EC investigation into the treatment of multinationals by UK tax authorities
A “controlled foreign company” (CFC) is just a name for a subsidiary company that is potentially subject to the CFC anti-avoidance regime. If CFC’s were illegal then a UK company could never create a subsidiary, anywhere.
The CFC finance company exemption is hardly akin to the European Commission’s recent ruling against Amazon’s sweetheart deal with the Luxembourg tax office. The finance company exemption is a statutory exemption available to every company in the UK.
It is quite possible that the cost of the EC investigation will far outweigh any additional tax that may have to be paid to HMRC.
History and purpose of UK CFC regime
Most high tax jurisdictions operate controlled foreign corporation (CFC) rules. They were first introduced in the UK in 1984, following removal of UK exchange controls in 1979 by the Thatcher government. UK companies were able to set up subsidiaries in low or no tax territories such as the Channel Islands and use such subsidiaries to, amongst other activities, contract with customers, thereby shifting profits out of the UK and reducing the UK tax base.
Broadly, a CFC was traditionally defined to include a controlled subsidiary company subject to tax at less than 75% of the UK tax. A UK company will generally have ‘control’ of a subsidiary if it holds 51% of the voting rights and rights to profits. It can also apply to 40% holdings in certain circumstances.
Where a CFC existed, its profits were deemed to belong to its UK parent and therefore subject to UK corporation tax. There were a couple of defences to the rules that were subjective. Only really large MNCs could escape application of the CFC rules since they could afford to put proper substance in the foreign territory and apply the exempt activities or motive defence. In relation to intra-group financing activities, a large UK headquartered MNC would locate all of its treasury functions (intra-group financing, hedging etc.) in the CFC territory and escape a UK tax charge on those financing profits.
Since c.2009, the UK has been tinkering with its corporate tax regime to make it an attractive location for MNCs to base their headquarters (exemption for dividends received, lower corporate tax rate etc.). The idea was that without the manufacturing industry it once had, the UK had to do something to create jobs and increase tax revenue through employment. The CFC rules, however, were a significant deterrent to multinational companies. As a result, there was a wholesale reform of the rules and the current regime became effective from 1 January 2013.
The current CFC regime
The definition of a CFC was widened to include all controlled foreign subsidiary companies – there was no requirement for them to be subject to a lower level of tax than in the UK. This means that more subsidiaries are now initially caught by the CFC regime.
A CFC’s business profits are also no longer automatically deemed to belong to its UK parent. Instead, the rules were aligned with international concepts included in the OECD Transfer Pricing Guidelines and focuses on allocating profits to the jurisdiction that housed the people critical to generating the profits, whether that was senior management or those people that created or exploited assets such as IP. This means that some of the CFC’s profits might be deemed to belong to the UK parent and some remain overseas.
It’s worth highlighting that the UK’s current CFC regime is broadly in line with the OECD’s CFC recommendations in BEPS Action 3.
Taxation of a CFC’s finance profits
MNCs typically establish a group finance or treasury company, responsible for managing the financing needs of the group. It is able to utilise funds from cash rich group companies for investment in other group companies, acquisitions and people, etc.
There are tax benefits that arise from a group financing company where it is established in a low or no tax territory and the lending is to a high tax territory. For example, a UK MNC could establish a subsidiary in Jersey and could make a loan to a German group company. Germany has a high effective corporate tax rate of 30-33%. The German group company would then pay interest to the Jersey finance company and would receive a deduction for the interest expense against its income, saving German tax at 33%. There ought to be no withholding tax on the interest paid to Jersey and there would be no tax in Jersey. However, if the UK CFC regime applied, the profits would be apportioned to the UK and subject to UK CT at 19%. Reducing the tax saving from 33% to 14%.
The taxation of profits arising from financing activities is considered separately within the current CFC regime. There is a similar test to that described above for business profits, but broadly, if there is any involvement by the UK parent in managing or controlling the CFC’s financing activities or funding from the UK, the CFC’s financing profits will be allocated to the UK.
The UK government recognises that for MNCs, it is sensible to consolidate their financing activity in one group company, so as to have visibility over group cash flow and be able to lend quickly when needed, etc. It also recognised that many large MNCs were able to escape a CFC apportionment under the old regime, and did not want to remove this. At the same time, it wanted to extend this benefit to all UK companies with overseas operations and provide certainty (i.e. no reliance on a subjective criteria to escape a CFC apportionment on financing profits). The finance company partial exemption was therefore introduced.
Finance company partial exemption (FCPE)
The FCPE allows an MNC to set up a foreign finance subsidiary and will exempt 75% of its intra-group financing profits from UK CT. This reduces the UK effective tax on the CFC profits to 4.75% (i.e. 19% CT rate x 25%). Following on from the example above, this would reduce the effective tax saving on lending to Germany from 33% to 28.25% – a significant sum.
However, this example is not the norm. Most high tax territories levy withholding tax on interest payments, which would erode the tax saving. This means the financing subsidiary has to be located in a territory that has concluded a double tax treaty with the target country, or be able to benefit from EU Interest / Royalty Directive to reduce the withholding tax.
Such territories usually operate high rates of corporation tax (e.g. Switzerland, Luxembourg) and a complex structure using hybrid instruments or entities, or a favourable ruling is required to lower the corporate tax rate so as not to erode the tax saving. All things that have either been closed down due to OECD BEPS changes or existing state aid action. This gives a period of three years (2013-2016) where MNCs may be exposed to the EC investigation.
In my experience, there were not many takers outside the large MNCs to the foreign finance structures because they were too complex and costly to run. Many simply ran their financing activities from the UK and were happy with a tax saving resulting from the UK’s low CT rat (e.g. funding a jurisdiction with a 35% tax rate such as the US would still create a 15% (now 16%) tax saving). The large MNCs may indeed have no CFC apportionment, even if the FCPE wasn’t available due to the levels of substance overseas. It is quite possible that the cost of the EC investigation will far outweigh any additional tax that may have to be paid to HMRC.
Impact of Brexit
If the UK remains part of the European Union, it will have to implement the EU’s Anti-Tax Avoidance Directive to bring its CFC rules in line with the Directive. This would mean removing the exemption in any event. This latest EC investigation is yet further evidence that it is in the UK’s best interest to leave the union as soon as possible and to never look back.