In our previous article (‘International tax issues for SMEs’, Tax Journal, 24 May 2019), we discussed some of the key international tax considerations of which SMEs should be aware. In this article, we examine some of the tax issues facing a UK SME should it decide to establish an overseas subsidiary. In recent times, we have seen a number of clients setting up an EU subsidiary in response to Brexit. We have also seen more clients establishing subsidiaries outside the UK as they look to penetrate new markets and in response to perceived PE risk.
It is important when establishing an overseas subsidiary to consider both UK and overseas tax rules, as well as compliance with local laws and regulations. The following sets out some of the key tax matters that must be considered.
Corporate residency
The location of corporate residency is an important matter as many countries seek to tax the worldwide profits and gains of companies resident in their jurisdiction.
In most countries, a company will be treated as tax resident in a jurisdiction if it is incorporated in that country. The UK, for example, has such an incorporation test. Many countries also have some form of ‘place of management’ test. For example, a company will be resident in France if it is incorporated or has its place of effective management in France.
Through a collection of UK case law, a non-UK incorporated company can also be treated as resident in the UK if its place of central management and control is in the UK. This principle was established in De Beers Consolidated Mines v Howe (1906) 5 TC 198 where it is stated that ‘a company resides where its real business is carried on … and the real business is carried on where the central management and control actually abides’.
Over the last 113 years, case law has developed and is a useful source for understanding the UK’s approach to corporate residency. Statement of Practice SP 1/90 sets out HMRC’s view on how it determines residency. HMRC will seek to identify where the highest level of control – the ‘place of central management and control’ – is located. This is not necessarily the same place where the main business activities are carried on, but for an SME it will frequently be the same place.
HMRC’s approach is to first ascertain whether the directors actually exercise central management and control. If they do, HMRC will then establish where that control is exercised. If they do not, it will establish who in fact does exercise central management and control, and where.
For SMEs, it can be difficult and impractical to maintain residency of an overseas subsidiary outside of the UK. Where there are only a couple of key individuals running the business, there is naturally a reluctance to cede control to an individual residing overseas. It would be possible to arrange for board meetings to take place overseas, although this can mean significant costs and time commitments and it would still need to be demonstrated that the key business decisions are being made at the meetings rather than decisions already made in the UK being ‘rubber-stamped’.
If a company is deemed to be resident in both the UK and another country under the domestic law of each country, it will be necessary to review the double tax treaty between the two countries which should allocate residency to one territory or another. Usually this is where the place of management is located but as a result of the OECD multilateral instrument, it is becoming more common that the issue is to be resolved under a mutual agreement process.
HMRC sets out the circumstances when it will question residency in its International Manual at INTM120120. If the overseas subsidiary carries on activity in the jurisdiction of incorporation and is remunerated on an arm’s length basis, there may be little incentive for HMRC to challenge the residency position. The question of residency needs serious consideration at the outset. If there is a desire to maintain residency outside of the UK, it will be necessary to take practical steps to mitigate the risk of an HMRC challenge.
Maintaining corporate residency outside of the UK may be desirable if the overseas corporation tax liability is lower than the equivalent charge in the UK (if the company was deemed to be UK tax resident). However, the UK does have a competitive corporation tax rate and therefore the incentives, from a tax saving perspective, to take steps to avoid UK residency are not as strong as they once were. The long-term plan needs to be considered as uncertainty over residency and compliance with tax obligations, both in the UK and overseas, can be an issue in the future, e.g. on a future due diligence exercise.
For the rest of this article, we have assumed that the overseas subsidiary is tax resident in the local jurisdiction in which it is incorporated.
Transfer pricing
It is likely that the overseas subsidiary will be transacting with the UK parent company in one way or another. The subsidiary may be acting a distributor and acquiring goods from the UK company for resale in the local market. Alternatively, the subsidiary may be providing a manufacturing function for the UK company; for example, by acting as a sub-contractor. The UK company is also likely to provide some form of central services support for the subsidiary. These are examples of transactions that could take place between the UK and overseas subsidiary which would make it necessary to consider the possible application of transfer pricing rules.
The transfer pricing rules look to ensure that the price charged between associated enterprises is, for tax purposes, an arm’s length amount. If it is not, a tax adjustment should be made when calculating the taxable profits of both parties.
