cfc examiner article july 2013 vital

8/13/2019 Cfc Examiner Article July 2013 Vital

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Controlled Foreign Companies (CFCs)

The examiners explain how to deal with CFCs in your technical integration and Business

Planning: Taxation exams in 2013.

INTRODUCTION

A UK resident company, holding shares in a non-UK resident company is not generally taxable onthe income of its non-UK resident subsidiaries; it is not taxed on the income when it arises, and inmost cases dividends will be exempt. Therefore, if assets or activities can be located in foreigncompanies in foreign jurisdictions with tax rates lower than the UK rate, a tax saving can beachieved.

The CFC rules are an anti-avoidance measure, targeting these tax savings. UK resident

companies with a minimum 25% shareholding in a CFC will be charged to UK corporation tax atthe main rate on their share of the CFCsprofits. New UK CFC rules apply to accounting periods ofCFCs starting on/after 1 January 2013 and aim to identify and apportion only those profits whichhave been artificially diverted from the UK.

However, the new CFC rules are not simple, so what do you need to know? This article sets outwhat you need to know to answer a question in the exam.

WHAT IS A CFC?

This is the easy bit. A CFC is a company which: Is resident outside the UK, and

Is controlled by persons resident in the UK (>50%, or de facto control), or is at least 40%

controlled by a UK resident and at least 40% but no more than 55% by a non-UK resident.

If a company is a parent undertaking under FRS2 then it is deemed to have control. In a corporategroup, all of the non-UK resident subsidiaries of a UK holding company will therefore be CFCs.

DOES A CFC CHARGE APPLY?

Once it is established that a foreign company is a CFC you then need to determine whether a CFC

charge arises. There is a CFC charge if (and only if):

There is a UK company which (together with connected companies) holds an interest of atleast 25%, an d No CFC exemptions apply, an d The CFC has 'chargeable profits'.If one of the CFC exemptions applies it is not necessary to consider whether the CFC has anychargeable profits.

In the exam, it will therefore be important to identify the following:

Start with the obvious:

1. Is it a CFC?

2. Is there a 25% holding by a UK company?


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3 Is there an applicable exemption?

Before you move on to the more complicated:

4. Are there any chargeable profits? (Applying the gateway tests)

The CFC Charge

A CFC charge can only apply if there are chargeable profits. To have chargeable profits the CFC

must have profits which pass through the CFC charge gateways

These gateways are tests designed to define the profits which have been artificially diverted from

the UK and are therefore subject to a CFC charge.

Any chargeable profits are then apportioned to the CFCs shareholdersand a tax charge only

arises where at least 25% of the CFCs chargeable profits are apportioned to a UK resident

company. If a CFC has a number of unrelated UK shareholders, each of which has a less than

25% interest, there will therefore be no charge.

Chargeable profits are taxed at the main rate of corporation tax, with double tax relief given for any

creditable tax (ie local taxes suffered on the profits). A claim can be made to offset losses againstthe apportioned profits.

The Gateway Tests

We only examine two of the five gateway tests, as follows:

Business profits that have been diverted from the UK through tax avoidance arrangements,

and

Certain finance profits.

Only the part of the foreign companys profits that 'passes through' the gateway are chargeable

profits' potentially subject to apportionment.

Chargeable gains and property income are not chargeable.

Exemptions

Strictly, the legislation suggests considering the gateway tests before the exemptions, however, inthe exam we expect you to recognise that if an exemption is applicable, there is no need toconsider the gateway test, so it is easier to consider the exemptions first.

THE EXEMPTIONS

There are five entity level exemptions which exempt the whole of a companys profits from a CFCcharge. They are:(i) Exempt period

This is intended to give companies coming within the UK CFC rules time to restructure so that

they are not subject to a charge. It lasts for 12 months (or longer, with the agreement of

HMRC) after a company comes under the control of UK residents.

(ii) Excluded territories


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HMRC has issued regulations setting out a list of good territories, where a companys profits

are not generally subject to a low rate of tax. A company, which is resident and fully taxable in

a listed territory, will not generally be subject to a CFC charge.

Tax havens (such as the Channel Islands, Bermuda, and the Cayman Islands) are not listed,neither are other jurisdictions that have often been used for tax planning in the past (mostnotably Switzerland and Ireland).

(iii) Low profits

If a companys profits (on a tax or accounts basis) are no more than 500,000 and its non-

trading profits are not more than 50,000.

(iv) Low profit margin

If a companys accounting profits are no more than 10% of its relevant operating expenditure

(i.e. operating expenditure per the accounts, less amounts paid to related parties and the cost

of goods sold, unless the goods are used by the CFC in its local territory).

