UK Corporate Tax Reform

Paris, 20 janvier 2011 - Visualiser l'eAlerte

Un avant projet de réforme fiscale vient d'être soumis à consultation par le gouvernement britannique. Il contient de nombreuses mesures affectant les revenus réalisés à l'étranger ainsi que de nouvelles règles destinées à contrer certains montages.

On November 29, 2010 a substantial consultation document (condoc) setting out a series of corporate tax reforms was issued in a single program. The condoc was followed by the release of draft legislation for the Finance Bill 2011 which included provisions intending to enact anti-avoidance rules set out in a written ministerial statement released on the 6 December.

With the issuance of the condoc the UK Government confirmed the intention to move toward territorial taxation by proposing positive reforms designed to create a more attractive tax environment for investors. Specifically, the condoc covers the taxation of Controlled Foreign Companies, provides an exemption for foreign branches of UK companies and introduces a "Patent Box". The condoc also confirms that there are no significant changes planned to the rules on interest deductibility as a result of the move towards a more territorial system of tax. As with any consultation process, however, there are areas of uncertainty and the Government will address these areas with the business community.

CFC Interim Improvements

The interim improvements provide a set of welcome measures for UK business. It is proposed that the rules are effective for accounting periods beginning on or after April 1, 2011; however, this is open to consultation.

The extension to the transitional period for holding companies, increase in de minimis limit and widening and extension to the motive test period of grace should help relieve the compliance burden for UK groups in certain situations. Although the motive test has been widened for certain circumstances the anti-avoidance may be problematic as it restricts the ability to meet the test where either the overseas company or assets were previously under the control of the UK.

The foreign to foreign intra group trading exemption, and the narrower exemption for intellectual property (IP), where there is minimal or no connection with the UK are designed to allow UK multinationals to manage overseas operations more efficiently than is possible under the current rules and should provide groups with new opportunities to structure operations without causing CFC concerns.

Under the intra-group trading exemption, provided UK income or expenses are under 10% of the total amounts of income or expense of the CFC, the exemption should be available. As promised by the CT reform document, a  "safe harbour" is provided to ease the burden of the UK connection condition. Where the "safe harbour" substance conditions are satisfied a company which has UK-related gross income or business expenses in excess of 10% of the total gross income or business expenses, but not more than 50%, will not be considered to have a significant connection with the UK and may avail itself of the full exemption. The "safe harbour" substance conditions were expected to include an effective management requirement plus a mechanical test. The legislation clarifies that the mechanical element of this test will require relevant profits to be 10% or less of the relevant staff costs for the period (in respect of staff resident in the same territory as the CFC). If the "safe harbour" conditions are not met, there may be the opportunity, in certain circumstances to apply for a reduction in CFC apportionment. This partial exemption may be available where the company failed the 10% UK connection test but would not have failed had the limit been 50% (in line with the safe harbour requirement) and/or the combined finance and IP income of the CFC exceeds 5% of gross income but the relevant IP income of the CFC does not exceed 5% of gross income.

For the IP exemption where financing income exceeds 5% of gross income full exemption will not be available. However, a partial exemption may be available by application to the Commissioners to reduce the relevant chargeable profits such that only the excess finance income (over 5% total gross income) is apportioned.

A number of areas of uncertainty arise through the use of the phrase "substantial" throughout the draft legislation for the two new exemptions. In the consultation document, it was suggested (in respect of the extent of non-trading activities in a company seeking to rely on the new intra-group trading exemption) that the threshold would be set at 10% but no definition, or figure, has been included within the legislation to define this phrase.

Foreign Branch Taxation

The foreign branch exemption regime will allow a UK company to make an election for all its foreign branches to be exempt from UK corporation tax on its "relevant profits". The exemption is available for profits including gains, with profits / gains defined by reference to the relevant double tax treaty, in territories with a treaty in place and the Organisation for Economic Development and Cooperation (OECD) model treaty in all other cases. However, it is worth noting that there are certain qualifications in respect of exempting gains and a number of complex transitional rules for branches with brought forward losses.

As stated in the CT reform proposals the branches will be subject to anti-diversion of profits provisions similar to those currently in place for CFCs. This draft legislation (which is expected to only apply until amended to mirror full CFC reform in Finance Act 2012) proposes that where an overseas branch pays a lower level of tax (similar to the test in place for CFCs), unless the branch meets the specified de minimis (referred to the "entry limit") or motive tests, the exemption will not be available. Depending on HMRC's approach to the motive test, these anti-diversion rules have the potential to be broadly applied.

