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UNITED KINGDOM
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CORPORATE TAXATION FOR MULTINATIONALS
FOREIGN PROFITS AND CFC REFORMS
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UK Corporate Taxation for Multinationals


Corporate Taxation for Resident Multinationals

If a multinational corporation (meaning, a company with subsidiaries or affiliates in more than just one or two countries) needs to be based in a high-tax country, for instance because it must have a listing on a major stock exchange, then the UK is often a good choice. As a member state of the EU, the UK is within the EU parent-subsidiary directive, and in addition the UK has a very broad network of double tax treaties, so that it is well-placed to receive dividend income with the lowest possible amount of foreign tax deduction.

However, this advantage has been somewhat compromised by measures in successive Finance Acts to limit international tax planning by multinationals.

Firstly, the UK's Controlled Foreign Company rules have been tightened to the point at which only marginal benefits can be obtained by locating a subsidiary in a low-tax jurisdiction. In addition, enabling legislation in the 2002 Finance Act allowed the British government to alter the tax treatment of controlled foreign companies in jurisdictions which were considered to allow 'harmful tax practices'.

Secondly, the use of tax 'mixing' intermediate companies in such jurisdictions as Holland and Denmark was severely pruned back by the Finance Act 2000. Whereas it used to be possible to use, say, a Dutch holding company to mix dividends from foreign subsidiaries taxed at say 10% and 50% to achieve a blended rate of 30%, thus ensuring that only a very small amount of UK corporation tax would be payable, the rules were changed.

One improvement that should be noted, however, was the abolition of the ACT (Advance Corporation Tax) withholding tax in 1998: although corporation tax is now payable earlier than before, the problem of excess ACT has disappeared.

Dividends to both resident and non-resident shareholders are paid without deduction of withholding tax.

Another improvement, contained in the 2001 budget, was the abolition of withholding tax on interest and royalty payments to companies subject to UK corporation tax.

Gordon Brown announced the extension of the abolition of withholding tax on international bonds and intra-UK payments of interest and royalties, to include non-bank entities, such as venture capital companies.

While this announcement was welcomed by British industry, there was disappointment that the change was not more far-reaching. The Chartered Institute of Taxation made the following suggestion for further reform:

"We are disappointed that this will only apply where the recipient company is within the charge to UK corporation tax. Gross rental income may be received by non-resident landlords who have undertaken to comply with UK tax obligations, and we would suggest that consideration be given to the introduction of such a scheme for the receipt of interest and royalty payments by those outside the charge to UK corporation tax."

Some further improvements to the withholding tax regime were included in the 2002 Finance Act

As a result of the accumulation of negative measures imposed by the Treasury, it was reported in December, 2004, that leading tax advisers and accountancy firms such as PricewaterhouseCoopers and KPMG were advising their international clients to avoid establishing operations in the United Kingdom.

One favourable development for existing UK-based multinationals was (and is) the gung-ho attitude of the European Court of Justice, which is rapidly tearing down national fiscal barriers inside the EU. In 2002 it ruled against fiscal exit penalties on corporate relocation.

In a preliminary hearing of the Conseil d'Etat v de Lasteyrie du Saillant case, the ECJ's Advocate General decided that the French government had violated the freedom of establishment provisions contained within EU law by levying a punitive residential exit tax on an individual who wanted to transfer his tax residence out of France.

Several of the EU's member countries impose company emigration exit charges. They include the UK, France, Germany, Italy and Spain. The huge tax penalties act as a deterrent on companies wanting to relocate to other member states where running costs are less.

Tax charges vary from country to country, but most countries, including the UK, levy a penalty of about 30% of the value of a company's capital assets. Individuals must often pay up to 40%. These have, however, come under attack from the European Commission, which considers such taxes in breach of EU freedom of establishment laws.

The ECJ has ruled against national governments in a number of cases involving freedom of establishment, and in August 2003 the English High Court followed ECJ precedents in a test case brought by Deutsche Morgan Grenfell, concerning EU 'freedom of establishment' and anti-discrimination laws.

