UK Tax Flash. Foreign Profits Update The eagerly anticipated draft legislation outlining a new regime for the taxation of foreign profits was published on 9 December 2008. A summary of the provisions is below. Next week we will be issuing another Tax Flash in which we will discuss the practical implications of these proposals in greater detail. However, if you have any questions in the meantime please contact Guy Brannan tel: (44 20) 7456 5690), Mike Hardwick tel: (44 20) 7456 5658, Jonathan Richards tel: (44 20) 7456 5695, or your usual contact. Background The story of the reform of the taxation of foreign profits began in earnest back in June 2007, with the publication of a discussion document outlining a number of potentially far reaching reforms in relation to the taxation of foreign profits of UK companies. The plans, which (particularly in relation to the proposed controlled companies regime) met with widespread criticism, were almost certainly one of the factors that influenced the decisions taken by a number of UK listed companies over the last year to redomicile outside of the UK. In the Pre-Budget Report the Government indicated that it had listened to taxpayers concerns and was committed to bringing forward a balanced package of reforms to enhance the competitiveness of the UK. In this latest instalment, HMRC and the Treasury have jointly published draft legislation and guidance in relation to the proposals for consultation. It is noted in the guidance that the draft legislation has been released at an earlier stage than is normal to enable full consultation and debate, and that this may mean that the drafting is likely to change, and that the draft legislation may not currently meet its intended objectives. All of the provisions will take effect from a date to be appointed by Treasury Order; no such date has yet been confirmed. However, it is intended that such a date will be after the rewritten Corporation Tax Bill has been enacted next year, and therefore the legislation has been drafted on the basis that it will be amending that Act rather than the existing legislation. Contents Background 1 Distribution Exemption 2 Controlled Foreign Companies 3 Worldwide Debt Cap - Overview 4 Worldwide Debt Cap - Detail 5 Unallowable Purpose Rules 7 Treasury Consent 8 Next Steps 9 December 2008 1
Distribution Exemption UK dividends can now potentially be taxable if they do not fall within an exemption There is a corridor of uncertainty for dividends on shareholdings that confer a stake of between 10% and 50% in the issuing company The real carrot of the foreign profits reform package has always been the proposed exemption for foreign dividends. The draft legislation seeks to put UK and foreign dividends on the same footing with wide-ranging exemptions applying. It is important to note, however, that dividends from UK companies could become taxable if one of these exemptions does not apply. Specifically, the draft legislation provides that dividends or other distributions will not be subject to corporation tax on income if they fall within one (or more) of five exempt classes, they do not fall within Section 209(2)(d) or (e) ICTA 1988 (e.g. represent more than a reasonable commercial return, or are results dependent ) and they do not give rise to a tax deduction in a foreign jurisdiction. The five exempt classes are: distributions from controlled companies ( control is as defined in Section 755D ICTA 1988, and therefore includes control exercised by income and asset rights in addition to control by voting rights); distributions in respect of non-redeemable ordinary shares; distributions in respect of portfolio holdings (i.e. where the recipient together with any connected persons holds 10% or less of the issued share capital of the payer, and is entitled to 10% or less of the income and asset rights); dividends (although seemingly not distributions) derived from transactions that are not designed to reduce UK tax; and dividends (although seemingly not distributions) in respect of shares accounted for as liabilities in accordance with generally accepted accounting practice. Such shares would be dealt with instead under the proposed new rules dealing with disguised interest. Therefore, dividends on holdings which amount to 10% or more of issued capital, but less than a controlling interest are in a corridor of uncertainty where exemption may, or may not, be available. Distribution Exemption - Mini-TAAR There is to be a mini-taar to prevent avoidance. Broadly, a dividend or other distribution will not fall within an exempt class if it has been made as part of a scheme the main purpose, or one of the main purposes of which is to obtain a tax advantage (other than a negligible tax advantage), and the scheme involves: quasi-preference shares, i.e. ordinary shares that are subject to side agreements so that the shareholder obtains rights consistent with those that might have been obtained from a preference share; payments, or the giving up of a right to income, in return for the distribution; 2 December 2008
