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 on the income of its non-UK resident subsidiaries; it is not taxed on the income when it arises, and in most cases dividends will be exempt. Therefore, if assets or activities can be located in foreign companies in foreign jurisdictions with tax rates lower than the UK rate, a tax saving can be achieved. 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 at the main rate on their share of the CFCs profits. New UK CFC rules apply to accounting periods of CFCs starting on/after 1 January 2013 and aim to identify and apportion only those profits which have been artificially diverted from the UK. However, the new CFC rules are not simple, so what do you need to know? This article sets out what 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 corporate group, 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 at least 25%, and No CFC exemptions apply, and The CFC has 'chargeable profits'.

If one of the CFC exemptions applies it is not necessary to consider whether the CFC has any chargeable profits. In the exam, it will therefore be important to identify the following: Start with the obvious: 1. 2. Is it a CFC? Is there a 25% holding by a UK company?

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3 4.

Is there an applicable exemption? Are there any chargeable profits? (Applying the gateway tests)

Before you move on to the more complicated:

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 shareholders and 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 against the 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, in the exam we expect you to recognise that if an exemption is applicable, there is no need to consider 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 CFC charge. 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 (most notably Switzerland and Ireland). Low profits If a companys profits (on a tax or accounts basis) are no more than 500,000 and its nontrading 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 be apportioned 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 through this gateway and become chargeable profits if the company meets one or more of the entry conditions. If one of these conditions is met none of the companys profits pass through this gateway (although the CFC may also have non-trading financing profits, which need to be considered 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 and risks were to stop.

(iii)

So, for example, if a company had entered into significant tax planning transactions but had absolutely no UK management, it would meet one of the entry conditions and none of its profits would be chargeable profits under this gateway. If none of the entry conditions are met the CFC must analyse the active decision making relevant to its assets and risks. If any of the active decision making is carried on in the UK by a connected person, 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 is more 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 exchange differences 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 as incidental 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 gateway and become chargeable profits if they are derived from: Assets and risks in relation to which any relevant active decision making is carried out in the UK, 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 CFC provisions.

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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 Helier which 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 UK shareholder, 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.

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