Corporates - general
Controlled foreign companies reform
The controlled foreign company (CFC) rules are designed to prevent UK tax resident companies from artificially diverting UK income to subsidiaries located in jurisdictions where those profits would be subject to a lower level of tax. In general terms, a CFC is a non-UK company controlled by UK resident companies whose local tax liability is less than three quarters of the amount that would be chargeable on its profits if it were UK resident. The basic effect of the CFC rules is to charge UK resident companies with a 25 per cent or more interest in a CFC to corporation tax in respect of a proportion of the CFC’s profits.
Background to the reform
The legality of the CFC rules has been challenged before the European Courts and they have been cited as a key deterrent to multinational groups choosing to locate their headquarters in the UK. The Government has been consulting on the reform of the CFC rules for some time now and those participating in the consultations or following the reforms closely will have seen significant developments in the past year. A consultation document was published on 30 June 2011, which set out in detail the proposals for the new CFC regime to be introduced in the Finance Bill 2012. This was followed by draft legislation published on 6 December 2011. A policy update and further draft legislation was published on 31 January 2012 and was followed by a further policy update and further draft legislation on 29 February 2012.
Detail of the reforms
The revised CFC regime will represent a significant change in the approach to determining whether UK residents should be subject to tax on the profits of their non-UK subsidiaries. The new regime includes a number of “gateway” provisions, which are intended to identify profits that have been artificially diverted from the UK. If a non-UK subsidiary’s profits do not pass the gateway, they will fall outside the scope of the CFC rules. When these gateway provisions were originally published in the draft legislation released on 6 December 2011 they were met with a lot of criticism. The gateway had been intended as a simple, principles-based test that groups could easily self-assess. However, the tests were widely regarded as too difficult to apply and did not act as a gateway for entry into the CFC rules, but rather by defining the CFC’s chargeable profits. The revised legislation published on 29 February 2012 introduced changes to the gateway provisions that were designed to alleviate these concerns by including additional “entry tests”. However, these entry tests only apply in respect of one of the gateways and so do not address the concerns for the other gateways.
The new regime also contains a number of “safe harbours” that will apply to exclude specific profits from the CFC rules and so-called entity-level exemptions that will exclude all of a CFC’s profits from the CFC rules provided the relevant conditions are met.
Companies will be able to choose the order in which to apply the gateway test, the safe harbours or the entity-level exemptions to establish whether or not any profits of their overseas subsidiaries are subject to apportionment under the CFC rules.
The gateway provisions are structured as a number of distinct gateway tests. The separate gateway tests include gateways for general business profits, non-trading finance profits and finance profits. The general business profits gateway provisions are preceded by an entry test containing three conditions. If any of these conditions is met, the CFC’s profits will be excluded from the general business profits gateway test. However, the profits could fall within a different category and so it may still be necessary to look at another gateway.
Broadly speaking, the three entry conditions focus on:
- the extent to which the control or management of the CFC’s assets or risks is carried on in the UK
- the capability of the CFC to carry on its business without the UK activities referred to above
- whether there are arrangements in place that have a main purpose of achieving a reduction in UK tax.
Where the entry conditions cannot be relied on for exclusion from the CFC charge, it would be necessary to consider the more detailed provisions of the gateway. In practice, many groups will prefer to consider first the entity level exemptions and mechanical safe harbours before returning to the detailed provisions of the gateway, which require an attribution of the CFC’s profits in accordance with principles contained in the Organisation for Economic Co-Operation and Development’s report on the attribution of profits to permanent establishments.
Entity level exemptions
The entity level exemptions relate to the circumstances or characteristics of the CFC, rather than the nature of its profits. They comprise:
- a lower level of tax exemption (which exempts an entity from the CFC regime where the CFC’s local tax is at least three quarters of the UK tax that would be chargeable on its profits)
- a low profits exemption (for profits up to £500,000, with a separate limit on investment income of £50,000). This exemption does not apply to certain managed service companies
- a low profit margin exemption (where profits do not exceed 10 per cent of operating expenditure, excluding certain related party expenditure)
- an excluded territories exemption (where the CFC is resident in a territory with a headline tax rate of at least three quarters of the UK main corporation tax rate and a number of additional conditions are satisfied).
Whilst the list of relevant territories is quite long, the detailed conditions have been widely criticised and are likely to make it complicated to assess whether this exemption applies.