Mr Justice Park's decision in the High Court was the conclusion of a case first initiated when 50 companies submitted a group claim in the English courts as the result of an European Court of Justice precedent which ruled that the British government had illegally imposed advance corporation tax.

Under the rules which applied until the 2001 and 2002 reforms of corporation tax, UK subsidiaries of European firms were wrongly made to pay tax on dividends repatriated to their continental parent companies.

Although tax law in this area has since changed (as mentioned above), the UK investment banking arm of the German bank was attempting to establish how far claims of wrongly paid tax can be backdated.

The Inland Revenue (now HMRC) argued that the claims are restricted to a six year period by the 1980 Limitation Act. However, Justice Parks ruled otherwise, announcing that such claims were not time-barred by the 1980 Act.

However, he added that: "This is not a result which I reach with much enthusiasm."

A further blow for national treasuries came in September 2004 when the ECJ ruled that the Netherlands' domestic tax law on 'exempt participations' was discriminatory and as a consequence, unlawful.

The ruling related to a case involving Bosal Holdings, a Dutch manufacturer of car exhausts which acquired a number of European firms during the 1990s, and was prevented from claiming tax relief for interest paid on borrowings financing subsidiaries which did not generate income taxable in Holland.

The ECJ found that this breached Bosal's fundamental 'freedom of establishment' rights, laid down in the founding Treaty of Rome, and therefore upheld its claim against the Dutch government.

The ECJ decision was expected to benefit many firms elsewhere in the union which had similar claims pending against national governments.

One such company was UK retail firm Marks and Spencer. M&S argued that under Article 43 of the European Union Treaty, it should be allowed to offset losses of around 160 million euros made by its French, Belgian, and German subsidiaries between 1997 and 2001 against UK profits, claiming a tax refund of GBP30 million.

In March 2005 came the initial result of the much-followed Marks and Spencer case, in which Advocate General Mr Poiares Maduro agreed with the company. European Union finance ministers however vowed to find a "defence mechanism" to counter the likelihood of tax revenue shortfalls should the British retailer ultimately be successful in its legal bid to offset losses made by foreign subsidiaries against tax.

The issue formed one of the main talking points during an Ecofin meeting of EU finance ministers. "There is great concern about this," remarked Jeannot Krecke, Economy Minister of Luxembourg, which was holder of the rotating EU presidency at that time.

The Advocate General's opinion was supported later that year by the full ECJ.

With regard to CFCs, further changes were brought forward in the 2005 budget. The 2005 Controlled Foreign Companies (Excluded Countries) (Amendment) Regulations aimed to prevent CFCs from manipulating their profit location in order to evade taxes, to stop them from secreting income in non-corporate entities, and to exclude them from receiving the benefits of the CFC regime if they are not liable for tax in another country. The measures came into full force on March 31st.

A spokesman for the Inland Revenue (as HM Revenue & Customs was known at the time) explained that: "All of the changes made are a reaction to schemes including some that were identified via the disclosure rules. The government could not have allowed significant amounts of tax to remain at risk."

In February 2006 HM Revenue and Customs won an important legal battle when the House of Lords ruled that companies which claimed a tax credit on a dividend paid to a foreign parent cannot claim a refund of advanced corporation tax.

The group litigation was brought by more than 60 companies and led by Pirelli, the Italian tyre manufacturer, which claimed that the obligation to pay advance corporation tax (ACT) in the UK on dividends it paid to its Dutch parent was in breach of European Union law concerning taxes levied on dividends.

Although the Dutch parent had received a repayment of 50% of the tax credit attached to the dividend under the tax treaty between the UK and the Netherlands, it claimed that the parent's right to receive the credit was legally separate from any obligation of the subsidiary to pay ACT.

However, in overturning judgments by the High Court and the Court of Appeal, Lord Nicholls, one of the five judges on the panel, said that Pirelli was looking to obtain "the best of both worlds."

