Taxation of foreign profits

15 December 2008

Catherine Ramsay, Levent Gurdenli

HM Treasury clarified its position on the taxation of foreign dividends received by UK companies by publishing draft consultation on 9 December 2008. This package of reforms will be introduced in the Finance Bill 2009 and will provide significant changes to current UK tax law. The measures include:

  • An exemption from UK tax on foreign dividends for large and medium groups; 

  • A worldwide debt cap on the amount of interest deducted for UK members of a multi-national group; 

  • Changes to the current CFC exemptions; 

  • Abolition of Treasury Consent rules and notification requirements; and 

  • An extension of the unallowable purpose rules for loan relationships.

UK tax on foreign dividends

The central measure of the reforms is to promote the UK as a more attractive base for multi-national companies. Foreign dividends received by large and medium groups will be exempt from UK corporation tax on ordinary shares and most non-ordinary shares. This will replace the existing foreign tax credit regime. There will be a targeted anti-avoidance rule introduced to prevent those seeking to exploit these exemptions. Small UK companies will still be subject to the existing foreign tax credit regime, although it is not yet clear what the definition of ‘small’ entails. This new exemption will not cover a dividend paid by a foreign company which is deductible under local law.

Worldwide debt cap

This will restrict interest relief claimed by UK members of worldwide groups by reference to the group’s worldwide net external finance costs. This restriction will be in addition to those already existing under the thin capitalisation and anti-avoidance rules.

The restriction will prevent a multi-national group having more debt in the UK than it needs to service the worldwide group. It will also discourage a UK parent in a multi-national group from using interest-bearing loans from their overseas subsidiaries in order to repatriate cash generated overseas back into the UK. Intra-group borrowing will be allowed providing it does not exceed the remaining net finance costs of the group worldwide.

The new rules could have an adverse effect on many groups. In particular it could potentially pose problems for UK parents who want to borrow from foreign subsidiaries for perfectly legitimate commercial reasons.

However, the draft legislation is not in final form and the government has acknowledged that it may require further work. It has invited businesses to comment on the legislation on a range of issues. Specifically:

  1. whether there should be a “gateway” test to mitigate the compliance burden;

  2. how to deal with non-sterling external debt;

  3. how to deal with groups which hold excess cash that is not available to the group; and

  4. situations where the worldwide groups’ report in GAAPS rather than under IAS or equivalent.

Future reform of CFC rules

Wider reforms of CFC rules have been deferred. It is the government’s intention to take this forward, but it will follow its own timetable. An open letter was sent by the Financial Secretary to HM Treasury to the CBI and Hundred Group which stated that the aim of the new rules would be to modernise the current rules. Central to this was the intention that the new CFC system should not tax profits genuinely earned in overseas subsidiaries. Future action in terms of the reforms is not clear, but it is likely that a consultation document or discussion paper on options for reform will be the next step.

The Treasury announcement included the abolition of some exemptions available for offshore subsidiaries to qualify as exempt CFCs. This has the potential to adversely affect some very common commercial arrangements.

The Acceptable Distribution Policy (ADP) exemption currently allows a CFC to be exempt if it distributes at least 90% of its profits back to the UK via a dividend within 18 months of the end of the accounting period. The introduction of the new dividend exemption means this CFC exemption is no longer necessary and it will be repealed. Even if it were not abolished it would not be effective anymore as the requirement for the dividend to be subject to UK tax would no longer apply under a dividend exemption system.

The second proposed change is to abolish the holding company tests, subject to a 24 month transitional period, to allow groups to unwind holding companies within a sensible timeframe. This proposal does not take into account the fact that many groups have holding companies which are used for genuine commercial reasons. This could be the case where a holding company is used to provide services to other companies within the same territory. Holding companies are also commonly used as bid vehicles in an acquisition to provide finance. Whereas under the existing rules such holding companies would be outside the scope of CFC rules, they are likely to be affected by the proposed abolition of the holding companies exemption. Affected companies will need to consider whether any alternative CFC exemptions are available to them or be prepared to suffer a CFC apportionment which may increase their tax burden.

Abolition of Treasury Consents

The current out-dated Treasury Consent rules will be replaced by quarterly post transaction reporting requirements for high risk transactions with a market value of over £100 million. Transactions in the ordinary course of business (including providing security to banks) will be excluded from the requirements as will transactions within the current General Consents for the same territory exceptions. The reporting is likely to be to the company’s Client Relationship Manager and only limited information will have to be reported. Trusts and partnerships will also be subject to these reporting requirements.

Extension of unallowable purpose rule for loan relationships

Under current anti-avoidance rules interest deductions are restricted where a particular loan or derivative contract has an unallowable purpose. The rules will be extended to cover schemes and arrangements which have a tax avoidance purpose even where any loan or derivative contract does not have that purpose if viewed in isolation. The purposes of other parties in the arrangement will therefore be taken into consideration.

Who will be affected?

The new reforms will impact different sectors in different ways.

UK outbound groups should benefit from the dividend exemption. However, the interest cap will adversely affect groups with upstream loans where external debt is borrowed wholly in the UK.

Many inbound groups will not be affected by the dividend exemption but they could be negatively affected by the interest cap proposals. It may not result in an increased tax burden but it is likely to be an extra compliance cost.

It is unclear how the interest proposals will affect the typical investments made by private equity groups. It is likely to depend on whether shareholder investment in the consolidated group accounts is regarded as external debt.

Finally, groups that hold liquid assets in their business are likely to be adversely affected by the debt cap depending on how the net consolidated interest position of the group is calculated and how much of their external debt is located in the UK.

What’s next?

The Treasury announcement said that draft legislation containing the detailed proposals will be published in the coming weeks with the intention that the final legislation be introduced in the Finance Bill 2009. No timetable has been announced for the proposed CFC reforms although it is unlikely to be complete before 2010. In the meantime, companies should start to think about what planning they must undertake to minimise the impact of these provisions.