1 slaughter and may Article october 2010 Graham Airs On 27 July 2010 the UK Treasury released a discussion document on foreign branch taxation. This explores the possibility for changing the UK tax rules on the taxation of profits from permanent establishments of UK companies outside the United Kingdom, basically by introducing an exemption from UK tax for those profits. Although the document is called a discussion document, it seems that the Treasury is determined to introduce new rules from An exemption for profits derived from overseas branches sounds simple. But, somehow, UK corporate taxation never is; and it appears clear from the discussion document that any new rules introduced on the taxation of profits from foreign branches will be anything but simple. The problem is that the Treasury will not want to encourage UK taxpayers to move income-generating activities out of the United Kingdom. So the Treasury will want to limit the exemption to income that has been taxed elsewhere. That leads to the complications that are further explained below. Why? For most UK groups the current system of taxation of overseas profits is perfectly acceptable. Although UK tax is imposed on profits earned anywhere in the world, credit is given for tax imposed on those profits in overseas jurisdictions. Furthermore, just as profits earned overseas are included in a UK company s taxable profits, losses incurred overseas are also taken into account in calculating a UK company s taxable profits. So relief is given in the United Kingdom for overseas losses. That means that a UK company starting a new venture overseas can begin operations though a branch, claiming relief against UK tax for any losses incurred in the start-up phase, and then, once those overseas operations become profitable, transfer them into an overseas subsidiary. The profits earned by the overseas subsidiary, as such, will not then be within the UK tax net; and any repatriation of those profits by way of dividend will (since the introduction of the similarly over-complicated UK dividend exemption ) almost certainly be exempt from tax when those dividends are received in the United Kingdom. So, for most people, the need for change may not be evident. In particular, there is no EU reason driving change. It is true, as just noted, that the taxation of profits earned overseas by a UK group differs according to whether those profits are earned in an overseas branch or an overseas subsidiary. If they are earned in a branch, the results of that branch are incorporated into the calculation of the UK company s taxable profits; but if they are earned in an overseas subsidiary, those profits should not be subject to tax in the United Kingdom. However, that is perfectly acceptable in the eyes of the European Court of Justice, as the judgment in X Holding BV (Case C-337/08) shows1 although, as the well-known judgment in Marks and Spencer (Case C-446/03) shows, that is subject to a qualification requiring a Member State, in certain circumstances, to give relief for losses incurred by overseas subsidiaries. 1 see paragraph 40 [A]s permanent establishments situated in another Member State and non-resident subsidiaries are not.in a comparable situation with regard to the allocation of the power of taxation, the Member State of origin is not obliged to apply the same tax scheme to non-resident subsidiaries as that which it applies to foreign permanent establishments.
2 Banking, Insurance and Oil and Gas The Treasury discussion document reveals that relatively few UK businesses operate outside the United Kingdom through foreign branches. Given the UK corporation tax advantages of conducting profitable overseas operations through subsidiaries, explained above, that is not surprising. It seems from the Treasury discussion document that the businesses that do make significant use of branches tend to be large companies in the banking, insurance and oil and gas exploration sectors. It seems to be banking and insurance companies that are driving this change. Regulatory and commercial reasons, especially the efficient allocation of capital (in the case of banks) and developments in solvency rules (in the case of insurance companies) drive banks and insurance companies to operate through larger commercial entities, with branches, rather than subsidiaries, abroad. It is these sectors, it seems, that have inspired the proposal for change. The oil and gas exploration sector, whilst also affected, seems likely to be less enthusiastic. There, the main reason for operating through branches overseas, as opposed to subsidiaries, seems to be the desire to obtain relief in the United Kingdom against UK tax for losses incurred abroad. A simple exemption system would, of course, prevent that; indeed, the Treasury acknowledges that, given the choice, oil and gas companies would be likely to opt out of any such system. Hence the discussion in the discussion document (explained below) about the possibility of exempting profits but still allowing some tax relief for overseas losses. Definition of Branch Profits Of those parts of the discussion document that are devoted to explaining just how any exemption system would work, about three-quarters of them are dedicated to the definition of the branch profits that would benefit from any exemption. The discussion document identifies two broad options. One is to define branch profits for the purposes of the exemption by reference to the United Kingdom s individual tax treaties with various overseas territories (the United Kingdom has an extensive network of over 100 double tax treaties). The alternative would be to define foreign branch profits