FINANCE BILL 2000
CLAUSE 103: CONTROLLED FOREIGN COMPANIES (CFCs)
SUMMARY
1. This clause makes four changes to improve the fairness and effectiveness of the anti-avoidance rules for controlled foreign companies. The changes strengthen the legislation and update it to take account of developments in the ways multinationals are structured and do business. UK companies will continue to be exempt in respect of CFCs that are not involved in UK tax avoidance. The motive test in the CFC rules means that additional tax will only be payable in situations where companies are seeking to avoid UK tax.
2. The first change updates the definition of whether there is sufficient control from the UK for a company to be a CFC. The clause brings the test more into line with the recently modernised rules for transfer pricing. In particular, the clause means that companies that are owned by international joint ventures in which there is significant UK interest will in certain circumstances be CFCs.
3. The second change deals with companies that pay tax under so-called designer rate regimes. A number of countries have introduced such regimes to allow companies to sidestep the CFC rules. The clause will ensure that a company cannot stay outside the rules by paying tax under such a regime.
4. The third change updates the list which sets out the types of business that are not automatically excluded from the CFC rules. To counter the growing use of intra-group service businesses to shelter income in tax havens and preferential regimes, the clause adds to the list all types of intra-group service business not already covered.
5. The fourth change amends the automatic exemption for holding companies. The change will stop the exemption being used to avoid tax on income that is received to any significant extent out of the pre-tax profits of subsidiaries.
DETAILS OF THE CLAUSE
Clause 103
6. The clause provides for Schedule 31 of the Bill to have effect.
Schedule 31
7. Paragraph 1 provides for amendments to be made to the CFC rules so that the four changes can be made.
Meaning of "control"
8. Paragraphs 2 and 4 provide a new test for control based on that used for transfer pricing. The new test includes a "40% test" whereby a company is regarded as being controlled by UK persons if it is at least 40% controlled by a UK person and at least 40% controlled by another person.
Designer Rates
9. Paragraph 3 provides that companies paying tax under "designer rate tax provisions" are automatically treated as if they are subject to a lower level of taxation. It also provides for Regulations to be made specifying which provisions are to be regarded as being designer rate tax provisions.
Intra-group service companies
10. Paragraphs 5 and 8 extend the list of businesses that are excluded from the exempt activities test. The extension covers all types of predominantly intra-group service businesses that are not already excluded.
Holding Companies
11. Paragraph 6 provides that the income test in the local holding company exemption will only be met if the company receives the income in the territory in which it is resident.
12. Paragraph 7 provides that the income test for other holding companies will only be met if either: a) the income is received in the territory in which the company is resident and the income is from subsidiaries resident in that territory, or b) the income is in the form of dividends from subsidiaries resident anywhere.
Commencement
13. Paragraph 9 brings the control changes into effect from 21 March 2000, and the intra-group service company and holding company changes into effect for CFC accounting periods beginning on or after that date.
14. Paragraph 9 also provides that the designer rate provisions have effect for CFC accounting periods beginning on or after 6 October 1999 (the date the Chancellor first announced his intention to legislate).
BACKGROUND
15. A CFC is a company which is not resident in the United Kingdom (but which is controlled to a significant extent by persons who are) and which is subject to a level of taxation of less than three quarters of that which it would have been subject to had it been resident in the United Kingdom.
16. The CFC rules are designed to stop UK companies avoiding tax in this country by diverting income to CFCs in tax havens and other preferential regimes. The rules work by requiring the UK company to pay an amount of CFC tax equal to any tax that would otherwise be avoided.
17. The rules were introduced in 1984, and a number of changes have been made since then to keep the rules up to date with the changing face of international business. The present changes reflect the Government's resolve to ensure that the rules continue to keep pace with developments in the global economy and with the ways in which multinationals are structured and do business.
18. The rules contain a number of exemptions. One of these is the Exempt Activities Test that is being changed by Paragraphs 5-8 of Schedule 31. The other exemptions are a motive test, a list of 74 countries in which companies are outside the CFC rules if they meet certain conditions, a distribution test, and a public quotation test. CFC tax is only payable if a company fails all of these tests. The motive test specifically ensures that CFC tax is only payable if a company is involved in UK tax avoidance.
19. The changes introduced by Schedule 31 will bring the UK's CFC rules more into line with those in other countries but the UK is unique in having a motive test to ensure that the rules only apply in cases of tax avoidance.
Meaning of "control"
20. At present, to be a CFC a company must be controlled from the UK. Most commonly, this means that more than 50% of the shares must be held in the UK.
