Checking tax liability of foreign subsidiary profits easier under latest draft reforms, Treasury says

The Treasury said firms will be able to review a new set of "conditions" around the CFC regime meaning that "in most cases" they will not have to consider more detailed rules in order to check whether foreign subsidiary profits are subject to tax.

A CFC is an overseas company controlled by UK residents which pays less than three quarters of the tax which it would have paid on its income if it had been resident in the UK. The Government has outlined legislative reforms to CFC rules which will mean that not all profits of foreign subsidiaries will necessarily be potentially subject to a charge. A charge will only arise on the proportion of overseas profits that have been 'artificially diverted' from the UK. The proposed rules are due to come into effect for accountancy periods beginning on or after 1 January 2013.

Under the new rules business profits of a foreign subsidiary will be outside the scope of the CFC regime unless they meet specified conditions set out in a 'gateway'. These conditions define what is to be treated for the purposes of the regime as profits artificially diverted from the UK. In broad terms this will be where there is a significant mismatch between business activities undertaken in the UK and the profits arising from those activities which are located outside the UK.

The rules provide 'safe harbours' covering general commercial business, incidental finance income and some sector-specific rules. A foreign subsidiary can rely on these to show that some or all of its profits are outside the scope of the regime.

The rules are intended to capture companies which artificially divert UK profits to low tax territories or other favourable overseas tax regimes to reduce their UK tax liabilities.

There are a number of exceptions to the draft rules which apply to low taxed foreign companies controlled from the UK. Those exceptions are being significantly modernised to reflect current business practice.

Following a consultation on the reforms the Treasury and HM Revenue & Customs (HMRC) have now issued details (16-page / 255KB PDF) of a new "introductory chapter" which sets out conditions which businesses can review in order to check whether foreign subsidiary profits are liable to be taxed.

"The introductory Gateway chapter expressly defines profits which are artificially diverted from the UK and therefore within the scope of the rules," the Treasury said. "Like the Gateway more generally, it deals separately with business profits and other types of profits such as finance profits. However, finance profits from investment that are incidental to the trade or property business of a foreign subsidiary now form part of the introductory Gateway chapter."

Profits will be considered to be outside the scope of the CFC charge for general business profits "unless the control or management of a foreign subsidiary’s assets or risks is carried on to a significant extent in the UK; [and] if a foreign subsidiary has the capability to carry on its business without the UK activities referred to ... [including] replacing them with services which a third party might reasonably be expected to provide; [or] if [the arrangements in place from which a foreign subsidiary derives its profits] do not have a main purpose of achieving a UK tax reduction".

The 'tax purpose' condition will also be said to be met "where there are commercial purposes for the arrangements, such that it is reasonable to suppose that they would have been entered into in the absence of any UK or foreign tax advantages," the Treasury said.

Property business profits and non-trading finance profits are not treated as 'business profits' for the purposes of the CFC rules, the Treasury said.

The Treasury announced the new assessment framework as it published an update (76-page / 757 KB PDF) to its draft legislation on the on the tax treatment of CFCs.

The legislation update includes changes to the way the texts are structured. The 'gateway' rules are more prominently positioned so that "for most foreign subsidiaries, groups will not need to consider chapters in the legislation beyond the introductory Gateway chapter to establish that a company’s profits are outside the scope of the rules," the Treasury said.

Among the other changes, it said that the Government was considering narrowing the scope of some of the targeted anti-avoidance rules (TAARs), which explain in detail when exemptions to CFC tax being levied do not apply.

"Throughout the consultation on CFC reform respondents have said that exemptions should be wide in scope to allow the rules to be as flexible as possible, recognising that might only be practical through the inclusion of TAARs to protect these wide exemptions. The preference has also been for a series of narrow, TAARs rather than a broad rule that applied to the whole regime, on the basis that targeted rules are more certain in their application," the Treasury said.

"In response to the feedback, including helpful and constructive contributions from a working group, the Government is considering proposals to narrow the scope of a number of the TAARs to ensure that they are appropriately targeted and to make clear their intended scope," it said.

The Treasury said it welcomed feedback on the latest draft of its reforms.

"The changes to the Gateway test are welcome, and that the Government is considering proposals to narrow the scope of a number of the TAARs is also good news," Eloise Walker, tax law specialist at Pinsent Masons, the law firm behind Out-Law.com, said.

"But whilst HMRC is to be encouraged to continue accepting feedback on the draft legislation, the downside is that this is still a moveable feast, so we won't see the final proposals until the Finance Bill to be published on 29 March 2012, and maybe not even then," she said.