Certain profits of a CFC can also be excluded from the CFC charge where the conditions of a safe harbour are met. The safe harbours include:
- a trading income exclusion (where conditions relating to business premises, trading income, expenditure, exploitation of intellectual property and export of goods are met)
- a property business exclusion (whereby all profits from a property business will be excluded)
- an incidental finance income exclusion (whereby non-trading finance profits can be excluded provided they meet the conditions for being incidental to an exempt trade or property business)
- an arm’s length exclusion (where arrangements have been entered into that would have been entered into by independent companies).
Finance company rules
Where a CFC derives non-trading finance profits from qualifying loans, only one quarter of those profits will be subject to a CFC charge. With the proposed reduction in the main rate of corporation tax in the UK, this will result in an effective rate of tax of 5.75 per cent on such profits by 2014. The rules will also provide for full exemption in certain circumstances, including where a qualifying loan has been made without reliance on wider group funds (for example, as a consequence of a share for share exchange or rights issue).
Legislation will be introduced in Finance Bill 2012 to repeal the current legislation and replace it with the new CFC regime. The new CFC regime will become effective for accounting periods ended on or after 1 April 2013.
There are a number of outstanding issues to be resolved before the introduction of the new CFC rules. In particular, members of the banking and insurance sectors are awaiting details of a safe harbour that is proposed to apply where minimum regulatory capital requirements are met. Draft regulations dealing with this are expected shortly. The Government is also looking at the anti-avoidance provisions contained in the current draft legislation, following criticism of the number and scope of the provisions.
Changes to the taxation of discounted or impaired debt
On 27 February 2012 the Government announced that it will introduce specific legislation aimed at countering arrangements, which at least one bank had implemented, to prevent a tax charge on buying back its debt at a discount. In addition it will introduce a targeted anti-avoidance rule which is intended to prevent similar structures from having effect. In a highly unusual move, a further change will be made which has retrospective effect from 1 December 2011. Although the arrangements in question were disclosed to HMRC by the bank, any company wishing to buy in its debt could have implemented these arrangements.
The arrangements seek to circumvent the rules which require a debtor company to recognise a taxable profit if its debt is acquired by a related party from a third party, or if it becomes related to an existing creditor. In the first case, the tax charge only arises if the related party creditor acquires the debt for less than the carrying value of that debt in the debtor's accounts. In the second case, the tax charge only arises if the creditor would have impaired the debt if it had drawn up accounts immediately before becoming related to the creditor. This left it open for an unrelated party (eg, an orphan special purpose vehicle) to be established to acquire debt which was trading at a discount to its face value. As that unrelated party acquired the debt at a discount, it would not recognise any impairment of the debt on becoming connected to the debtor. Accordingly, the debtor would not have to recognise a taxable profit either on the acquisition of its debt at a discount, or on subsequently acquiring the special purpose vehicle.
This is not the first time that companies have exploited perceived loopholes in these rules, which were amended by Finance Act 2010 to block similar arrangements. In part, the Government's willingness to introduce retrospective legislation seems to have been prompted by concern that taxpayers had not heeded previous warnings that profits made on buying back debt should be taxed.
This specific scheme is to be countered by changing the way in which the tax charge which arises on an unrelated third party creditor becoming related to a debtor is calculated. Instead of being limited to the impairment which the creditor would recognise upon becoming related to the debtor, the taxable profit will be the higher of that amount and the difference between the carrying value of the debt in the accounts of the creditor and the debtor. This change will not have retrospective effect, only applying where the creditor becomes connected to the debtor on or after 27 February 2012.
This will be accompanied by a targeted anti-avoidance rule which will disregard any arrangements which have a main purpose of avoiding (or reducing) the tax charge which would arise in either of the two cases described above. This will apply to arrangements entered into on or after 27 February 2012. It will also apply to arrangements entered into before then, but only if the event which would have given rise to the profit (eg, the acquisition of debt for less than its face value) occurs on or after 27 February.
The proposal which will have retrospective effect imposes a tax charge at the time that the unrelated party acquires debt at a discount. At this point, the debtor will recognise a taxable profit equal to that discount, but only if both the acquisition of that debt and the parties becoming connected occur between 1 December 2011 and 27 February 2012 and do so in consequence of, or in connection with, any arrangement (whether or not legally binding). In view of its retrospective effect, some effort has been taken to reduce the risk of it applying to arrangements other than those which were specifically designed to take advantage of what seems to have been a loophole in the legislation; not withstanding this, there is concern that other arrangements may be caught.