The proposals will have effect for accounting periods beginning on or after a specified date in 2011 however the specific date is still open to consultation.
The regime should make branches more viable for doing business as they will broadly be taxed on the same footing as companies. Situations where branches may be preferred include:

• Intellectual property management strategies, where using a company may create an immediate exit charge;
• Establishing businesses in territories where there is a positive rate of withholding tax on distributions but not on branch remittances;
• Establishing businesses in territories where there are significant incremental corporate law requirements (e.g. statutory audit, board of director requirements etc.);
• Establishing businesses in territories where there are incremental regulatory requirements (e.g. exchange control);
• Establishing businesses in territories where there are incremental commercial issues (e.g. the need for a local sponsor to hold shares) and establishing businesses in territories where there are other hurdles (e.g. works councils, statutory profit share etc).

Patent Box

The Government has confirmed its intention to introduce a patent box regime effective April 1, 2013 as part of a strategy "to encourage companies to locate high value jobs and activities associated with the development, manufacture and exploitation of patents in the UK".

As the name suggests, the patent box regime will only apply to patent rights and will not cover other technological intellectual property or brands.
The optional patent box regime will provide for a 10% tax rate on patent income, net of associated costs.

Patents commercialized after November 29, 2010 will qualify for the patent box regime. There may be a claw back mechanism for patents commercialized prior to that date, for which tax deductions on the related expenses have been claimed at the standard rate. As part of the regime's anti-avoidance measures, the Government is considering linking the amount of income attributable to the patent box to the level of associated R&D or manufacturing.

Interest Deductibility

There have been suggestions that the UK should adopt a fully territorial approach to both CFC and interest deductibility in the UK. The Government has concluded that this is unlikely to result in a more competitive system, could be more disruptive and remove one of the more attractive aspects of the UK tax regime, i.e. the UK's interest deductibility rules. The condoc therefore expressly states that the Government does not intend to pursue significant changes to the interest deductibility rules.

Group Mismatch Schemes (GMS)

There are two changes here. Both were expected although the inclusion of CFCs in the TAAR would seem to be out of step with CT reform.
Firstly, changes have been introduced with effect from December 6, 2010 to counter planning using convertible loans. The planning in question generated tax deductions in the borrower which exceeded the corresponding taxable income in the lending company. Broadly, the impact of the legislation is to deem additional income in the lender to match the expense in the borrower.

Secondly, a new principle based TAAR targeting GMS is to be included in Finance Bill 2011. The rules are intended to apply from the date of Royal Assent (anticipated to be mid-2011). The legislation takes a generic/principles based approach as seen in other recent TAARs (e.g. disguised interest rules introduced in 2009). The GMS rules are widely drafted and complex. The key messages are that the GMS rules:

• Aim to prevent the development of further GMS arrangements
• Apply to CFCs that are required to compute chargeable profits
• only apply where there is a mismatch under UK legislation between the treatment of loans or derivatives within a group (i.e. they will not apply simply because there is a difference between the UK and foreign treatment of an item) and
• Don’t grandfather existing arrangements (unlike the disguised interest rules).
  Where the GMS rules apply only debits and credits relating to the mismatch are adjusted.

Functional Currency

The draft clauses for Finance Bill 2011 include provisions to counter tax avoidance involving changing the functional currency of an investment company. These are designed to ensure that in a period when a UK resident investment company changes its functional currency, no foreign exchange gains or losses arising from loan relationships or derivative contracts will be brought into account. The legislation will take effect for accounting periods beginning on or after April 1, 2011.

However, there is also a rule which allows investment companies to elect for a functional currency to be used for tax purposes that is different to the currency used in the company's accounts. The key features of the legislation are that:

• Any election can only be made prospectively (the legislation provides that an election can be made at any time after December 9, 2010 – i.e. before the legislation comes into force!).
• The elected currency must meet one of two tests at the time the election is made. It is either (i) the currency in which a “significant proportion” of the “assets and liabilities” of the company are denominated or (ii) the functional currency of another company in the consolidated accounting group.
• Once an election has been made it is effective until (i) the company makes another election or (ii) neither of the conditions for originally making the election are satisfied.

This new rule intends to make hedging foreign currency exposures for tax purposes more straight-forward for many companies, however, complexities may arise on transition.

Conclusion

Through the condoc proposals, the Government has demonstrated greater appreciation of the commercial realities of multinational companies, including how they operate and the issues to address to encourage them to invest in the UK. While the rules may not appear to meet the Government's stated objective of "simplicity" in the tax law, hopefully, through consultation with taxpayers and tax professionals, the rules will be made workable for business, thereby enhancing the UK's competitiveness.

Taxpayers affected by the proposals should consider the submission of representations or self-nominations for participation in the relevant working groups to help shape the new legislation.

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