered in future editions).

Profits artificially diverted from the UK

The concept of ‘artificially diverted’ profits is a crucial one, underlying the whole of the new regime. However, there is no specific definition of the term.

It is not until page 44 of the document that two examples are given:

  • transactional diversion – eg, a transaction giving rise to a UK tax deduction that would not have arisen had the arrangements been at arm’s length; or
  • diversion through the transfer of assets – eg, the separation of an intangible asset (previously in the UK) from the active decision-making regarding the risks inherent in the ownership of the asset.

The government appears to be adopting the Humpty Dumpty approach to definition – ‘It means what I say it means, no more and no less’.

This is a clear sign that there is still nervousness about potential avoidance, which is perhaps not surprising given the proliferation of structures over the past few years – partnerships, double partnerships, discretionary trust structures and the like.

Perhaps there needs to be a firm statement that entities which have no commercial purpose (such as a discretionary trust within a 100% group) will be automatically regarded as artificial.

One clear and helpful statement is that there will not be a default assumption that profits received by a CFC would have arisen in the UK if the CFC did not exist.

This was always the most difficult hurdle in the old motive test (see, eg, Association of British Travel Agents Ltd v IRC [2003] STC (SCD) 194) and its removal is welcome.

There are several references to the need for TAARs, but no detail yet. Striking a balance between protecting the tax base and encouraging investment will clearly be difficult.

Basic exemptions

Most of the exemptions look similar in substance to the current regime, but with many differences of detail. Chapter 4 deals with three basic exemptions.

The low profits exemption is a de minimis exemption. There are still some options around the size of the limit, but a figure of between £200,000 and £1 million appears likely. An accounts-based test is the likely measure of profits.

There will be an excluded countries exemption, but it seems likely that this will include detailed conditions. In particular, the option of giving a clear exemption for EU countries does not seem to be under consideration.

The temporary period exemption gives a breathing space of three years for companies which come under UK control as a result of commercial transactions.

This will be similar to the rule introduced by Finance Bill 2011 and is a more generous rule than the ‘period of grace’ approach in the current motive test.

Territorial Business Exemptions (TBEs)

The TBEs are intended to provide ‘relatively straightforward exemptions for CFCs that undertake genuine commercial activities and do not pose a significant risk of artificial diversion of UK profits’.

In concept, they are similar to the current exempt activities test. However, the detailed TBEs comprise three separate, highly mechanical tests, with numerous conditions relating to the interaction of commercial activities with intellectual property (IP), investment activities and finance income.

A principles-based approach is mentioned as a possible alternative, but with very limited and tentative suggestions as to how this would work.

It seems unlikely that this will progress further in the time available: in my view, this is a disappointing outcome.

General Purpose Exemption (GPE)

The GPE is similar to the motive test, but without the default assumption that profits ‘ought’ to have arisen in the UK.

Due to the complexity of the other specific tests, it seems likely that the GPE will be more widely used than its predecessor motive test.

While this allows for flexibility, it may also put pressure on the clearance regime, and leaves significant discretion in the hands of HMRC.

The GPE introduces the concept of profits which are ‘commensurate with the CFC’s own activities’. Provided such profits have not been diverted from the UK for tax purposes, they will be exempt.

The excess will be taxable, to the extent that it represents UK diverted profits and is not finance income. Any non-incidental finance income will be dealt with under the FinCo regime.

The FinCo regime

As set out in Budget 2011, there will be a finance company partial exemption (FCPE) which will generally give a 5.75% tax rate on overseas financing operations from 2014.

After much deliberation, the UK’s generous regime for interest deductibility is not to be substantially changed.

The FCPE is described as a ‘pragmatic and competitive approach’ to give groups flexibility to manage their financing operations, while protecting the UK tax base.

The FCPE is likely to be warmly welcomed by business, and accounts for virtually the whole of the estimated cost of £840 million set out in the Tax Impact Assessment.

It will give groups a simple method of achieving both a UK and offshore financing deduction, for the price of a tax charge of just under 6%.

In many cases, this will mean a tax deduction for financing costs which is in the region of 50%.

Some of the detail still remains to be worked through, but the questions in this area are relatively straightforward and it will be for business to decide what balance it prefers between simplicity and flexibility.

Note that the FinCo regime only applies to an offshore finance company: apparently to allow a UK FinCo regime would have been ‘too complex’ in legislative terms.

However, at this stage the use of a UK company with a FinCo branch has also been ruled out: surely it should be possible to apply the regime to a UK special purpose vehicle, whose only activity is an offshore financing branch?

Treasury companies will normally be fully exempt under the GPE, and will prefer this to a partial exemption under FCPE.

But note that finance income from monies invested with third parties cannot qualify under FCPE, and is likely to be subject to a full CFC charge, unless it can be shown to be incidental to other business activities.

The IP regime

The debate on IP has been the most difficult part of the CFC consultation.

The focus has now narrowed to ‘more complex cases that pose a higher risk of artificial diversion of UK profits’.

Where IP has been transferred from the UK within the past six years, or is effectively managed in the UK, the main exemption available will be the GPE.

The TBEs cannot be used in these circumstances. The most striking feature of the IP regime is the failure by HMRC to apply existing transfer pricing principles robustly.

If IP is transferred out of the UK at its market value, representing the net present value of the future income stream, how have profits been ‘artificially diverted’?

And if IP is subsequently managed from the UK, surely the solution is for that service to command a high price under OECD principles?

There are still some significant questions posed in this document, but it seems likely that the eventual regime will be one of nervous acceptance of IP activities, with many caveats and detailed rules to be followed.