Convertible debt - impact on group relief
Companies which issue convertible debt risk being excluded from their parent company's group relief group, thereby restricting their ability to claim, or surrender, tax losses. This is because the holder of the convertible is treated not as the holder of a normal commercial loan but as an equity holder in the issuer, for the purposes of determining whether the issuer is a 75 per cent (or more) subsidiary of its parent company.
Not all convertibles have this effect, but there are only limited types of convertible which do not prejudice the issuer's ability to claim group relief. These exceptions are strictly circumscribed, and restrict the scope for debt instruments to be used to allow unrelated parties access to group relief. HMRC has become aware of concerns about a particular type of convertible, which they acknowledge should not prejudice group relief. The convertibles in question are loan notes (typically issued by financial institutions) which give the holder the right to convert into the shares of a listed company which is not connected to the issuer; there could be interesting questions as to the definition of “connection” for these purposes. In the current low interest environment, such a conversion right makes the loan more attractive. There is no reason why such a commercial feature should prejudice the issuer's ability to claim group relief, and the Government has announced that the Finance Bill 2012 will include legislation to treat such convertibles as normal commercial loans rather than equity for group relief purposes.
The Government has announced it will consult on introducing a rule to allow companies which operate with a non-sterling functional currency to compute their capital gains and losses in that currency which, would bring calculations into line with the calculation of corporation tax on income for non-sterling functional currency companies.
Currently, companies which operate with a non-sterling functional currency compute their income profits and capital allowances claims using that functional currency. They then translate the resulting profit into sterling to calculate the corporation tax due. The current rule is that capital gains and losses must be calculated in sterling with the foreign currency acquisition cost and disposal value being translated into sterling at the respective dates of acquisition and disposal to calculate any gain or loss. The current rule results in foreign exchange movements being reflected in the gain or loss which may create unfairness and distortion.
If the change is introduced, legislation will be included in the Finance Bill 2013.
VAT groups - enactment of extra statutory concession
It has been confirmed in Budget 2012 that a long standing extra statutory concession, concerning UK VAT groups that include non-UK members, will be given effect by legislation contained in the Finance Bill 2012. Draft legislation was published on 6 December 2011 and is intended to preserve the effect of the concession.
The concession applies to reverse charge supplies made between members of a VAT group by limiting the value of an anti-avoidance VAT charge that would otherwise arise in a UK VAT group that receives services from a non-UK member of its VAT group. It allows the charge to be based on the external cost of the services (ignoring intra-group expenditure) rather than the full value of the supply, thereby preventing excessive charges arising.
Following the House of Lords decision in R (on the application of Wilkinson) v IRC, in which it was held that HMRC did not have the power to make extra statutory concessions to relieve taxpayers from the strict application of tax law, HMRC have been reviewing their concessions. In order to ensure that all concessions continued to apply, legislation was introduced to allow HMRC’s extra statutory concessions to become law by Treasury order.
The Bank Levy was introduced in Finance Act 2011 and imposes a charge based on the relevant assets and liabilities of UK banks or their groups or a bank operating in the UK through a branch or permanent establishment. The stated aim was that this should raise £2.5 billion per annum. In order to maintain this yield, the rate is to increase to 0.105 per cent from 1 January 2013. This follows an increase announced last autumn for the 2012 accounting period.
In part, the increased charge is likely to be offset by the reduction in the corporation tax rate. But, this is only in part; many UK banking operations will have losses so that the benefit of the reduction in the rate of corporation tax is minimal. Further, much of their income will be exempt from UK tax, either because it is in the form of tax-exempt dividends or because it represents profits from non-UK branches, which are potentially exempt from UK tax, as a result of changes made in Finance Act 2011. Some of the banks affected may therefore question whether this Bank Levy increase can be justified by the reduction in the rate of corporation tax.
Basel III capital instruments - result of consultation
In Budget 2011 the Government confirmed that it would begin a consultation on the tax issues associated with certain forms of capital instruments issued by banks. The particular concern is how capital instruments issued in response to the Basel III proposals should be taxed. The nature of such instruments is typically somewhere between debt and equity, and the tax treatment of some of these instruments is currently uncertain. For example, there may be a question over whether income payments under the instrument should be treated as tax deductible interest or non-deductible distributions.