payments, receipts, or the giving up of a right to income in respect of goods or services not on arm s length terms where the reason for the difference is that one of the parties receives the distribution; the manipulation of the controlled foreign company rules to take advantage of the fact that the controlled foreign company rules apply at the time the profit arises, but the exempt class applies by reference to the circumstances at the time that the distribution is paid. The controlled company exempt class will not apply where the dividend is paid out of profits that arose at a time when the recipient did not control the payer (although there is an exclusion from this provision for companies acquired wholly or mainly for commercial purposes); or in certain circumstances, arrangements in the nature of a loan relationship, where the distribution constitutes part of an interest-like return. Controlled Foreign Companies The Government proposes making two specific changes to the current controlled foreign company rules (which it sees as a consequence of the move to a distribution exemption), but leaving wholesale reform until after the further consultation that will take place in 2009. The first change is the abolition of the acceptable distribution policy ( ADP ) exemption from the controlled foreign company rules. This is perhaps an inevitable consequence of the introduction of a distribution exemption - a tax system with both features would be at real risk of taxpayers diverting profits outside its scope. There will be transitional provisions such that the ADP exemption will continue to be available in respect of profits arising before the day on which these rules come into force if the dividend is paid within 18 months (although dividends paid in connection with such an ADP will not be exempt under the new distribution exemption). The second change is the repeal of the exemption for certain holding companies. The need for this change is less clear, however it is likely that, as set out in the guidance, this exemption will no longer be so significant because with the introduction of the distribution exemption most of the dividends received by holding companies will be exempt under UK tax principles and thus will not be subject to a controlled foreign company apportionment. Moreover, in many cases it will no longer be necessary to establish a complex holding company structure in order to repatriate profits to the UK in a tax efficient manner. The repeal will take place subject to a transitional period of 24 months for existing holding companies, during which time special rules will apply. The ADP exemption is to be abolished (subject to transitional rules) The repeal of the exemption for holding companies needs to be considered further December 2008 3
Worldwide Debt Cap - Overview External debt is not subject to a deductibility restriction. The cap applies only to debt raised by UK corporation taxpayers from other members of the group 4 A worldwide debt cap has been proposed with the stated aim of preventing international groups putting a greater amount of debt into the UK part of the group than the group as a whole has borrowed. In its draft guidance the Government has also indicated that it is concerned about upstream loans which might otherwise permit UK companies to benefit from deductible interest payments to overseas subsidiaries whilst being able to repatriate cash from those overseas subsidiaries by way of tax-exempt dividends. The draft legislation that has been published for consultation is extremely complicated but essentially prescribes a five step process: Step 1 - Identify the relevant worldwide corporate group as defined for the purposes of International Accounting Standards. This group will include both UK and non-uk resident companies. Step 2 - Identify the UK corporation taxpayers in the group which are either the ultimate parent company of that group or direct or indirect 75% subsidiaries of that parent company (the definition of 75% subsidiary being based on the definition which currently applies for group relief). These UK corporation taxpayers in the group are referred to in the legislation as relevant group companies. Identify the intra-group finance expenses incurred by those UK corporation taxpayers (most obviously this will include interest payments on intra-group borrowings but will also include certain other kinds of finance costs - set out in some further detail below). Add up those intra-group finance expenses. The outcome of this process is the tested amount that is potentially subject to restriction by the cap. Finance expenses incurred on borrowings from companies outside the group are generally not relevant for the purposes of this calculation and are not subject to the restriction on deductibility. There are, however, anti-avoidance rules to prevent relevant group companies from being artificially degrouped so as to prevent their debt from counting towards the tested amount and to prevent back-to-back loans being used to hide intra-group borrowing. Step 3 - Identify the finance expenses shown in the consolidated accounts of the (worldwide) group. (By definition this will be debt from external sources as intra-group debt will disappear on consolidation.) Subtract from that external finance expense figure the amount of external finance expense that is attributable to UK members of the group and then offset any external finance income of the worldwide group. The amount remaining is the available amount which acts as a ceiling on the amount of UK deductions available for intra-group finance expenses. It follows that a group that raises all of its external debt in the UK will have an available amount of zero. Step 4 - UK tax deductions in respect of tested amounts cannot exceed the available amount. Groups can allocate the disallowance among their UK corporation taxpayers as they see fit. (Again it follows that a group that raises all of its debt finance in the UK will have an available amount December 2008