UK SME exemption
The common message is that a UK SME does not need to worry about UK transfer pricing rules because it benefits from the SME exemption (TIOPA 2010 s 166). However, this is not always the case. The exemption does not apply where a business has transactions with or provisions which include a related business in a territory with which the UK does not have a double tax treaty with an appropriate non-discrimination article (HMRC helpfully provides a list of treaties with the appropriate article at INTM412090).
HMRC can also issue a notice to comply with UK transfer pricing rules to medium-sized entities (TIOPA 2010 s 168). A notice can also be issued to a UK SME which is within the patent box regime. Therefore, we would always recommend that, even if the SME exemption does apply, efforts should be made to ensure pricing is reasonable and broadly comparable to an arm’s length price.
Overseas transfer pricing rules
Note that the SME exemption applies only for the purposes of the UK transfer pricing rules. Therefore, when transacting with an overseas subsidiary, the local transfer pricing rules must also be considered. One cannot assume that a similar SME exemption will apply overseas – for instance, the USA has no SME exemption – so it is important to ensure compliance with local rules and obligations. This means that the UK SME may have to consider transfer pricing rules for the first time as it starts to expand overseas.
Entity classification
This is a complex area that can lead to uncertainty for the UK tax position. Where an entity is established under foreign law, it is not always clear whether the entity is viewed as being a ‘company’ for UK tax purposes. The distinction is vital as it will in part determine how the taxable profits of the overseas subsidiary will be subject to tax in the UK.
Opaque versus transparent
If the entity is accepted by HMRC as being the equivalent to a UK company, it will be opaque for UK tax purposes. HMRC will treat the profits as belonging to the overseas entity which are only subject to tax when repatriated back to the UK (unless caught by the CFC rules which are discussed below).
However, if HMRC views the overseas entity as not being equivalent to a UK company, it may be viewed as transparent for UK tax purposes. This means that HMRC will treat the profits of the overseas entity as belonging to the UK parent, and they will be subject to corporation tax on an arising basis.
Entity classification has a number of consequences. For example, one may be expecting the entity to be treated as opaque and for the UK company to benefit from the dividend exemption on the repatriation of profits back to the UK. If in fact it is viewed as transparent, the UK company will be assessed to UK corporation tax on the profits of the overseas entity on an arising basis. There may be no additional tax due (if double tax relief is available), but there would be an additional tax cost if the overseas tax liability is lower than the UK equivalent.
Classification is also vital in determining the availability of the substantial shareholdings exemption (SSE). SSE applies to treat the gain on the disposal of ordinary share capital in companies as being exempt from UK corporation tax. If the entity is viewed as transparent by HMRC, then the UK company would instead be treated as disposing of each of the underlying assets of the overseas entity. In effect it would be treated as a trade and asset sale and would not benefit from SSE.
When considering whether a foreign entity is opaque or transparent for UK tax purposes, regard should be given to the leading authority of Memec Plc [1998] STC 754. HMRC’s guidance at INTM180010 sets out the factors outlined in the case. HMRC states that the following matters should be considered (and it pays particular attention to points 3 and 4):
HMRC also provides a helpful list (at INTM180030) giving its view on the opaque and transparent position of certain overseas entities. This is a good starting point for anyone who is asked to advise on the tax structure on a UK SME setting up subsidiaries overseas.
Profit extraction
All being well, the overseas subsidiary will make a profit, and the issue then is how ‘best’ to repatriate profits back to the UK. The various options include paying interest on debt provided by the UK parent, management and other service charges, royalties for use of IP, and dividends. There is some flexibility in how intra-group transactions are structured and the tax position will be considered as part of the final decision-making process.
For example, debt funding may be attractive where the overseas tax rate is higher than the UK tax rate. It would obviously be beneficial if the interest charge overseas generates tax deduction at a rate higher than the corresponding interest income does in the UK. For instance, the main rate of corporation tax is Italy is 24%, so a net tax saving at 7% of tax deductible interest could be achieved where profits are passed back to the UK through interest.