(v) Tax exemption

If the local tax paid by a CFC on its profits is not less than 75% of the corresponding UK tax on

those profits.

A full UK corporation tax computation would be needed to determine whether this exemption

applies. This may be simple for an investment company, but in relation to a trading company it

is likely to be easier to see whether another exemption applies, or to look at the gateway tests

instead.

THE GATEWAY TESTS:

We only examine two gateway tests out of the five in the legislation. Remember, profits can only beapportioned to the UK shareholders if they fall within a gateway.

TEST 1: THE GATEWAY FOR PROFITS ATTRIBUTABLE TO UK ACTIVITIES

The gateway for profits attributable to UK activities has an entry test. Profits will not pass throughthis gateway and become chargeable profits if the company meets one or more of the entryconditions. If one of these conditions is met none of the companys profits pass through thisgateway (although the CFC may also have non-trading financing profits, which need to beconsidered under the second gateway test, see below).

Entry conditions:

The CFC has no assets or risks deriving from tax planning schemes, or

None of the CFCs assets or risks are managed from the UK, or

The CFC has the ability to manage its own business if any UK management of assets andrisks were to stop.

So, for example, if a company had entered into significant tax planning transactions but hadabsolutely no UK management, it would meet one of the entry conditions and none of its profitswould be chargeable profits under this gateway.

If none of the entry conditions are met the CFC must analyse the active decision making relevantto its assets and risks. If any of the active decision making is carried on in the UK by a connectedperson, the profits attributable to that UK active decision making process pass through the gateway

and will be chargeable profits subject to the CFC charge. (Note that active decision making ismore correctly referred to as the significant people functions in the study manual.)


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TEST 2: THE GATEWAY FOR NON-TRADING FINANCING PROFITS

This is the second gateway test we will be examining.

Non-trading finance profits consist of:

Non-trading profits taxable under the loan relationship rules (eg interest, foreign exchangedifferences and derivative contract profits),

Dividends and other distributions that are not exempt under the distribution exemption and

Non-trading profits from relevant finance leases.

However, these profits may be excluded if they are considered incidental. Profits are treated asincidental if the CFC also has:

trading or property business profits, or is a holding company for 51% subsidiaries, and

its non-trading finance profits are no more than 5% of its good income.

Where the CFCs non-trading finance profits are not incidental they will pass through the gatewayand become chargeable profits if they are derived from:

Assets and risks in relation to which any relevant active decision making is carried out in theUK,

Capital investment from the UK,

Specified arrangements in lieu of dividends (typically loans) with the UK, or

UK finance leases.

HMRC believes that in a UK parented group an analysis of the active decision making will always

result in a significant proportion of any intra-group loan being allocated to the UK. Although for

qualifying loan relationships (see below), the CFC charge may be reduced for intra-group loans

with a non-UK resident borrower.

FINANCE COMPANY EXEMPTION (Qualifying Loan Relationships)

Where a CFCs non-trading finance profits include profits from qualifying loan relationships, which

are not considered incidental and therefore appear to pass through the gateway and give rise to

chargeable profits,these profits may be exempt if they can be identified as qualifying loan

relationships profits.While most of the CFC rules are aimed at discouraging groups from locating

activities outside the UK, the rules relating to qualifying loan relationships (QLRs) actively

encourage it. They are the result of lobbying from large corporates, and are intended to provide an

incentive for groups to remain headquartered in the UK.

In order for these rules to apply, the CFC must have business premises in its local territory, its UK

controlling shareholder must have elected for the rules to apply, and the company must have at

least one QLR.A loan is a QLR if:

The CFC is the creditor, and

The ultimate debtor is a connected company which is controlled by the same UK resident

person or persons who control the CFC, and

The loan is not part of an arrangement which has a tax avoidance purpose, and

The ultimate debtor is not:

- A UK resident company (unless the debit is within an exempt PE), or a UK PE, or

- A CFC if the debits on the loan reduce the amount which is chargeable under the CFCprovisions.


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75% Exemption

Where an election is in place, the basic rule is that 75% of the profits attributable to QLRs are

exempt.

Qualifying Resources Exemption

However, where a loan is funded out of qualifying resources and is the subject of a further election

it will be fully exempt. Qualifying resources are:

Profits earned by the CFC from loans to members of the group which are resident in the

same territory as the borrower under the QLR,

Funds raised from the issue of shares or debentures, and

Certain pre-acquisition assets of companies which have been acquired by the group in a

share for share exchange.

