In-house view: compliance implications of draft rules on foreign branch profits

Since Finance Act 2009 introduced an exemption for foreign dividends, the basis of UK corporation tax has shifted towards a more territorial basis: focusing on corporate profits earned in the UK and not abroad. This shift becomes more complete with proposed legislation to exempt foreign branch profits from UK corporation tax, issued in December as part of the government’s overall package of reform to make the UK corporate tax regime the most competitive in the G20.

This brief comment will not cover all aspects of the proposed legislation, such as those dealing with chargeable gains, but will comment only on certain compliance implications. As the draft legislation is currently subject to consultation, it may change before enactment.

The exemption will cover a foreign branch’s trading profits and its effectively connected investment income. Foreign branch profits will be exempt from UK tax and foreign branch losses will not attract UK tax relief. The earlier Discussion Document on foreign branch taxation outlined the possibility of allowing UK relief for exempt branches’ losses subject to some method of clawback. The treatment of losses in the draft legislation may well reduce the attraction of the exemption regime to some companies.

The ‘opt-in’ basis

The basis for exemption will be an ‘opt-in’: a company electing for all its foreign branches to be permanently exempt from UK tax. The election will therefore be irrevocable. If an election is not made, the current basis of taxation (with credit for foreign tax) will continue.

The start date for the new regime has not been announced but is expected to be a date in 2011 after Royal Assent to the Finance Bill. From that date, a company will be entitled to opt into exemption which will apply from the beginnning of its next accounting period (subject to transitional rules for prior losses). A company with a calendar year-end which made the election in December 2011 would be within the exemption regime from 1st January 2012.

The election will be on a company, rather than a group, basis – and will apply to all of the company’s existing foreign branches and any it may establish in the future. As the election will be irrevocable there can be no ‘cherry-picking’ to exempt branches only in years when they are profitable and subject to a UK tax ‘top-up’ (having paid foreign tax at a rate lower than the UK’s).

Deciding whether and when to opt into exemption will depend on expectations of foreign branch results (particularly for new branches). It is unlikely that an election would be made if overall losses were expected, as they would not then qualify for UK tax relief.

Transitional rules

There are also transitional rules around earlier losses in foreign branches, for which UK tax relief will already have been given. If you elect for exemption, foreign branch profits will become exempt only once the aggregate tax losses of foreign branches in the six years immediately preceding the date of the election have been matched by profits in foreign branches.

But very large losses (defined as exceeding £50m) are to be measured over the six years immediately preceding the introduction of the new regime (not the election). These losses must be carried forward until the aggregate of all foreign branch losses has been matched by foreign branch profits. Only then will the foreign branches be exempt from UK tax.

So, you will always need to measure aggregate foreign branch losses in the six years immediately preceding the introduction of the new regime. If they exceed £50m, exemption can begin only once they are covered by profits – regardless of the date of election. If they do not exceed £50m, exemption will begin once losses in the six years preceding the election have been covered.

These transitional rules for losses may make it more difficult for some companies to join the exemption regime.

Effect of the election on tax computations

Having made an election, what will its effect be on tax computations for a company with foreign branches? The company will still have to produce a worldwide profit computation following UK tax rules, including all its foreign branches. The profits in foreign branches will then be deducted from the worldwide profits, any losses in foreign branches will be excluded from the overall calculation and the remainder brought into UK tax. The computation will not be restricted to UK activities alone, so the company’s UK tax compliance effort will be reduced only in relation to tracking overseas tax paid.

The ‘anti-diversion’ rules

‘Anti-diversion’ rules are also proposed, to provide consistency with foreign subsidiaries which are subject to CFC rules. The CFC rules are themselves subject to staged reform and when finally amended in 2012 are intended to apply equally to foreign branches and subsidiaries. In the interim, there will be a separate anti-diversion rule for branches.

If a particular branch fails the anti-diversion test in any year, the profits from that branch for that year will be subject to UK tax (with relief for foreign tax).

Limited exemptions from this interim anti-diversion test will be imported from the CFC regime: lower level of tax, de minimis profits and motive test. It is hoped that this last can be drafted to grandfather existing foreign branches – as they have been subject to UK tax until now they can hardly have been set up in contemplation of avoiding UK tax.

Companies have until 9 February to make comments on the draft legislation and the implementation of these fundamental changes.

Mike Lomax, Standard Chartered Bank