Transfer pricing rules will need to be considered where intra-group transactions give rise to tax deductible expenses in the overseas jurisdiction. Withholding taxes will also need to be considered as different rates of WHT can apply to different types of income. Leakage through WHT could mean that an anticipated saving achieved on the main corporation tax rate is wiped out and ends up being more costly. It would also be necessary to consider any VAT implications both in the UK and overseas to ensure there is minimal VAT leakage, particularly where management and service charges are concerned.
Turning back to the Italian example, under the terms of the UK-Italy double tax treaty, in most cases WHT on interest will be applied at 10%. One would anticipate the Italian WHT to be relievable in full against the UK corporation tax liability, but this cannot always be taken for granted.
EU directives
Where EU subsidiaries are involved, the Parent-Subsidiary and the Interest and Royalties Directives currently apply to reduce WHT to 0% on the payment of dividends, interest and royalties intra-EU. However, with Brexit impending, the directives cannot be relied on in the long-term and therefore the treaty position should be reviewed to determine whether there are any differences between the two.
Distribution exemption
The receipt of dividends from the overseas subsidiary is, in the majority of cases, going to benefit from the distribution exemption, i.e. the dividend income will not be subject to UK corporation tax (CTA 2009 Part 9A). In order for a small company (one with fewer than 50 employees and either less than €10m turnover or less than €10m gross assets) to benefit from the exemption:
As mentioned above when discussing transfer pricing, a list of countries which are qualifying territories can be found at INTM412090.
In some cases, it may be beneficial to make an election to disapply the distribution exemption (CTA 2009 s 931R). This may be desirable where a reduction in the WHT is available under a ‘subject to tax’ clause in the relevant tax treaty. If the UK company has available tax losses to reduce taxable profits, including taxable dividend income, to nil, then making the election could be beneficial if it eliminates any WHT.
Controlled foreign company (CFC) rules
Finally, it is necessary to consider the UK’s CFC rules. The CFC regime applies to companies resident outside the UK that are controlled by UK residents. If the CFC rules apply, then some or all of the profits of the overseas subsidiary are subject to UK corporation tax in the hands of the UK parent. The aim of the rules is to prevent UK companies artificially sheltering profits in an overseas jurisdiction.
A charge under the CFC rules can only apply if there are ‘chargeable profits’ and if none of the ‘CFC exemptions’ apply. The legislation does not prescribe which to consider first, but we would typically assess whether any of the CFC exemptions (set out in TIOPA 2010 Part 9A Chapters 10 to 14) apply first.
Exemptions
In the context of an SME, the effect of the exemptions is to take most overseas subsidiaries outside of the CFC regime. For example, ‘the low profits’ exemption (TIOPA 2010 Part 9A Chapter 12) applies if the CFC’s accounting profits or its assumed taxable total profits are no more than £500,000 for the accounting period and the amount of those profits that are non-trading income is no more than £50,000.
Another exemption is the ‘tax exemption’ (TIOPA 2010 Part 9A Chapter 14). The tax exemption will apply where the ‘local tax amount’ is at least 75% of the ‘corresponding UK tax’. This requires comparison of the actual tax paid on the profits of the CFC in its territory of residence with what tax would have been paid if the profits had been subject to UK taxation on a UK measure of profits. This requires more than just comparing the tax rate as differences in calculating the tax base (for example if different tax deductions are available for the purposes of computing the company’s local taxable profits) can have an impact on the overall tax liability.
Broadly speaking, if the overseas subsidiary is located in a specified country, then the ‘excluded territories’ exemption (TIOPA 2010 Part 9A Chapter 11) can apply. The list of excluded territories is provided by reg 3 and Part 1 of the Schedule of the Controlled Foreign Companies (Excluded Territories) Regulations, SI 2012/3024.
The CFC rules are complex and should be considered at the planning stage of setting up overseas, even if simply to rule out that a CFC charge will not apply.
Summary
As to be expected, the tax position associated with establishing an overseas subsidiary can be complex. We have highlighted the main issues that should be considered. However, in the majority of cases, issues such as entity classification and application of the CFC rules can be quickly considered and disregarded. Profit extraction will always be a key concern in order to minimise the overall tax cost of the structure. Overseas transfer pricing rules are likely to be in point in most cases, with the level of risk in part depending on the attitude of the overseas tax authorities.