for the purposes of the exemption in accordance with the rules in UK domestic law that define the profits of overseas companies that are subject to UK corporation tax as being attributable to a permanent establishment in the United Kingdom. The use of UK domestic rules ought to lead to a result which would be quite similar to the use of definitions from individual tax treaties, because both the United Kingdom s tax treaties, and its domestic rules, are based on OECD principles. However, there are some detailed differences. These differences might be exacerbated by the new business profits article (Article 7) incorporated into the 2010 update of the OECD Model Treaty. The new Article 7 recognises internal interest payments for non-financial concerns, and internal royalties for all concerns, whereas UK domestic rules do not. If it is assumed (as the discussion document appears to assume) that the new Article 7 will not be incorporated into UK domestic law, the differences between a definition of foreign profits by reference to treaties and by reference to UK domestic law will be increased. In particular, the UK domestic law measure of profits (disregarding internal interest payments and royalties) would be greater than the measure of overseas profits for the purposes of treaties, and so the measure of overseas profits that could be taxed in the other territory. That would mean that any UK exemption (if it applied to profits as defined in accordance with UK domestic law) would extend to profits that had not been taxed overseas and that would be anathema to the UK Treasury. Capital Attribution One related issue is that of capital attribution, which is part of the process for determining the amount of interest for which a branch of a bank or of an insurance company may obtain tax relief. The issue is that of determining how much capital ought to be attributed to a particular branch, as opposed to the company s head office. 2 SLAUGHTER AND MAY
3 The two options put forward in the discussion document are what are referred to as the capital allocation approach, where the relevant share of the total assets of the financial institution as a whole, weighted for risk according to regulatory requirements, is attributed to the branch; and the thin capitalisation approach, which is based on the principle that the capital to be attributed to a branch should be comparable to that which would be held by a separate legal entity which is of a size, and conducts a business, similar to that of the branch in question. These options are developed further in Annex A to the discussion document. In the case of banks, the discussion document explains that both the capital allocation and the thin capitalisation approach are approved by the OECD, and that, in most cases, as applied in the United Kingdom they in fact produce similar results. The discussion document seems to lean towards a capital allocation approach, to the extent that there are differences, explaining that this is routed in and utilises the Basel regimes, which are familiar to UK banks and to overseas tax authorities. As far as insurance companies are concerned, the Annex explains that the authorised OECD methodologies are an allocation approach and an adaptation of the thin capitalisation approach, and that the approach taken in the United Kingdom utilises simplified versions of these approaches. Given, however, that a thin capitalisation approach (based on a greater number of hypothetical legal entities than actually exist) is capable of requiring a theoretical allocation of more assets than a single legal entity actually holds, the discussion document concludes that the capital allocation approach would be the most appropriate methodology should an exemption regime be adopted. Anti-Avoidance Of course, as with any so-called simplification of the UK tax system, there have to be anti-avoidance rules. Given, however, that the United Kingdom (like most other jurisdictions) has rules designed to prevent UK groups accumulating profits in subsidiaries incorporated in tax havens the controlled foreign company rules it is not unreasonable for the Treasury to propose, as the discussion document does, that profits that would have been subject to UK tax had they been in a foreign subsidiary, so that the controlled foreign company rules apply, should also be subject to UK tax if, instead of being generated through an overseas subsidiary, they are generated through an overseas branch. One of the issues that the discussion document puts forward for consideration in this context is whether any exemption system should extend to territories with which the United Kingdom has not concluded a double tax treaty (bearing in mind that the United Kingdom has concluded double tax treaties with 116 countries and territories). It would be perfectly possible (at least, as long as the United Kingdom retains its treaties with all Member States of the EEA) to restrict any new exemption system to profits generated by branches in jurisdictions with which the United Kingdom has a treaty, retaining the current system of taxation in the United Kingdom (with credit for any overseas tax paid on the same profits) for profits generated by branches in other territories. An alternative would be to extend the exemption to all territories. If foreign branch profits were then to be defined in accordance with double tax treaties, that definition would have to be adopted in the case of jurisdictions with which the United Kingdom does not have a treaty, and the discussion document suggests that the definition in the OECD Model Treaty (including the new text of Article 7 in the 2010 update) could be used for that purpose. But the United Kingdom s controlled foreign company rules are not restricted to subsidiaries in jurisdictions with which the United Kingdom does not have a treaty, and so the discussion document also considers ways in which an equivalent result could be achieved for overseas branches in this context as is the case with overseas subsidiaries. Three options are put forward. The first would limit the scope of the exemption by providing that it was not to apply to profits that would be subject to the controlled foreign company rules were the overseas branch a foreign subsidiary. The second is a variation on this approach, which would limit the scope of the exemption by reference 3 SLAUGHTER AND MAY
