The Controlled Foreign Company (CFC) regime must be considered where an overseas company is controlled from the UK. The legislation can be quite daunting for the uninitiated as it contains 22 different, and highly detailed, Chapters.
Given the complexity of the CFC legislation, it is easy to get bogged down in the detail, and this edition of Tax Connect seeks to provide outline guidance on a sensible approach to applying the series of different gateways, safe harbours and exemptions contained within the legislation.
Who could the CFC legislation apply to?
In simple terms, the CFC legislation applies to all companies that are resident outside the UK that are controlled by UK residents.
The definition of control is widely drawn and examples of situations where the legislation could apply include:
- More than 50% of the shares are held by UK persons.
- Factors indicate that legal, economic or accounting control is in the UK
- It is a joint venture company and more than 40% is controlled from the UK
Where a CFC has been identified, and a UK company has a relevant interest of 25% or more in that CFC, a UK tax charge can arise on that company but only if the profits pass through a CFC charge ‘gateway’.
Standing at the outer gateway
The CFC charge gateways are designed to identify profits that have been artificially diverted from the UK. Only if profits pass through the gateways will they be subject to a CFC charge, and there are a number of ways in which a UK company can obtain complete exclusion from such a charge arising.
To visualise the manner in which the gateways work, imagine an outer gate with five locks in it, behind which there are a number of inner gates each with one lock. Profits will only be assessed under the CFC regime if the gates cannot be locked to prevent the profits from passing through them.
Locking the outer gate via entity-level exemptions
There are five entity-level exemptions, only one of which has to be met, to lock the outer gate and provide a complete exclusion from a CFC charge. In general terms, subject to specific anti-avoidance provisions, the exemptions are as follows:
- Low Profit Exemption; where annualised total taxable profits or accounting profits are less than £500,000 (of which less than £50,000 represents non-trading income).
- Low Profits Margin Exemption; this applies if the CFC accounting profits are no more than 10% of relevant operating expenditure. The relevant terms are defined in the legislation, with certain costs being specifically excluded from the calculation.
- Excluded Territories Exemption; this may be relevant where a company is resident and carries on business in an excluded territory (as specified in the regulations) and meets certain conditions. The regulations are simplified for certain low risk territories (Australia, Canada, France, Germany, Japan and the USA).
- Tax Exemption; whereby if the CFC is resident in a high tax territory, it will be exempt if the local tax amount is at least 75% of the corresponding UK tax that would be charged in respect of the CFC’s total profits for the accounting period (certain restrictions apply in relation to the calculations).
- Temporary Period of Exemption; which provides a 12 month temporary exemption in respect of acquisitions and reorganisations (providing certain conditions are met)
Standing at the inner gates
Where none of the entity exemptions apply, it is necessary to proceed to the inner gates. The gates that need to be considered will depend on the nature of the CFC profits, and are classified as follows:
- Chapter 4: General Profits
- Chapters 5 and 9: Non-trade financial profits
- Chapter 6: Trading financial profits
- Chapter 7: Captive Insurance profits
- Chapter 8: Solo consolidation waivers
To determine if any of the Chapter 4 to 8 internal gates are passed through, the conditions and requirements laid out in Chapter 3 should be considered. The difficulty here is that these are to some extent subjective in nature, and the outcome will not always be clear.
However, for companies that have general profits within the Chapter 4 gateway (most trading companies), there are various ‘safe harbour’ provisions, and an initial approach would be consider these ahead of the more subjective Chapter 3 tests.
The Chapter 4 safe harbour provisions offer a full exclusion from a CFC charge provided all five conditions can be satisfied in order to confirm that there is not a significant UK connection.
These conditions can be briefly summarised as follows:
- The business premises condition; this condition requires the CFC to have a physical presence in its territory of residence, and to have premises which it uses with a reasonable degree of permanence for the carrying on of its activities.
- The income condition; this condition limits the extent to which income can arise from the UK. The condition is met if no more than 20% of CFCs relevant trading income derives directly or indirectly from the UK.
- The management expenditure condition; this condition assesses the extent to which management of the CFCs business takes place from the UK, and restricts the UK related management expenditure to no more than 20% of the total expenditure that relates management activity.
- The IP condition; this condition concerns the extent to which Intellectual Property (“IP”) is transferred from related parties in the UK, and provides a rule of thumb that no more than 10% of the CFCs profits can derive from such transfers of IP.
- The export of goods condition; this condition is designed to limit the extent to which the CFCs income can arises from UK exports, and restricts this to no more than 20% of the total trading income (however, goods which are exported from the UK into the CFCs territory of residence are disregarded).
If the safe harbour provisions cannot be applied, it would usually be worthwhile making a clearance application to HMRC to confirm their view on the conditions and requirements laid out in Chapter 3. This is likely to be preferable to undertaking the detailed and subjective assessment that applies when profits of the CFC pass through the inner gates.
Passing through the inner gates
If a company has reached this stage, and cannot lock the inner gates, the profits of the CFC will need to be carefully assessed. A CFC charge can only arise to the extent that the profits of the CFC that pass through the inner gates are classified as ‘chargeable profits’.
Making this assessment will require carrying out a functional and factual analysis of each CFC’s activities, and considering this against the specific measures included within each gateway test.
For instance, both Chapter 4 and 5 require identification of the location of the Significant People Functions (SPFs) in relation to the management of the assets and risks of the CFC.
For some groups, it may be that it is judged that there are no chargeable profits or, for companies with non-trading profits, that it is possible to claim a partial or full exemption. Where there is material doubt or difficulty in making this assessment, it is possible to submit a clearance letter to HMRC to obtain certainty of position.
CFC analysis and reporting
As highlighted all CFCs must now be separately tested against the various exemptions, safe harbours and gateway provisions. This will require obtaining a variety of information about each CFC so that the appropriate analysis can be carried out, and documentation drawn up, to support the conclusions that are reached.
This analysis will be important for the completion of the UK tax return, and the CFC supplementary pages (CT600B) of the corporation tax return will need to be completed unless a CFC satisfies the Tax Exemption, the Excluded Territories Exemption or the Low Profit Margin Exemption.
Please contact your usual Menzies tax team representative or e-mail email@example.com