In our previous article (‘International tax issues for SMEs’, Tax Journal, 24 May 2019), we discussed some of the key international tax considerations of which SMEs should be aware. In this article, we examine some of the tax issues facing a UK SME should it decide to establish an overseas subsidiary. In recent times, we have seen a number of clients setting up an EU subsidiary in response to Brexit. We have also seen more clients establishing subsidiaries outside the UK as they look to penetrate new markets and in response to perceived PE risk.
It is important when establishing an overseas subsidiary to consider both UK and overseas tax rules, as well as compliance with local laws and regulations. The following sets out some of the key tax matters that must be considered.
Corporate residency
The location of corporate residency is an important matter as many countries seek to tax the worldwide profits and gains of companies resident in their jurisdiction.
In most countries, a company will be treated as tax resident in a jurisdiction if it is incorporated in that country. The UK, for example, has such an incorporation test. Many countries also have some form of ‘place of management’ test. For example, a company will be resident in France if it is incorporated or has its place of effective management in France.
Through a collection of UK case law, a non-UK incorporated company can also be treated as resident in the UK if its place of central management and control is in the UK. This principle was established in De Beers Consolidated Mines v Howe (1906) 5 TC 198 where it is stated that ‘a company resides where its real business is carried on … and the real business is carried on where the central management and control actually abides’.
Over the last 113 years, case law has developed and is a useful source for understanding the UK’s approach to corporate residency. Statement of Practice SP 1/90 sets out HMRC’s view on how it determines residency. HMRC will seek to identify where the highest level of control – the ‘place of central management and control’ – is located. This is not necessarily the same place where the main business activities are carried on, but for an SME it will frequently be the same place.
HMRC’s approach is to first ascertain whether the directors actually exercise central management and control. If they do, HMRC will then establish where that control is exercised. If they do not, it will establish who in fact does exercise central management and control, and where.
For SMEs, it can be difficult and impractical to maintain residency of an overseas subsidiary outside of the UK. Where there are only a couple of key individuals running the business, there is naturally a reluctance to cede control to an individual residing overseas. It would be possible to arrange for board meetings to take place overseas, although this can mean significant costs and time commitments and it would still need to be demonstrated that the key business decisions are being made at the meetings rather than decisions already made in the UK being ‘rubber-stamped’.
If a company is deemed to be resident in both the UK and another country under the domestic law of each country, it will be necessary to review the double tax treaty between the two countries which should allocate residency to one territory or another. Usually this is where the place of management is located but as a result of the OECD multilateral instrument, it is becoming more common that the issue is to be resolved under a mutual agreement process.
HMRC sets out the circumstances when it will question residency in its International Manual at INTM120120. If the overseas subsidiary carries on activity in the jurisdiction of incorporation and is remunerated on an arm’s length basis, there may be little incentive for HMRC to challenge the residency position. The question of residency needs serious consideration at the outset. If there is a desire to maintain residency outside of the UK, it will be necessary to take practical steps to mitigate the risk of an HMRC challenge.
Maintaining corporate residency outside of the UK may be desirable if the overseas corporation tax liability is lower than the equivalent charge in the UK (if the company was deemed to be UK tax resident). However, the UK does have a competitive corporation tax rate and therefore the incentives, from a tax saving perspective, to take steps to avoid UK residency are not as strong as they once were. The long-term plan needs to be considered as uncertainty over residency and compliance with tax obligations, both in the UK and overseas, can be an issue in the future, e.g. on a future due diligence exercise.
For the rest of this article, we have assumed that the overseas subsidiary is tax resident in the local jurisdiction in which it is incorporated.
Transfer pricing
It is likely that the overseas subsidiary will be transacting with the UK parent company in one way or another. The subsidiary may be acting a distributor and acquiring goods from the UK company for resale in the local market. Alternatively, the subsidiary may be providing a manufacturing function for the UK company; for example, by acting as a sub-contractor. The UK company is also likely to provide some form of central services support for the subsidiary. These are examples of transactions that could take place between the UK and overseas subsidiary which would make it necessary to consider the possible application of transfer pricing rules.
The transfer pricing rules look to ensure that the price charged between associated enterprises is, for tax purposes, an arm’s length amount. If it is not, a tax adjustment should be made when calculating the taxable profits of both parties.
