Controlled foreign companies (CFC)
The examiners explain how to deal with CFCs in your Technical Integration and Business Planning: Taxation exams in 2013
A UK resident company, holding shares in a non-UK resident company shareholder is not generally taxable on the income of its non-UK resident foreign subsidiaries; it is not taxed on the income when it arises, and in most cases dividends will be exempt. Therefore, if assets or activities can be located in foreign companies in foreign jurisdictions with tax rates lower than the UK rate, a tax saving can be achieved.
The CFC rules are an anti-avoidance measure, targeting these tax savings. UK resident companies with a minimum 25% shareholding in a CFC, will be charged to UK corporation tax at the main rate on their share of the CFC’s profits. In a change from the previous regime, the new UK CFC rules apply to accounting periods of CFCs starting on/after 1 January 2013 and aim to identify and apportion only those profits which have been artificially diverted from the UK.
However, the new CFC rules are not simple, so what do you need to know? This article sets out the fundamental points that you need to know to answer a question in the exam. A more comprehensive version of this article is available at icaew.com/studentresources
What is a CFC?
This is the easy bit. A CFC is a company that:
- Is resident outside the UK; and
- Is controlled by persons resident in the UK (>50%, or de facto control), or is at least 40% controlled by a UK resident and at least 40% but no more than 55% by a non-UK resident.
A number of different factors are considered in determining control, including whether the company would be a subsidiary of a UK resident company. If a company is a parent undertaking in accordance with FRS2 then it is deemed to have control. In a corporate group, all of the non-UK resident subsidiaries of a UK holding company will therefore be CFCs.
Does a CFC charge apply?
Once it is established that a foreign company is a CFC you then need to determine whether a CFC charge arises. There is a CFC charge if (and only if ):
- There is a UK company which (together with connected companies) holds an interest of at least 25%; and
- No CFC exemptions apply; and
- The CFC has ‘chargeable profits’.
These conditions may be applied in any order, so that (for example) if one of the CFC exemptions applies it is not necessary to consider whether the CFC has any chargeable profits.
In the exam, it will therefore be important to identify the following:
Start with the obvious:
- Is it a CFC?
- Is there a 25% holding by a UK company?
- Is there an applicable exemption?
Before you move on to the more complicated:
- Are there any chargeable profits? (Applying the “gateway tests”).
The CFC charge
A CFC charge can only apply if there are “chargeable profits”. To have chargeable profits the CFC must have profits which pass through the CFC charge “gateways”. These gateways are tests designed to define the profits that have been artificially diverted from the UK and are therefore subject to a CFC charge. Any chargeable profits are then apportioned to the CFC’s shareholders and a tax charge only arises where at least 25% of the CFC’s chargeable profits are apportioned to a UK resident company.
If a CFC has a number of unrelated UK shareholders, each of which has a less than 25% interest, there will therefore be no charge.
Chargeable profits are taxed at the main rate of corporation tax, with double tax relief given for any “creditable tax” (for example, local taxes suffered on the profits). A claim can be made to offset losses against the apportioned profits.
The gateway tests
We only examine two of the five gateway tests, as follows:
- Business profits that have been diverted from the UK through tax avoidance arrangements; and
- Certain finance profits. Only the part of the foreign company’s profits that “passes through” the gateway is chargeable profits potentially subject to apportionment.
Chargeable gains and property income are not chargeable.
Strictly, the legislation suggests considering the gateway tests before the exemptions, however, in the exam we expect you to recognise that if an exemption is applicable, there is no need to consider the gateway test, so it is easier to consider the exemptions first.
There are five entity level exemptions which exempt the whole of a company’s profits from a CFC charge. They are:
This is intended to give companies coming within the UK CFC rules time to restructure so that they are not subject to a charge. It lasts for 12 months (or longer, with the agreement of HMRC) after a company comes under the control of UK residents.
HMRC has issued regulations setting out a list of “good” territories, where a company’s profits are not generally subject to a low rate of tax. A company, which is resident and fully taxable in a listed territory, will not generally be subject to a CFC charge.
Tax havens (such as the Channel Islands, Bermuda, and the Cayman Islands) are not listed, neither are other jurisdictions that have often been used for tax planning in the past (most notably Switzerland and Ireland).
If a company’s profits (on a tax or accounts basis) are no more than £500,000 and its non-trading profits are not more than £50,000.
Low profit margin
If a company’s accounting profits are no more than 10% of its relevant operating expenditure (ie operating expenditure per the accounts, less amounts paid to related parties and the cost of goods sold, unless the goods are used by the CFC in its local territory).
If the local tax paid by a CFC on its profits is not less than 75% of the corresponding UK tax on those profits.