of zero and so will not be entitled to a UK tax deduction for any interest on intra-group debt.) Step 5 - Having scaled back the deductions for intra-group finance expenses, taxable receipts of intra-group finance expenses are also scaled back. Broadly, that treatment can apply if a relevant group company receives finance income from a UK or non-uk member of the worldwide group, however the reduction in taxable receipts cannot exceed the disallowance of interest deductions. Again, groups can allocate the reduction in taxable receipts among relevant group companies as they see fit. Where intra-group finance expenses are restricted by the cap, taxable receipts may also be scaled back Worldwide Debt Cap - Detail The Tested Amount (the Amount Potentially to be Restricted) The intra-group financing costs of UK group members that count towards the tested amount and so are potentially subject to restriction are as follows: the net debits (i.e. total debits less credits - for example in respect of foreign exchange movements) arising on a company s debtor loan relationships where the creditor under those loan relationships is another member of the worldwide group (a group debtor relationship ); the net debits arising on a company s derivative contracts where those contracts hedge a group debtor relationship of the company; any finance charge element of a finance lease of plant and machinery where the relevant group company is lessee and the lessor is another member of the worldwide group; and any finance costs payable on debt factoring (or any similar transactions) entered into with another member of the worldwide group. The total amount of intra-group financing costs for a particular relevant group company may end up being negative (which, when taken into account as part of the calculation of the tested amount, will have the effect of reducing that amount). While external financing costs of UK corporation taxpayers are generally not restricted by the new provisions, there are two exceptions. First, as can be seen, payments under derivative contracts entered into with non-group entities will be treated as intra-group financing expenses if the contract hedges a loan relationship entered into with another member of the group. Second, an anti-avoidance provision will seek to uncover any intra-group debt that has deliberately been given the appearance of third-party funding (where, for example, by virtue of back-to-back or similar arrangements with another group company external finance costs of a relevant group company effectively take the place of intra-group financing costs). Certain amounts are disregarded when calculating the intra-group financing costs of relevant group companies, most notably: December 2008 5
financing expenses incurred in the course of a lending business of that company where at least 75% of the gross trading income of the company s lending business (calculated in accordance with IAS or UK GAAP) is derived from non-group entities. In-house treasury companies would not be able to benefit from this exclusion; financing expenses, broadly, incurred in the course of a business dealing in financial instruments; and financing expenses, broadly, arising in relation to an intra-group capital instrument used to raise funds forming part of the company s FSA regulatory capital requirements. In addition to these exclusions, it is understood that draft provisions will be published in due course to carve out from the operation of the debt cap, inter alia, companies within the REIT regime and the securitisation companies regime and also deal with the situation where a group is temporarily cashrich (for example, following the disposal of part of its business). A group that raises all of its external finance in the UK will have an available amount of nil. It follows that no intra-group finance costs will be deductible in the UK in these circumstances (although there may be a corresponding reduction in taxable receipts of UK corporation taxpayers) 6 The Available Amount (the Cap) The available amount is the non-uk external finance cost of the group which is basically the amount of the worldwide group s external finance expenses (less external finance income) less the amount of such expenses attributable to UK members of the group (as disclosed in the financial statements of those companies). The calculations of external finance costs (and external finance income) take amounts disclosed in the consolidated profit and loss account of the group for the relevant period as prescribed by an exhaustive list set out in the draft legislation. The Government explains in its draft guidance that these amounts are based on those that would be treated as borrowing costs under IAS 23 (and the income counterparts), but they will not include dividends payable on redeemable preference shares where those shares are treated as a liability in the balance sheet. Where the consolidated financial statements of the group are prepared in a currency other than sterling (which may be likely where the group is headed by a non-uk company), the amounts which are to be taken from the accounts are required to be translated into sterling using the average exchange rate over the relevant period. Certain of the prescribed amounts appearing in the consolidated accounts are however to be disregarded, broadly mirroring those amounts which are disregarded when calculating the tested amount and including, for example, amounts incurred in the course of largely external lending businesses of non-uk group members. Credits and deductions in the consolidated profit and loss account in respect of fair value adjustments (in accordance with IAS 39) are also not to be included in the calculations. The Government notes in the draft guidance that where significant amounts of a group s non-uk external finance costs relate to borrowings in a foreign currency, the application of the debt cap could, in many cases unfairly, result December 2008