In May 2011, HMRC issued a discussion document on these tax issues and held meetings with a working group of interested parties. Following that consultation, the Government has announced that these issues will be addressed in regulations. Finance Bill 2012 will contain the power to make such regulations, but as yet there is no public indication of what the regulations will contain.
The Chancellor has brought in two anti-avoidance rules in the life insurance industry, one affecting the life companies themselves, the other life insurance policies.
The rules for the taxation of UK life insurance companies are to change radically from 1 January 2013, with their tax treatment to be based on their financial statements, rather than their regulatory returns. Prompted by the EU “Solvency II” Directive, this change has been the subject of much discussion and consultation over the last few years. In particular, detailed draft legislation was published in December 2011. That legislation set out the transitional arrangements. Within those rules was an anti-avoidance rule, aiming to prevent life companies taking advantage of the change. A revised version of that rule has been published, and is to apply to arrangements entered into on or after 21 March 2012 - i.e. in advance of the main rules coming into effect. Because of this, HMRC have confirmed that an informal clearance process will apply in the interim.
The other anti-avoidance measures are to counter personal tax planning with life insurance policies. This has been a fertile area for the tax planning industry recently; the life insurance policy legislation is lightly drawn and prescriptive in its application and a high profile tax case (Mayes v HMRC) was recently upheld in the taxpayer’s advantage by the Court of Appeal. One area where there appeared to be potential for planning was where there were a number of connected policies, such that it was possible to avoid a chargeable event occurring by shifting from one policy to another. This has now been blocked. In working out what the amount of the gain was on the chargeable event, credit was also previously available for gains realised off-shore (so that no UK tax was payable). This has now been amended so that credit is only available if the previous gain was taxable in the UK.
Other life insurance changes include the introduction in 2013 of a £3,600 limit on the amount of premiums that can be paid into Qualifying Policies and consultation on the apportionment rules in the chargeable event regime, where a policyholder has been resident outside the UK.
The changes to the life policy rule will apply to policies made or arranged on or after 21 March 2012. It will also apply were policy holders to pay further premiums after that date.
The tax treatment of Lloyds Members is governed by a particular regime, which relies in part on the way in which they are regulated. One of the features of the regime to date has been the existence of claims equalisation reserves, payments into which were deductible and payments out are taxed. The requirement to keep these reserves will disappear, when Solvency II comes into force (expected, but this is not final, to be in January 2014). As a result, the Government is to introduce provisions to tax the accumulated reserves over a six year period, when Solvency II becomes live.
One of the features of that regime is that profits are recognised only after the underwriting year closes, which is after three years. By contrast, tax relief for a premium paid under a member-level stop-loss policy is currently available in the year in which that premium is incurred. On 6 December 2011, the Government issued draft legislation to defer that tax relief (and tax relief under certain quota share contracts) so that it will not be available until the profits of the underwriting year in question are recognised. The Government has confirmed that this legislation will be included in Finance Bill 2012.
Technology and pharma
One measure that has been anticipated for some time is the proposed introduction of the Patent Box regime that is intended to make the UK a more attractive holding location for intellectual property. From 1 April 2013 qualifying companies that elect for the regime can benefit from a tax deduction that will, in effect, mean that, once the regime has been fully brought in, profits derived from certain patent interests are subject to a 10 per cent rate of tax. This benefit is to be phased in over four years.
Budget 2012 provides the latest update on this proposal, and follows the publication on 6 December 2011 of draft legislation for Finance Bill 2012 and the completion of a further consultation process that ended in February 2012.