In February, 2006, the ECJ seemed set to confirm the House of Lords ruling, when Advocate General Leendert Geelhoed stated that whilst the UK tax authorities were required to treat non-UK firms fairly, there was no pre-requisite for equal treatment.

Consequently the UK was entitled to enter into different tax treaties with different countries and did not need to offer the same benefits to everyone. In his opinion, Mr Geelhoed noted that this was an area where "predictability and legal certainty are crucially important, so that Member States can plan their budgets and design their corporate tax systems on the basis of relatively reliable revenue predictions.

Following up on the M & S case, the United Kingdom government announced in February, 2006, that it would introduce legislation in the Finance Bill 2006 to amend the UK loss relief rules.

According to the UK government, the ECJ considered that the country's group loss relief rules are in principle compatible with European law, meaning that the system of group relief can be kept broadly as it is now, although the Court also held that, in some very limited circumstances, relief should be available in the UK for the otherwise unrelievable losses of some group companies resident in other States.

However, the government fears that groups with loss-making companies resident in another state could "engineer" their circumstances so as to preclude the possibility of a loss making company obtaining relief in its state of residence by, for example, liquidating that company whilst transferring its business to another company.

In response, the government introduced legislation to deny loss relief where there are arrangements which either: result in losses becoming unrelievable outside the UK that were otherwise relievable, or; give rise to unrelievable losses which would not have arisen but for the availability of relief in the UK, if the main purpose or one of the main purposes of those arrangements is to obtain UK relief.

The legislation was to be effective from Monday, February 20 of that year.

Then in April, 2006, the European Court of Justice Advocate General, Leendert Adrie Geelhoed, gave an opinion in favour of four UK companies who had claimed that corporation tax charged on dividends received from EU subsidiaries was illegal under EU free movement of capital rules.Between 1973 and 1999, when the UK scrapped its Advanced Corporation Tax system, which allowed UK companies to pay up dividends domestically at a favourable rate, dividends from non-UK EU subsidiaries of UK companies were charged at higher rates.

Although the four companies in the case, British American Tobacco, British Petroleum, Aegis Group and Imperial Chemical Industries, were claiming refunds of 'only' some hundreds of millions of pounds, the UK government warned during court proceedings that the total cost of an adverse ruling might be as high GBP7 billion if many companies applied for refunds, and that the ECJ should therefore reject the companies' case on the grounds that the UK's financial stability could be affected.

Mr. Geelhoed denied this reasoning.

In December 2006, the European Court of Justice followed his opinion, and ruled that ACT operated illegally between 1973, when the UK acceded to the EU, and 1999, giving rise to the prospect of substantial rebates to companies which have paid this tax in the past.

The Treasury warned that such a ruling could leave it open to repay claims totalling GBP9 billion, although draft blocking legislation which would limit a company's claims to six years would reduce this to about GBP2 billion, the government has estimated.

“In principle, today’s decision is good news for companies hoping for an ACT rebate. However, they are unlikely to receive anything until the UK and European courts reach a decision as to the legal status of the blocking legislation – a process that is likely to take some time," observed Jonathan Bridges of KPMG’s EU law group at the time.

The Court referred the matter back to the UK courts to determine whether the UK rules operate to achieve this parity.

“It is disappointing that the ECJ has stopped short of ruling that the UK should apply the same rules to both UK and foreign sourced dividends," Bridges noted.

He continued: “Achieving equality of treatment via a credit system may, on the face of it, sound reasonable but it is not straightforward."

"The ECJ’s ruling today fails to fully appreciate the fact that not all profits in the UK are taxed at the corporate tax rate of 30%. For example those deriving from share sales are completely exempt."

Bridges concluded:

"What today’s ruling does is potentially introduce yet another layer of complexity into the UK’s already overly cumbersome corporate tax system.”

In 2007, the UK Finance Bill implemented changes to the Controlled Foreign Company regime made in response to the previous year's high-profile Cadbury-Schweppes decision by the European Court of Justice.