in a situation where UK deductions on on-loans into the UK are disallowed even though the debt levels at group level are higher than those in the UK part of the group because, for example, interest rates on sterling borrowings are higher than interest rates payable on foreign currency borrowings. The Government intends to draft provisions to deal with this situation. Some Practical Issues Clearly the legislation is by no means in final form but the following high level consequences appear to arise: Groups owned by private equity funds often raise external funding at many levels in the group (for example to reflect different levels of subordination). Previously it was possible to on-lend the proceeds of external finance raisings down through the group with the ultimate borrowing being at the level of the trading company which could use or carry forward the finance expense to set against the taxable profits of its business. If intra-group interest is neither deductible nor taxable, groups in this position might find that external finance costs become stranded losses which are not available for offset against the relevant trading company s profits. Groups headed by non-uk parent companies could find that the amount of interest deduction available in the UK depends on the extent to which the ultimate parent company is equity funded or debt funded. For example, if a non-uk parent company raises equity finance and on-lends the proceeds of that equity finance to a UK subsidiary on entirely arm s length terms an interest deduction could be restricted by the new cap (as the non-uk parent s equity finance does not count towards the available amount ). By contrast, if the non-uk parent raises external debt and onlends it to the UK there might be no restriction on UK deductibility (as the debt raised by the parent would count towards the available amount ). We may, therefore, see a trend towards UK resident companies raising debt direct from external sources rather than tiers of intra-group debt being put in place. We may also see taxpayers seeking to arbitrage the new system. For example, if a category of finance raising can be identified which falls outside the specified constituents of the tested amount because of a specific accounting treatment, there may be scope for groups to step up the amount of UK interest deduction that is available. Groups headed by non- UK parent companies could find that the amount of interest deduction available in the UK depends on the extent to which the ultimate parent company is equity funded or debt funded We may see a trend towards UK resident companies raising debt direct from external sources Unallowable Purpose Rules A strengthening of the unallowable purpose rules applicable to loan relationships and derivative contracts is also seen as a necessary part of the package. Broadly, the proposals will require the unallowable purpose test to be applied not just to a particular loan relationship or derivative contract in December 2008 7
isolation (as currently), but also, separately, to any arrangements of which the loan relationship or derivative contract is part. However, the arrangement as a whole will only have an unallowable purpose if its main purpose, or one of its main purposes, is to obtain an increased debit or a decreased credit under either the loan relationships or derivative contracts regime. ( Tax advantage, and consequently the meaning of unallowable purpose, is defined more widely when applied to the loan relationship or derivative contract in isolation). Treasury Consent A final change is the abolition of the existing Treasury consent legislation. In its place, new provisions will be introduced pursuant to which the top UK resident company of a group will be required to make a quarterly report to HMRC in respect of any reportable events or transactions that have taken place in the preceding quarter. An event or transaction will generally be reportable if it is of a value exceeding 100 million (HMRC may make Regulations including in relation to how value is to be determined) and it involves: an issue of shares or debentures by a foreign subsidiary; a transfer by the UK reporting body, or a transfer caused or permitted by the UK reporting body, of shares or debentures of a foreign subsidiary in which the UK reporting body has an interest; a transfer by the UK reporting body, or a transfer caused or permitted by the UK reporting body, of assets other than shares or debentures of a foreign subsidiary where the transferor is a body corporate, the assets are held by the transferee subject to a trust and immediately before the transfer the transferor is connected with any body corporate that is a beneficiary of the trust; a subsidiary becoming, or ceasing to be, a partner in a partnership that is controlled by the UK reporting body; or any event or transaction specified in Regulations made by HMRC. Some transactions will, however, be excluded from the reporting requirement (mirroring the fact that some transactions are currently excluded from the Treasury consent rules by the Treasury general consents). These include: transactions carried out in the ordinary course of a trade; transactions all the parties to which are, at the time the transaction is carried out, resident in the same territory; certain security transactions; transactions specified in Regulations made by HMRC. Perhaps of most practical comfort is that the seemingly disproportionate criminal sanctions which applied to a breach of the Treasury consent rules 8 December 2008
will not apply to these new reporting rules. Instead any penalty will be monetary, imposed under Section 98 TMA 1970. Next Steps The deadline for submitting comments to the Government on the draft legislation and guidance is 3 March 2009. Details can be accessed by clicking here. As noted above, next week you can expect a further Tax Flash from us summarising the practical implications of these proposals for UK groups. If you require further information or comment, please contact Guy Brannan tel: (44 20) 7456 5690, Mike Hardwick tel: (44 20) 7456 5658, Jonathan Richards tel: (44 20) 7456 5695, or your usual contact. December 2008 9
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