Unfortunately, this may produce perverse behaviour such as a decision to move IP out of the UK at an early stage, rather than suffer the complexity and potential cost of the new regime.


The finance company proposals are the most attractive part of the new regime, and will probably lead to significant restructuring of offshore financing arrangements over the next few years.

Overall, the new regime is probably one that most large corporates can live with, but it is unlikely to be seen as a bold move to attract new investment.

The decision to offer a large menu of detailed exemptions, and severe nervousness around IP in particular, will lead to a new CFC regime which will be as complex as the old one.

Heather Self, Tax Director, McGrigors LLP

David SmithA difficult balancing act

David Smith
Head of Group Tax, International Power

David Gauke’s foreword notes the need to deliver a CFC system which is ‘both competitive for business and protects the UK tax base’.

The echo of this tension between delivering what is attractive to business and what the government considers affordable can be seen repeatedly through the document.

Leaning too much towards protecting the UK tax base will deliver a complex and unworkable system that fails to reverse the trend of businesses leaving the UK.

Leaning too far from the protection of the UK tax base is clearly unaffordable in the current state of the public finances.

In this context the Tax Impact Assessment sets out HMT’s estimate that the proposed reforms will cost the Exchequer £840 million per annum from 2015.

Given that these figures are net of the tax raised from the end of so-called ‘swamping’, HM Treasury might have an uphill struggle to persuade some of the robustness of these figures.

Highly positive aspects of the new proposals include the new tax charge based on ‘proportionality’ (rather than all or nothing), a focus on only the highest risk situations (including the exemption of many foreign-to-foreign exemptions) and importantly the removal of the ‘default presumption’ which has caused so much disagreement over the current motive test exemption.

Various references to the need for targeted anti-avoidance rules will worry many

One particular proposal that caught my eye was that in para 3.18 to finally fix the problems with US LLCs.  (Several years ago I received a Motive Test clearance from HMRC covering various LLCs with the proviso that they couldn’t be used for ‘clumsy tax planning’!)

More worrying aspects include the fact that although long, in many areas the document is light on detail and given the very tight timetable (representations required by September; draft legislation to be published during the autumn) there remains much thinking and work to be done.

The government will need to continue to work hard to ensure that we don’t replace today’s highly complex rules with a new set which are equally as complex.

Various references to the need for targeted antiavoidance rules will worry many, particularly those concerned over the developing trend of being taxed by statute and then untaxed by guidance.

Perhaps my favourite example of the visible tension in the proposals lies in para 4.13. Category 1 of this exemption will include ‘territories with corporate regimes sufficiently similar in terms of base and rate to the UK ... It is expected that this category of territories would be small’.

Given the government’s commitment to the most competitive tax system in the G20, could we be forgiven for thinking that ‘small’ means at least 19?

The latest proposals represent an important step along the path to reform and include many positive aspects.

The next few months will be crucial in seeing the final balance between a competitive tax system and one protecting the UK tax base.

This balance will determine whether the government delivers on its promise and succeeds in making the UK once again an attractive place to base multinational business. The jury remains out for the time being!


Philip Baker QCAre the proposals EU compliant?

Philip Baker QC
Gray’s Inn Tax Chambers

It is worth remembering the two factors motivating the review of CFC legislation.

The first: UK groups consider the current system as too rigid, intrusive, compliance-costly, and a consideration pushing groups towards relocating abroad.

The second: remaining doubts, even after Cadbury-Schweppes, CFC GLO and Vodafone II, whether the legislation is compatible with EU law.

As to the first factor, the ConDoc unveils essentially the present system, with some tinkering at the edges, a new finance partial exemption, a new and more complex system for calculating apportionments, several TAARs, and probably greater complexity.

Whether this will quiet the concerns of business remains to be seen. The purpose of this comment is to focus on EU law aspects.

Because the proposals are pushing the envelope, future challenges may show incompatible elements

The ConDoc adopts the principle that the same system will apply to EU/EEA subsidiaries and the rest of the world.

The cynic would say this allows the government to pretend that we are not being driven by EU law.

However, this may no longer be a wise policy option. It means that we have to apply the same rules to subsidiaries located in out-and-out tax havens as we apply to subsidiaries in EU/EEA countries despite the different context.

Within the EU/EEA we have extensive exchange of information, and the ability to influence others tax system through the Code of Conduct.

Having one set of rules forces the government to push the envelope of EU law so as to have as much protection against the havens.

The question is whether this approach has burst the envelope.

Appendix I to the ConDoc entitled Interaction with EU Law explains the government’s understanding of EU law.

Parts of this Appendix are unimpeachable – CFC legislation is a restriction on the freedom of establishment, but may be justified as combating tax avoidance.

However, some parts raise an eyebrow or three. Surprising reliance is placed on the Thin Cap GLO and the SGI cases, both concerned with arm’s-length transfer pricing legislation.

In that context, one can talk of a loan only part of which is an artificial arrangement in that it exceeds arm’s length.

However, one cannot extract from this the concept of a partial ‘wholly artificial arrangement’ applicable to CFCs.

The operation of the new General Purpose Exemption (aka Motive Test II) and the apportionment of UK-diverted profits is constructed on this arm’s length approach.

Are the new proposals definitely incompatible with EU law? The answer is: no, not definitely. Equally one cannot say that the proposals definitely are compatible.

Because they are pushing the envelope, future challenges may well show incompatible elements. In which case this exercise – to try to achieve an EUcompatible system, impervious to challenge – has failed.

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