Although CFCs were not mentioned in the Chancellor's March Budget speech, the Treasury released a detailed response to the ECJ's decision, which commentators said represented the minimum that the Government could have done to comply with Cadbury.

The new provisions restricted the application of CFC rules to profits arising from the activities of employees but not of capital, meaning that they will only become significant in respect of trading operations in a 'low-tax' EU or EEA territory. The ECJ did not make such a distinction. To the disappointment of many tax advisers, the Treasury did not provide for an advance clearance mechanism for the CFC regime. In addition, the Treasury stiffened the effective management test, making it more difficult for EEA-based companies to satisfy the Exempt Activities exemption.

Then in July 2008, it emerged that Vodafone had won a key legal battle against the UK tax authority in a judgment that cast major doubt on the compatibility of the UK's controlled foreign companies (CFC) regime with European Union law.

Mr Justice Edward Evans-Lombe ruled in the High Court on 4th July that Vodafone does not have to pay UK corporation tax on income attributed to its Luxembourg holding company Vodafone Investments Luxembourg Sarl (VIL). Consequently, he ordered HMRC to shut an ongoing tax inquiry into Vodafone's tax for the year to March 2001.

Vodafone estimated that the court victory has saved it more than GBP2bn (USD4bn) in tax and interest that it might have been ordered to pay had the judgment gone against the company.

However, the ruling also had ramifications that go much wider than Vodafone's corporate arrangements, and several UK-based multinationals with subsidiaries in favourable EU tax jurisdictions such as Ireland, Luxembourg and the Netherlands, who are said to be under a similar type of scrutiny from HMRC, are likely to be breathing a sigh of relief as a result.

The case dates back to 2002 after Vodafone set up VIL to dispose of its shares in the German telecommunications group Mannesman, which it acquired in 2000. VIL is also used to circulate cash and profits around the group and as a vehicle to fund other acquisitions.

HMRC argued that under the UK CFC rules, it had the right to tax the difference between rate a subsidiary pays in a low tax jurisdiction overseas and the rate it would have paid on that income in the UK - a principle that it attempted to apply in the Vodafone case.

However, Justice Evans-Lombe referred back to a precedent set in 2006 by the European Court of Justice (ECJ) in the case involving Cadbury-Scweppes, which said that the UK CFC rules were incompatible with EU law because they were too restrictive and should only be applied in cases where companies set up artificial arrangements aimed solely at avoiding tax.

While the UK Treasury moved to amend CFC regulations in the wake of the Cadbury-Schweppes ruling, Justice Evans-Lombe argued that these amendments had not gone far enough to address their incompatibility with EU law, and he urged the government to revisit the legislation.

"In my judgement, the CFC legislation must be disapplied so that, pending amending legislation or executive action, no charge can be imposed on a company such as Vodafone under the CFC legislation," he said, going on to add that:

"It seems to me that all UK taxpayers, including Vodafone, were and are entitled to be told by legislation, of which the meaning is plain, what the tax consequences for them will be if they decide to incorporate a controlled foreign company in a (EU) member state."

The UK government was in the process of reviewing its stance on the taxation of multinationals' international income at the time of the July ruling, but tax experts said that the latest judgment had thrown the situation into chaos, and may have left the UK with a completely unenforceable set of CFC legislation.

“The High Court has expressed ‘some doubt’ as to the efficacy of sticking plaster amendments introduced in 2006,” Mark Persoff of Clifford Chance, the legal firm was quoted as saying by the Financial Times. “This means, as matters now stand, the UK probably has no enforceable CFC legislation so far as EU/EEA subsidiaries are concerned.”

Peter Cussons, a tax partner at PriceWaterhouseCoopers, described the ruling as a "blockbuster judgement."

"This is big news because there are thousands of UK companies with foreign subsidiaries in the European Union," he told the Telegraph. "There will have been CFC tax paid over the years, hundreds of millions of pounds per annum, and potentially, upon claims being made, all that tax is up for grabs," he added.