4 to anti-avoidance rules that reflected the principles of the controlled foreign company rules (but without applying them directly). The third option, which the discussion document suggests might be more complicated to apply in practice, would be to allow the exemption to apply to all profits (or, at least, all profits generated by branches in jurisdictions with which the United Kingdom had a double tax treaty), but then tax under the controlled foreign company rules any branch profits that would have fallen within those rules had the branch been a subsidiary. Clearly, this is one particular area where the principle is reasonably easy to grasp, but the practical detail might be a little more difficult to apply. That is particularly the case at the present time, given the Government s continued commitment to reform of the controlled foreign company rules, which will result in some interim measures in 2011 and a more thorough reform in The controlled foreign company rules are less relevant to small companies than to larger groups. The discussion document suggests that, instead of trying to apply the controlled foreign company rules to them, they should instead be made the subject of a generic anti-avoidance rule. It also suggests that it is unlikely that any exemption for overseas branch profits would extend to overseas branch profits of a small company in a territory with which the United Kingdom does not have a double tax treaty (even if it did extend to profits of larger companies in such territories). And, just in case all of these rules do not provide sufficient protection for the Treasury, the Government will apparently be considering further whether any other anti-avoidance rules are required. Other Scoping Issues Although the discussion document is primarily concerned with the exemption or taxation of income profits generated by overseas branches, it also suggests that an exemption regime might extend to exemption for capital gains arising from assets used by a branch (as is apparently the case with the exemption regimes in France, Germany and the Netherlands). (That would be consistent, of course, with the approach taken by the OECD Model treaty, which permits such capital gains to be taxed by the territory in which the branch is located.) It is noted, however, that there would be some complications involved in extending an exemption to capital gains. First, the Government would want to consider the introduction of a transitional rule retaining its rights to tax gains that had accrued (but were unrealised) when the exemption was introduced. Secondly, many capital assets (including intangible assets) might be used partly by a branch and partly by the company s headquarters, so that any capital gain would need to be apportioned before an exemption could be applied. Thirdly, the United Kingdom s current rules allowing intra-group transfers of capital assets without payment of tax on any inherent gain would need to be modified to prevent assets pregnant with gain being transferred into a branch in which they could be realised on the basis that the gain would then be exempt. Another issue considered relates to shipping and air transport businesses, the overseas branches of which are generally exempt from tax in the territories in which they are located. To exempt the profits of overseas branches of UK shipping and air transport businesses from UK tax as well would mean that they were not taxable anywhere. Accordingly, the discussion document proposes that where a treaty exempts the profits of an overseas branch from taxation in the jurisdiction in which the branch is located, any new exemption from UK tax would not extend to those branch profits. The discussion document also considers the interaction between any new exemption and the United Kingdom s rules giving relief from double taxation. It correctly notes that, to the extent that an exemption applies to profits defined by reference to a double tax treaty, there would be no place for double taxation relief for overseas tax paid on those profits; by definition, those profits could not be subject to double taxation (because they would be exempt from UK tax). 4 SLAUGHTER AND MAY