21. The ways in which multinationals are organised and structured are becoming ever more varied and complex. For instance, it is becoming increasingly common for UK companies to enter into joint ventures with overseas companies. In such situations, a joint venture company in a tax haven may not be a CFC as currently defined, as the UK company may not have more than 50% control.
22. In order to keep pace with such developments in the business world, Paragraphs 2 and 4 of Schedule 31 modernise the CFC control test, broadly in line with a similar up-dating made in 1998 to the control test used for transfer pricing.
Designer rate tax regimes
23. The CFC rules normally only apply to companies paying less than 75% of the tax they would have paid if they were resident in the UK. To enable companies to get round CFC rules, a number of countries have introduced regimes that allow companies to arrange to pay just the right amount of tax needed in any given situation to avoid CFC tax. Most commonly, the regimes work by allowing companies in effect to choose their rate of tax.
24. Paragraph 3 of Schedule 31 sets aside the normal requirement that a company is only within the CFC rules if it has paid tax at a level less than 75% of that which it would have paid if resident in the UK.
25. The designer rate regimes that will be specified in the first regulations were named in the Inland Revenue's press release of 6 October 1999 ("Controlled Foreign Companies - Designer Rate and Similar Regimes.").
Intra-group service companies
26. Subject to certain specific exceptions, CFCs that are genuinely carrying on a straightforward commercial business are automatically exempt from the CFC rules. The exemption is known as the exempt activities test ("EAT").
27. Broadly, the EAT works by exempting all trading companies except specified highly mobile businesses that tended to be used for tax avoidance at the time the CFC rules were introduced in 1984. (E.g. invoicing companies and wholesale, distributive and financial businesses.)
28. Business has changed since then. Globalisation, along with transportation and communications advances, allow many more types of business easily to locate in tax havens in order to avoid United Kingdom tax.
29. Paragraphs 5 and 8 of Schedule 31 extends the types of business that are excluded from the EAT, so that the EAT no longer applies to any CFCs receiving 50% or more of their income from the provision of services to affiliates.
Holding Companies
30. Holding companies are outside the CFC rules if at least 90% of their income comes from non-resident subsidiaries that meet one or more of the CFC exemptions. There is a logic in saying that from a United Kingdom point of view it is largely immaterial whether the post-tax profits of a non-resident subsidiary are retained in the subsidiary or are held in a non-resident holding company.
International holding companies
31. The logic breaks down, though, where the payment from the subsidiary to the holding company crosses national borders and comes out of pre-tax profits - eg where the payment is in the form of interest or royalties. For, in those circumstances, pre-tax profits are shifted from the subsidiary to the holding company and from one country to another.
32. There is a tax deduction in the subsidiary and a new source of income in the holding company. However, the existing exemption for holding companies does not distinguish between holding companies that receive their income in the form of dividends and holding companies that receive their income in other forms. As a result, the exemption is distorting the way some overseas investments are structured, and is leading to a loss of UK tax.
33. For instance, a UK company wanting to put additional funds into a subsidiary in the United States will commonly borrow in the UK, put the borrowed money into a low tax subsidiary (e.g. in the International Financial Services Centre in Dublin Docks) in the form of share capital, and the low tax subsidiary will then lend the money to the United States.
34. In this way, the group gets two lots of tax deductions at normal tax rates (in the UK and the United States) and a single tax charge at a low rate (in Dublin Docks).
35. This kind of structure has become increasingly common since the abolition of Advance Corporation Tax (ACT). This is because groups are no longer under the same pressure as they were to bring profits back to the United Kingdom in order to absorb ACT set-offs.
36. Paragraph 7 of Schedule 31 stops this loss of tax by restricting the holding company exemption so that the 90% income test can only be met where the income is in the form of (non tax deductible) dividends.
37. This particular form of avoidance generally only works where the holding company is resident in a different territory than its subsidiary. Paragraph 7 of Schedule 31 therefore allows the holding company to continue to receive income in forms other than dividends where it is received in the territory in which the company is resident and is from subsidiaries resident in that territory.
Local holding companies
38. The CFC rules distinguish between holding companies that receive at least 90% of their gross income from exempt subsidiaries that are resident in the same territory as the holding company (called "local holding companies") and other types of holding company.
39. For similar reasons to those described in paragraph 37 above, local holding companies will continue to be able to receive income in forms other than dividends.
40. Paragraph 6 of Schedule 31 stipulates, however, that the income must be received in the territory in which the local holding company is resident. This will prevent local holding companies carrying out the above avoidance scheme by receiving the income in a branch located outside the territory in which it is resident.