Budget Notes

BN22 CONTROLLED FOREIGN COMPANIES: ANTI-AVOIDANCE

Who is likely to be affected?

1. UK owned groups of companies with subsidiaries and activities outside the UK, which are participating in any of the avoidance schemes described below.

General description of the measure

2. The purpose of the Controlled Foreign Companies (CFC) legislation is to counter the artificial diversion of profits from the UK so as to avoid UK tax. It taxes those profits that arise to low-taxed foreign companies that are controlled by UK persons and which would have been subject to UK corporation tax as income had they not been artificially diverted from the UK. It does not have effect if the controlled foreign company qualifies for one of five exemptions.

3. Legislation will be introduced in Finance Bill 2008 to block a number of artificial avoidance schemes that rely on the use of a partnership or a trust to escape a CFC charge either by misusing one of the exemptions from the CFC rules or by arranging for profits to be earned in such a way that they purportedly fall outside the scope of the rules.

4. HM Revenue & Customs (HMRC) does not believe that these schemes work but these measures will put the question beyond doubt and close off opportunities for other similar avoidance schemes.

Operative date

5. The changes will have effect on and after 12 March 2008. For changes that are relevant to an accounting period, the measure will provide that, for accounting periods that straddle that date, the accounting period will be split into periods before and from that date with the changes only having effect to the second part of that accounting period.

Current law and proposed revisions

6. To be treated as a CFC, a foreign company must be controlled by UK residents. Section 755D of the Income and Corporation Taxes Act 1988 (ICTA) defines control for the purposes of the CFC rules.

7. In one avoidance scheme, an offshore trust owns more than 50 per cent of the shares in an overseas company. The users of the scheme claim that the company is not controlled by UK residents even though the UK residents who hold the remaining shares retain the right to receive all of the company's profits.

8. This measure will amend the definition of control for CFC purposes so that rights to income and assets will be taken into account in determining whether UK residents control the foreign company.

9. A foreign company is exempt from the CFC rules if it satisfies one of five exemptions. One exemption is the exempt activities test. This exemption is made on the basis that a company that carries on genuine trading activities from a business establishment in the territory in which it is resident overseas can reasonably be assumed not to exist to artificially divert profits from the UK. The test is set out in paragraphs 5 to 12A of Schedule 25 to ICTA. Paragraphs 6, 12 and 12A provide that for holding companies to qualify, a minimum of 90 per cent of their gross income must come, generally by way of dividends, from companies they control that are carrying out exempt activities.

10. In a further avoidance scheme, the users seek to circumvent the test for holding companies by arranging for non-dividend income (usually interest) to accrue in a partnership in which the holding company has a major interest. They claim that this income does not form part of the gross income of the company.

11. This measure will put beyond doubt that the gross income of a CFC includes any income to which it is entitled (including the CFC's share of any partnership income) and any trust income in respect of which the CFC is either settlor or beneficiary.

12. In order to compute the CFC charge, the chargeable profits of the CFC have first to be calculated and those chargeable profits are then apportioned to the UK resident companies with an interest in the CFC. Chargeable profits are computed under section 747(6) of ICTA which broadly applies the rules of corporation tax to the CFC, except that chargeable gains are excluded.

13. An avoidance scheme is designed to ensure that income arises under a trust arrangement in which assets have been settled by the holding company of a CFC. Users of the scheme claim that, for a number of reasons, the chargeable profits of CFCs linked to the trust cannot include income arising in the trust. This measure will ensure that such income will be included in the chargeable profits of the scheme participants for CFC purposes.

14. A CFC may pay a dividend to its UK shareholders under an acceptable distribution policy (ADP) to avoid apportionment of its profits and a charge to UK tax under the CFC rules. This exemption is made on the basis that a dividend received by a UK company is taxable in the UK. But scheme users claim to be able to pay an ADP dividend out of profits other than those that have been diverted within the avoidance schemes.

15. Whether a CFC has arranged for income to accrue in a partnership or to a trustee of a trust in relation to which it is a settlor or beneficiary, the measure will ensure that a dividend can only be paid under an ADP if it is paid out of the diverted profits within the avoidance schemes.

16. Draft legislation has been published today on the HM Revenue & Customs website, together with a draft Explanatory Note.

17. HMRC is aware that a number of businesses (especially in the financial sector) use foreign trusts and special purpose vehicles (SPVs) for wholly commercial purposes. Although the SPV's shares are owned by the foreign trust, in many cases the SPV is nonetheless controlled by UK residents within the meaning of the CFC rules. But, since they exist for wholly commercial purposes, such SPVs are exempt from the CFC rules under the motive test. Where this measure newly brings SPVs that exist for wholly commercial purposes within the scope of the CFC rules, they will similarly be exempt from the rules by virtue of the motive test.

18. Any business, whether in the financial sector or otherwise, that would like the certainty of comfort that the motive test will effect may seek an advance clearance from HMRC. More information about the clearance procedure and how to apply may be found in the HMRC International Manual at: www.hmrc.gov.uk/manuals/intmanual/INTM214120.htm

Further advice

19. If you have any questions about this change, please contact Ian Wright on 020 7147 2701 (email: Ian.Wright1@hmrc.gsi.gov.uk). Information about Budget measures is available on the HM Revenue & Customs website at www.hmrc.gov.uk