5 Similarly, where profits were eligible for branch exemption, there would be no need for the United Kingdom s rules giving unilateral relief from double taxation to apply to them. Losses Clearly, a straightforward exemption system would mean that neither profits nor losses earned or incurred by overseas branches would be brought into account in calculating the UK tax liabilities of the company concerned. For some sectors, however, such as the oil and gas exploration sector, that would mean that an exemption system would be significantly worse than the current system (under which the profits of overseas branches are taxed in the United Kingdom but with credit for any overseas tax paid on them). The discussion document recognises this. It also recognises the fact that, although there might be some form of terminal loss relief as part of a branch exemption regime (much as the Marks and Spencer ruling has effectively led to the possibility of claiming relief for terminal losses incurred by EEA subsidiaries), that is unlikely of itself to assist. One of the options that the discussion document considers is that of allowing a company to make an election that the new exemption system should not apply to it (and the Impact Assessment that accompanies the discussion document recognises, at paragraph 3.3, that some sectors, such as oil and gas, would then choose to opt out of the proposed new regime). Such an election could be made permanently binding upon the company that makes it or, if capable of being revoked, would need to be accompanied by rules to reverse loss relief previously given under it (to the extent that the losses had not already been matched by taxable branch profits). The election might also be binding on other companies in the same group; and it would need to apply also to any company to which the branch business were transferred. An alternative put forward by the discussion document would be to allow loss relief generally (in combination with an exemption for branch profits), but then to clawback the loss relief once the foreign branch moved into profit. One way of doing that might be to tax subsequent profits to the extent necessary to reverse loss relief given earlier. The discussion document suggests that this might be done either subject to double tax relief for any foreign tax imposed upon those profits, or without any such double tax relief being allowed, and asks how beneficial these options would be to business (it would seem easy to guess which of them business would prefer). The discussion document then goes on to consider the position of companies that are carrying forward losses at the date of the introduction of branch profit exemption. Without more, the introduction of an exemption for overseas branch profits would allow such a company to carry forward past losses incurred in that branch to set against future profits generated in the United Kingdom (it would obviously have no need to set those losses against future profits generated in the overseas branch), and this is not something that the Government would wish to happen. Furthermore, the discussion document suggests that there might be a case for applying a clawback mechanism for past branch losses (for which relief would have been claimed in the United Kingdom) to the extent that those losses would have been set against profits generated by the overseas branch had those profits not been exempt from UK tax. Three options are put forward. One would involve the cancellation of brought-forward losses on the introduction of an exemption regime (although this would not apply to companies who opted out of the exemption regime, were such an option to be made available). The second option would be to provide that a company could not claim the benefit of the new exemption system until any losses previously incurred in the same branch had been set against profits earned in that branch. The third option would be to clawback losses for which relief was given before the introduction of an exemption system to the extent that the mechanism would apply if exemption rules had always been in place (see above). Although it is not a point made in the discussion document, any of these rules, to the extent that they involve comparing losses incurred in the past with profits earned in the future, would be likely to run 5 SLAUGHTER AND MAY
6 into difficulties in defining just what the branch was in which the losses were incurred and just what the branch is in which profits are earned. Businesses grow and contract; and groups transfer activities in between branches and in-between subsidiaries. But there is no recognition in the discussion document of how the Treasury would intend to counteract a reorganisation of a group s business so that profits were earned in an entity other than the branch in which losses had previously been incurred; or how they would identify a past loss-making branch with a current profit-earning activity where the relevant business might, literally, have changed out of recognition. Conclusion Although the idea of an exemption for overseas branch profits sounds simple, its implementation is likely to be anything but. (For comparison, the so-called dividend exemption introduced in the Finance Act 2009, was enacted in a schedule extending for ten pages, which introduced 23 new sections into the Corporation Tax Act 2009 and which will require amendment in the forthcoming Finance Bill.) Given that it appears that its introduction is driven by banks and insurance companies, that no other sectors have any particular need for it, and that British industry will require it to be modified by coupling it with some form of loss relief (as is available under the current system), it is not clear why any new exemption system could not be limited to the banking and insurance sectors. Unfortunately, as is the case with most consultations, the Treasury and HMRC have apparently already decided that there will be a new exemption system from next year; and so we can expect it to take up a considerable part of the first Finance Bill of This article originally appeared in the 7th edition of the International Comparative Legal Guide to: Corporate Tax published by Global Legal Group Ltd, London. Slaughter and May 2010 This material is for general information only and is not intended to provide legal advice. For further information, please speak to your usual Slaughter and May contact. zma5.indd1010