The draft legislation published in December 2011 provided detail on a number of important features:
- qualifying conditions - for patents to qualify they must be UK patents or patents registered at the European Patent Office (or certain other rights specified by Treasury Order), although the Government is considering this further. A company can qualify for the regime if it owns or holds an exclusive licence for such patents; cost-sharing participation may also qualify a company for the regime. A ‘development condition’ - the creation or significant contribution to the creation or development of a patented invention - must also be satisfied in certain circumstances, and companies within a group must also satisfy an ‘active ownership’ condition
- computational rules - there are detailed provisions to determine the profits that are to be subject to the regime. Broadly, qualifying profits will include profits arising from licensing, disposals of patent rights, sales of products that include patented inventions, income arising from infringements of qualifying IP and a notional arm’s length royalty income for using qualifying IP in a process or services. A qualifying company is required to determine the proportion of its gross income that is attributable to ‘relevant IP income’. This percentage is then applied to taxable trading profits and is subject to a number of further adjustments: the deduction of a ‘routine return’ equal to 10 per cent of certain costs; and the deduction of profits attributable to brand rights based on a notional brand royalty (subject to the making of a small claims election in which case a formula is applied in place of the need to calculate a notional brand royalty). The resulting amount qualifies for the Patent Box
- other provisions - a number of other relevant provisions are included in the draft legislation. For example it is possible, in certain circumstances, to apply a different method of calculation based on income streaming on a just and reasonable basis. There are also provisions designed to deal with Patent Box losses and targeted anti-avoidance rules are also included.
No significant changes to this proposal were announced at Budget 2012. The structure of the rules and the timing of its implementation remains the same. There is an indication that, as a result of the consultation process, clarifications will be made to:
- make it clear that worldwide income from sales of inventions covered by a qualifying patent are covered
- set out in more detail those expenses that are required to be subject to the 10 per cent ‘routine return’ deduction
- tighten up the category of companies that can make the small claims election to avoid having to calculate - and remove from the Patent Box – a notional royalty attributable to brands (and instead adopt a formulaic approach).
Research and development tax credits reform
In Budget 2010 the Government announced a consultation with business to review the support that research and development (R&D) tax credits provide for innovation and the proposals contained in Sir James Dyson’s report “Ingenious Britain, making the UK the leading high tech exporter in Europe”. This consultation ran from 29 November 2010 to 22 February 2011. Following from this, a number of announcements were made in Budget 2011 regarding reforms to the R&D tax credits schemes and a further consultation was launched, which closed on 2 September 2011. On 6 December 2011, the Government published their response to this further consultation and published draft Finance Bill legislation amending the R&D tax credits regime.
One of the most significant of the proposed amendments to the R&D tax credits regime was the introduction of an “above the line” credit for the distinct scheme applying for large companies. Currently, large companies incurring expenditure on R&D are entitled to an enhanced deduction at a rate of 130 per cent, but (unlike for smaller companies) any resulting losses cannot be surrendered to HMRC in return for payment. This has meant that the R&D relief has been reflected in the tax line of the company’s accounts, meaning that the benefit has been recorded within the finance or tax department rather than within the results for which the R&D team were responsible. This inability to record the benefit of the R&D relief within the R&D team has resulted in it often being ignored in investment calculations by the R&D team. In order to address this issue, large companies needed to have more certainty as to the timing and value of the relief. Where a claimant company has insufficient corporation tax liabilities to utilise the relief immediately, certainty as to the timing and value of the relief would only be possible if the relief could be surrendered for a payable sum (as is the case for smaller companies). This would enable the value of the relief to be booked to the R&D cost centre in the claimant company’s accounts (as an “above the line credit”), which should make the relief more effective as a driver for large companies to invest in R&D. The Government has confirmed in Budget 2012 that it intends to introduce this above the line credit in the Finance Bill 2013 and that it will consult on the detail.
The Finance Bill 2012 has also confirmed the increase in the rate of the enhanced deduction for smaller companies, which will rise from 200 per cent to 225 per cent from April 2012.
Corporation tax reliefs for the creative sector
The Government has stated that it will introduce corporation tax reliefs for the production of culturally British video games, television animation programmes and high end television productions. This is intended to be introduced in the Finance Bill 2013 and, subject to State aid approval, will take effect from 1 April 2013.
In the Chancellor’s statement he announced an intention to introduce a scheme that is similar to that currently applicable to film productions. Under current rules, film production companies can, in certain circumstances, be entitled to Film Tax Relief that can increase the amount of expenditure that is allowable as a deduction for tax purposes or, if the company makes a loss, can be surrendered for a payable tax credit. It seems likely that a relief along these lines will be extended to companies engaged in the production of certain prescribed video games, television animation programmes and high end television productions. However, the exact nature of this proposal will not be apparent until the consultation papers are released, which is expected to happen in the summer. This will be a boost for the video game industry in particular, which was expecting such a scheme two years ago, only for it to be scrapped, and has the aim of retaining programming expertise in the UK.