UK SME exemption
The common message is that a UK SME does not need to worry about UK transfer pricing rules because it benefits from the SME exemption (TIOPA 2010 s 166). However, this is not always the case. The exemption does not apply where a business has transactions with or provisions which include a related business in a territory with which the UK does not have a double tax treaty with an appropriate non-discrimination article (HMRC helpfully provides a list of treaties with the appropriate article at INTM412090).
HMRC can also issue a notice to comply with UK transfer pricing rules to medium-sized entities (TIOPA 2010 s 168). A notice can also be issued to a UK SME which is within the patent box regime. Therefore, we would always recommend that, even if the SME exemption does apply, efforts should be made to ensure pricing is reasonable and broadly comparable to an arm’s length price.
Overseas transfer pricing rules
Note that the SME exemption applies only for the purposes of the UK transfer pricing rules. Therefore, when transacting with an overseas subsidiary, the local transfer pricing rules must also be considered. One cannot assume that a similar SME exemption will apply overseas – for instance, the USA has no SME exemption – so it is important to ensure compliance with local rules and obligations. This means that the UK SME may have to consider transfer pricing rules for the first time as it starts to expand overseas.
Entity classification
This is a complex area that can lead to uncertainty for the UK tax position. Where an entity is established under foreign law, it is not always clear whether the entity is viewed as being a ‘company’ for UK tax purposes. The distinction is vital as it will in part determine how the taxable profits of the overseas subsidiary will be subject to tax in the UK.
Opaque versus transparent
If the entity is accepted by HMRC as being the equivalent to a UK company, it will be opaque for UK tax purposes. HMRC will treat the profits as belonging to the overseas entity which are only subject to tax when repatriated back to the UK (unless caught by the CFC rules which are discussed below).
However, if HMRC views the overseas entity as not being equivalent to a UK company, it may be viewed as transparent for UK tax purposes. This means that HMRC will treat the profits of the overseas entity as belonging to the UK parent, and they will be subject to corporation tax on an arising basis.
Entity classification has a number of consequences. For example, one may be expecting the entity to be treated as opaque and for the UK company to benefit from the dividend exemption on the repatriation of profits back to the UK. If in fact it is viewed as transparent, the UK company will be assessed to UK corporation tax on the profits of the overseas entity on an arising basis. There may be no additional tax due (if double tax relief is available), but there would be an additional tax cost if the overseas tax liability is lower than the UK equivalent.
Classification is also vital in determining the availability of the substantial shareholdings exemption (SSE). SSE applies to treat the gain on the disposal of ordinary share capital in companies as being exempt from UK corporation tax. If the entity is viewed as transparent by HMRC, then the UK company would instead be treated as disposing of each of the underlying assets of the overseas entity. In effect it would be treated as a trade and asset sale and would not benefit from SSE.
When considering whether a foreign entity is opaque or transparent for UK tax purposes, regard should be given to the leading authority of Memec Plc [1998] STC 754. HMRC’s guidance at INTM180010 sets out the factors outlined in the case. HMRC states that the following matters should be considered (and it pays particular attention to points 3 and 4):
HMRC also provides a helpful list (at INTM180030) giving its view on the opaque and transparent position of certain overseas entities. This is a good starting point for anyone who is asked to advise on the tax structure on a UK SME setting up subsidiaries overseas.
Profit extraction
All being well, the overseas subsidiary will make a profit, and the issue then is how ‘best’ to repatriate profits back to the UK. The various options include paying interest on debt provided by the UK parent, management and other service charges, royalties for use of IP, and dividends. There is some flexibility in how intra-group transactions are structured and the tax position will be considered as part of the final decision-making process.
For example, debt funding may be attractive where the overseas tax rate is higher than the UK tax rate. It would obviously be beneficial if the interest charge overseas generates tax deduction at a rate higher than the corresponding interest income does in the UK. For instance, the main rate of corporation tax is Italy is 24%, so a net tax saving at 7% of tax deductible interest could be achieved where profits are passed back to the UK through interest.