A full UK corporation tax computation would be needed to determine whether this exemption applies. This may be simple for an investment company, but in relation to a trading company it is likely to be easier to see whether another exemption applies, or to look at the gateway tests instead.
The gateway tests
As mentioned, we only examine two gateway tests out of the five in the legislation. Remember, profits can only be apportioned to the UK shareholders if they fall within a gateway.
Test 1: the gateway for profits attributable to UK activities
The gateway for profits attributable to UK activities has an ‘entry test’. Profits will not pass through this gateway and become chargeable profits if the company meets one or more of the entry conditions. If one of these conditions is met none of the company’s profits pass through this gateway (although the CFC may also have non-trading financing profits, which need to be considered under the second gateway test, see below).
- The CFC has no assets or risks deriving from tax planning schemes, or;
- None of the CFC’s assets or risks are managed from the UK; or
- The CFC has the ability to manage its own business if any UK management of assets and risks were to stop.
So, for example, if a company had entered into significant tax planning transactions but had absolutely no UK management, it would meet one of the entry conditions and none of its profits would be chargeable profits under this gateway.
If none of the entry conditions are met the CFC must analyse the active decisionmaking relevant to its assets and risks. If any of the active decision-making is carried on in the UK by a connected person, the profits attributable to that UK active decision-making process pass through the gateway and will be chargeable profits subject to the CFC charge. (Note that “active decisionmaking” is more correctly referred to as the “significant people functions” in the study manual.)
Test 2: the gateway for non-trading financing profits
This is the second gateway test we will be examining.
Non-trading finance profits consist of:
- Non-trading profits taxable under the loan relationship rules (eg, interest, foreign exchange differences and derivative contract profits);
- Dividends and other distributions that are not exempt under the distribution exemption; and
- Non-trading profits from relevant finance leases.
However, these profits may be excluded if they are considered “incidental”. Profits are treated as incidental if the CFC also has:
- Trading or property business profits, or is a holding company for 51% subsidiaries, and;
- Its non-trading finance profits are no more than 5% of its “good” income.
Where the CFC’s non-trading finance profits are not incidental they will pass through the gateway and become chargeable profits if they are derived from:
- Assets and risks in relation to which any relevant active decision making is carried out in the UK;
- Capital investment from the UK;
- Specified arrangements in lieu of dividends (typically loans) with the UK, or
- UK finance leases.
HMRC believes that in a UK parented group an analysis of the active decisionmaking will always result in a significant proportion of any intra-group loan being allocated to the UK.
Although for qualifying loan relationships (see below), the CFC charge may be reduced for intra-group loans with a non-UK resident borrower.
Refer to the online version of this article for greater detail on the exemptions and the gateway tests.
What does it all mean anyway?
Firstly, the complexity of the legislation means that it is worth taking time to make sure you can remember the basic structure of the rules. It is also useful to remember that neither chargeable gains (which are not part of chargeable profits) nor property business income (which does not pass through the gateways) can ever give rise to a CFC charge.
Secondly, if you are asked to give an overview of the rules (eg, explain to senior management in outline how the new rules work) you will almost certainly need to mention the control test, the gateways, the exemptions and how the charge is calculated. Whether you need to mention the QLR rules will depend on how the question is worded.
Thirdly, if you face a question which is based around a “golf course chat” scenario, where a director has been told by his friends to put income in a company based in a tax haven with no local substance the answer is likely to be (roughly) that:
- None of the exemptions will apply unless it has very low profits or a low profit margin, in which case it may not be worth doing anyway (havens are not excluded territories, do not have a high enough tax rate for the tax exemption to apply, and the company would not have previously been non-UK controlled so the exempt period is not relevant); and
- All of its profits will pass through the gateways and be apportioned to and taxed on the UK shareholder, unless they are non-trading finance profits and the QLR rules apply. This is because the clear tax avoidance motive and need for UK head office staff to be involved in managing the company’s assets mean that none of the entry conditions for the gateway for profits attributable to UK activities will be met. In addition, an analysis of the active decisionmaking (technically known as the “significant people functions”) is likely to conclude that substantially all of the assets and risks are managed from the UK. If there is no local substance at all, even the QLR rules will not apply because the company won’t have business premises. Fourthly, the fact that the gateway tests look at the extent to which assets and risks are managed in the UK means that if you are given a scenario where there is a debate around whether management and control of a subsidiary is in the UK, there may well be a CFC issue as well as a residence one.
Finally, there are no statutory clearance procedures in the FA 2012 CFC regulations, but where there is some material uncertainty as to how these rules apply, then HMRC will give guidance under the non-statutory business clearance rules.
This article originally appeared in the July 2013 edition of VITAL.