Switzerland: Tax Briefing - UK Taxation Of Foreign Profits

Article by Andrew Daley, David McNeil and Bill Dodwell

As promised, the UK Government’s discussion document entitled Taxation of the foreign profits of companies arrived shortly before the official end of Spring – on 21 June 2007. The 48 page document covers a lot of ground and is issued as a first step in a discussion process with business. The Government, through both Treasury and HM Revenue & Customs, will be holding discussion events and seeking input over the next 12 weeks (with final comments due by 14 September 2007).

The next step will be the publication of a Consultative Document (probably in December 2007), followed by legislation in 2009. It is thus likely that the reforms will take effect from 1 April 2009.

Despite the title, the following proposals in the document may equally apply to UK companies without overseas shareholdings:

• proposed new limitations in the deductibility of interest; and

• the introduction of an apportionment system for passive income, which, to ensure it is not viewed as discriminatory for EU purposes, will apply to UK subsidiaries as well as to overseas companies.

The first main proposal is the introduction of an exemption from UK tax for foreign dividends paid to UK companies, where the recipient holds at least 10% of the overseas company. At present such dividends are taxed in the UK but credit is available for any associated taxes paid on the profits from which the dividends are paid (‘underlying tax’) and withholding taxes. The exemption would apply to most dividends from controlled companies, following the definition of control within the new ‘controlled company’ regime - see below, and other dividends (e.g. those from companies not controlled from the UK) where those dividends are paid from income outside the controlled company rules. The dividend exemption would not apply to small companies¹, essentially because the Government would prefer not to apply the Controlled Company provisions to them. Instead a simplified form of double tax relief would be offered.

The controlled company rules are intended as a modern replacement for the current controlled foreign company (‘CFC’) regime. The CFC rules are anti-avoidance legislation aimed at preventing UK companies from accumulating income in subsidiaries in low tax areas or artificially diverting profits to such companies. If the CFC rules apply, overseas income is immediately taxable in the UK regardless of whether it is distributed to the UK. The current rules are based on an ‘all or nothing’ approach under which each overseas subsidiary is assessed as an entity and its profits are either exempted or taxed in the UK in their entirety.

The intention is that the new regime would focus on mobile, or passive, income, rather than on the status of the company. Passive income is defined as interest, royalties, rents, annuities and purchased income, dividends (other than those qualifying for the dividend exemption) and similar income.

Passive income would also include those categories of trading income that do not qualify under the ‘exempt activities’ exemption from the current controlled foreign company rules – intragroup/UK-derived sales or service income from wholesale, distributive, financial or service income, as well as sales income from dealing in goods to/from the UK, or with affiliates, where the goods are delivered outside the company’s territory.

The definition of UK control would be widened from the definition in the existing CFC rules.

The intention is that passive income would be allocated to and taxed on the UK parent of the group, with credit for any overseas tax suffered on such income. (Currently, a UK company will only be subject to tax if the CFC profits apportioned to it amount to 25% of the total profits. It is proposed that this threshold be reduced to 10%). This is likely to mean, for example, that no further UK tax would be charged on passive income earned and taxed in hightax countries, such as the US.

One of the difficulties raised in the document concerns the principles under which such passive income is calculated. UK GAAP is proposed, which is likely to represent an additional burden, as overseas profits are no longer calculated under UK GAAP, following the introduction of international accounting standards.

In order to ensure compatibility with the European Treaties the document suggests that the passive income rules would also need to be applied to UK subsidiaries, in a similar manner to the existing UK transfer pricing rules. As a result, passive income in UK controlled companies would be taxed on the UK parent, but a compensating adjustment made at the subsidiary level, so as to avoid double taxation. This complicated area will no doubt be scrutinised carefully by European lawyers.

As with the UK-UK transfer pricing rules, UK groups will be concerned at the increasing complexity of this measure.

There will be some exemptions from the passive income regime, the most important of which would allow overseas treasury companies to operate, provided they meet certain tests. Their income must be earned from companies not within the passive income rules and they must be ‘appropriately capitalised’. (For example, an overseas treasury company with more equity than expected could be viewed as inappropriately capitalised. This is because the equity could be taking the place of loans from the UK and the interest on these loans would form part of the lender’s UK taxable profits.)

There are envisaged to be further exemptions, covering:

• Incidental income – passive income incidental to a company’s active business

• Group income – from intragroup transactions within the same country, so as to allow groups as much flexibility as possible to organise their operations within a country

• Conduit income – to exempt income received in a fiduciary capacity for financing that does not involve the avoidance of UK withholding tax. This is intended to exempt special purpose financing companies that raise money from the public debt market, for on-lending into the group.

The Treasury recognises that little UK tax is currently received from foreign profits and that the introduction of a dividend exemption does not of itself justify the introduction of wide-ranging restrictions on interest deductions. The caveat to this, suggested in the document, is that the Controlled Company regime needs to deter multinationals from reducing current UK profits by diverting income to low-taxed countries, for future repatriation to the UK as exempt dividends.

Nonetheless, two anti-avoidance measures are proposed:

• A tighter ‘unallowable purpose’ rule to restrict UK deductions for finance costs and financial instrument charges. The proposed changes could potentially bring into account the motives and other actions of other group companies.

• A new restriction on financing charges claimed by the UK members of the group – where those exceed the overall group’s external finance costs.

This last restriction will need further clarification during the discussion process. However, as set out in the document, it would only apply where UK interest deductions exceeds the whole of the group’s external interest payments – not just a proportion, based on assets, or income. If correct, this is unlikely to have significant impact on overseas multinationals investing in the UK.

After a prolonged campaign by UK business over many years, the Treasury has finally conceded that the outdated Treasury Consent rules should be abolished. These rules require advance permission for certain share/debt transactions, involving overseas companies controlled directly or indirectly from the UK. Instead, consultation is invited about a new information power, whereby UK companies would provide information about certain group financing activities, on a ‘real-time’ basis.

Discussion is invited about how this might apply in practice.

There will be a separate consultation around the tax treatment of portfolio dividends (those from companies where a less than 10% shareholding is owned). The Treasury suggests there are three options:

• To tax all portfolio dividends – whether from UK companies or from overseas – with credit for underlying tax borne by the paying company and for withholding tax

• To tax all portfolio dividends – whether from UK companies or from overseas – with credit only for withholding tax. (Withholding tax does not need to be deducted from any dividend payments made by a UK company).

• To exempt from tax foreign dividends.

This expansion of the UK participation regime – adding to the capital gains exemption (substantial shareholdings exemption), the absence of a UK dividend withholding tax and the availability of interest relief on borrowings - is likely to make the UK an attractive holding location for overseas multinationals. Few other countries would offer all these advantages.

Footnotes

1. It would be expected that the definition of small would follow the European Commission recommendation. This being companies with less than 50 employees and a turnover or balance sheet which does not exceed €10m.

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