Transfer pricing rules will need to be considered where intra-group transactions give rise to tax deductible expenses in the overseas jurisdiction. Withholding taxes will also need to be considered as different rates of WHT can apply to different types of income. Leakage through WHT could mean that an anticipated saving achieved on the main corporation tax rate is wiped out and ends up being more costly. It would also be necessary to consider any VAT implications both in the UK and overseas to ensure there is minimal VAT leakage, particularly where management and service charges are concerned.
Turning back to the Italian example, under the terms of the UK-Italy double tax treaty, in most cases WHT on interest will be applied at 10%. One would anticipate the Italian WHT to be relievable in full against the UK corporation tax liability, but this cannot always be taken for granted.
EU directives
Where EU subsidiaries are involved, the Parent-Subsidiary and the Interest and Royalties Directives currently apply to reduce WHT to 0% on the payment of dividends, interest and royalties intra-EU. However, with Brexit impending, the directives cannot be relied on in the long-term and therefore the treaty position should be reviewed to determine whether there are any differences between the two.
Distribution exemption
The receipt of dividends from the overseas subsidiary is, in the majority of cases, going to benefit from the distribution exemption, i.e. the dividend income will not be subject to UK corporation tax (CTA 2009 Part 9A). In order for a small company (one with fewer than 50 employees and either less than €10m turnover or less than €10m gross assets) to benefit from the exemption:
As mentioned above when discussing transfer pricing, a list of countries which are qualifying territories can be found at INTM412090.
In some cases, it may be beneficial to make an election to disapply the distribution exemption (CTA 2009 s 931R). This may be desirable where a reduction in the WHT is available under a ‘subject to tax’ clause in the relevant tax treaty. If the UK company has available tax losses to reduce taxable profits, including taxable dividend income, to nil, then making the election could be beneficial if it eliminates any WHT.
Controlled foreign company (CFC) rules
Finally, it is necessary to consider the UK’s CFC rules. The CFC regime applies to companies resident outside the UK that are controlled by UK residents. If the CFC rules apply, then some or all of the profits of the overseas subsidiary are subject to UK corporation tax in the hands of the UK parent. The aim of the rules is to prevent UK companies artificially sheltering profits in an overseas jurisdiction.
A charge under the CFC rules can only apply if there are ‘chargeable profits’ and if none of the ‘CFC exemptions’ apply. The legislation does not prescribe which to consider first, but we would typically assess whether any of the CFC exemptions (set out in TIOPA 2010 Part 9A Chapters 10 to 14) apply first.
Exemptions
In the context of an SME, the effect of the exemptions is to take most overseas subsidiaries outside of the CFC regime. For example, ‘the low profits’ exemption (TIOPA 2010 Part 9A Chapter 12) applies if the CFC’s accounting profits or its assumed taxable total profits are no more than £500,000 for the accounting period and the amount of those profits that are non-trading income is no more than £50,000.
Another exemption is the ‘tax exemption’ (TIOPA 2010 Part 9A Chapter 14). The tax exemption will apply where the ‘local tax amount’ is at least 75% of the ‘corresponding UK tax’. This requires comparison of the actual tax paid on the profits of the CFC in its territory of residence with what tax would have been paid if the profits had been subject to UK taxation on a UK measure of profits. This requires more than just comparing the tax rate as differences in calculating the tax base (for example if different tax deductions are available for the purposes of computing the company’s local taxable profits) can have an impact on the overall tax liability.
Broadly speaking, if the overseas subsidiary is located in a specified country, then the ‘excluded territories’ exemption (TIOPA 2010 Part 9A Chapter 11) can apply. The list of excluded territories is provided by reg 3 and Part 1 of the Schedule of the Controlled Foreign Companies (Excluded Territories) Regulations, SI 2012/3024.
The CFC rules are complex and should be considered at the planning stage of setting up overseas, even if simply to rule out that a CFC charge will not apply.
Summary
As to be expected, the tax position associated with establishing an overseas subsidiary can be complex. We have highlighted the main issues that should be considered. However, in the majority of cases, issues such as entity classification and application of the CFC rules can be quickly considered and disregarded. Profit extraction will always be a key concern in order to minimise the overall tax cost of the structure. Overseas transfer pricing rules are likely to be in point in most cases, with the level of risk in part depending on the attitude of the overseas tax authorities.
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