Matched Interest Exemption

In addition, the balance of any profits attributable to QLRs which would be taxable after applying

these rules (ie the 25% relating to loans not funded out of qualifying resources) is:

Exempt if the group has no net UK interest deductions before taking a possible CFC charge

into account, and

Partially exempt where there would be no net deduction if the interest income included in a

CFC charge is taken into account.

The worldwide debt cap rules are used to determine whether there is a net UK interest deduction

for these purposes.

Qualifying loan relationships an example

Facts:

Company Z is a CFC, which is resident in Jersey and pays no local tax. It has an office in St Helierwhich is used for board meetings and by the companys part time staff member. It is 100% owned

by the Omega group, and the financing decisions are ultimately made by the treasury team in the

UK. The Omega group has net UK interest deductions in excess of 10 million.

In the year ended 31 March 2014, company Z has the following income (and negligible costs):

000

Income from money market deposits 750

Interest on loans to Omega plc 1,800

Interest on loans to company Q, a German resident group trading company 3,600

Interest on loans to company X, a 30% owned US joint venture company 4,250

Interest on loan to company Y 500

10,900

Company Y is an intellectual property holding company which is 100% owned by Omega plc. It is

not subject to a CFC apportionment because it has profits of less than 50,000 after taking account

of the interest deduction.

Application of rules:

Without the QLR rules the UK management involvement means that all of the companys profits

would pass through the non-trading finance profits gateway and be apportioned to Omega plc.

However, as company Z has business premises in its local territory, Omega plc could elect for the

QLR rules to apply to the extent that it has QLRs.


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When you analyse its income:

The money market deposits are not QLRs as the borrower is not a connected person. The

same is true for the loan to the JV company.

The loan to Omega plc is not a QLR as it gives rise to a UK deduction, and

The loan to company Y is not a QLR as, if it had not been made, company Y would have

been a CFC and its profits would have been subject to an apportionment.

The only QLR is therefore the loan to company Q. We are given no information to suggest that it is

made from qualifying resources, so we assume that it will be 75% exempt. If the relevant election

is made, company Zs chargeable profits which pass through the CFC charge gateway will

therefore be reduced by 2.7m (3.6m x 75%) to 8.2m. There are net UK interest deductions

even after the apportionment is taken into account, so the matched interest rules do not apply to

limit it further.

All of company Zs chargeable profits of 8.2m will be apportioned to Omega plc as it has a 100%

shareholding. It will be taxed at 23% to give a CFC charge of 1,886,000. As there is no local tax

suffered, there is no creditable tax to offset against the charge.

WHAT DOES IT ALL MEAN ANYWAY?

Firstly, the complexity of the legislation means that it is worth taking time to make sure you can

remember the basic structure of the rules. It is also useful to remember that neither chargeable

gains (which are not part of chargeable profits) nor property business income (which does not pass

through the gateways) can ever give rise to a CFC charge.

Secondly, if you are asked to give an overview of the rules (eg explain to senior management, in

outline, how the new rules work) you will almost certainly need to mention the control test, the

gateways, the exemptions and how the charge is calculated. Whether you need to mention the

QLR rules will depend on how the question is worded.

Thirdly, if you face a question which is based around a golf course chat scenario, where a director

has been told by his friends to put income in a company based in a tax haven with no local

substance the answer is likely to be (roughly) that:

None of the exemptions will apply unless it has very low profits or a low profit margin, in which

case it may not be worth doing anyway (havens are not excluded territories, do not have a

high enough tax rate for the tax exemption to apply, and the company would not have

previously been non-UK controlled so the exempt period is not relevant), and

All of its profits will pass through the gateways and be apportioned to and taxed on the UKshareholder, unless they are non-trading finance profits and the QLR rules apply. This is

because the clear tax avoidance motive and need for UK head office staff to be involved in

managing the companys assets mean that none of the entry conditions for the gateway for

profits attributable to UK activities will be met. In addition, an analysis of the active decision

making (technically known as the significant people functions) is likely to conclude that

substantially all of the assets and risks are managed from the UK. If there is no local

substance at all, even the QLR rules will not apply because the company will not have

business premises.

Fourthly, the fact that the gateway tests look at the extent to which assets and risks are managed

in the UK means that if you are given a scenario where there is a debate around whether


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management and control of a subsidiary is in the UK, there may well be a CFC issue as well as a

residence one.

Finally, there are no statutory clearance procedures (procedures by which you can ask for a ruling

about how a transaction will be treated for tax purposes) in the FA 2012 CFC rules, so in the real

world, where there is material uncertainty as to how HMRC will interpret the CFC rules in a

particular case HMRC will give guidance under the non-statutory business clearance rules.

cfc examiner article july 2013 vital

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