Vodafone suffered a court setback in May 2009 in its bid to avoid the UK back tax bill in relation to VIL when the Court of Appeal ruling overturned the 2008 decision by the High Court that Vodafone does not have to pay UK corporation tax on income attributed to its Luxembourg holding company.

The Court of Appeal decided that the UK’s CFC law should be interpreted as if it had a new exception for companies established in the European Economic Area (EEA) which carry on ‘genuine economic activities’ there. This means that the CFC rules will still apply to companies operating outside the EEA and also to EEA companies without genuine economic activities.

The decision meant that HM Revenue and Customs could reopen its inquiry into Vodafone’s tax arrangements for the year to March 2001.

The UK Supreme Court, which replaced the House of Lords as the country's highest court in 2009, refused to hear the company's appeal fo the Court of Appeal ruling.

According to law firm McGrigors, the Supreme Court's decision to throw out the case was unexpected, as most tax specialists had anticipated that, given the potential ramifications of the case, the Supreme Court would review the matter.

“This shows that the Supreme Court will not hear cases simply because of the amounts at stake," observed Rupert Shiers, a partner at McGrigors.

Shiers added that Vodafone had won a "convincing" victory in the High Court in 2008 and can be "entitled to be surprised and very disappointed not to be allowed their day in court”.

“HMRC will see this as a major victory," he noted. "They were shocked to hear people arguing that once the ECJ intervenes to say that a piece of legislation is not quite right, the whole legislation is poisoned and it simply falls away. The courts have now said very clearly that you should just cut out the infection and leave the healthy parts intact.”

Foreign Profits And CFC Reforms

The Finance Act 2009 foreign profits package was expected to be implemented during 2009 and included:

  • A dividend exemption for most foreign dividends irrespective of the level of shareholding
  • Interest cap, a comparison of a UK tax group’s gross intra-group finance expense with the global group’s net finance expense after excluding gross external finance expense of the UK tax group, with some corresponding UK taxable income exclusions.
  • Super para 13 looks to whether any group company, and not just the borrower, is part of arrangements whereby there are increased debits or reduced credits, and is currently very wide reaching.
  • Controlled company regime to be modified to remove the ADP exemption and holding company tests, with a further review after Budget 2009.
  • Treasury consent to be repealed and replaced by a retrospective quarterly reporting requirement.

In May 2009, Stephen Timms, Financial Secretary to the Treasury, announced that the government had amended its proposed changes to the taxation of foreign profits in an effort to simplify the legislation.

A letter circulated by Timms on April 30 explained that changes to the debt cap element of the reforms would be inserted into the 2009 Finance Bill, which was published on the same day, following discussions with business.

“The legislation in the bill has been subject to extensive consultation over the past year, and we have worked to ensure the responses are accommodated, where possible, and the bill is as complete as it can be,” Timms wrote.

In its original form, Clause 34 and Schedule 14 of the 2009 Finance Bill determine the scope of the corporation tax charge on both UK and foreign company distributions. According to the relevant Budget Note, the result of the reforms, due for introduction on July 1, 2009, will be that the great majority of distributions will be exempt from corporation tax. The Schedule also contains anti-avoidance rules to prevent abuse of distribution exemption.

Clause 35 and Schedule 15 of the Finance Bill make provision for the restriction of the tax deduction available for finance expenses of groups of companies (the 'debt cap'). The effect of the new measure is to limit the aggregate UK tax deduction for the UK members of a group of companies that have net finance expenses to the consolidated gross finance expense of that group.

Timms stated, however, that “a couple of areas” of the proposed reforms “have given rise to significant comment.” These include the exclusion for financial services and the targeted anti-avoidance rule. “We plan further discussions (on these two aspects of the reforms) before the final legislation is published,” Timms explained.

“There are also points of detail relating mainly to further exclusions and interaction with other parts of the tax code that have not yet been reflected in the Bill because of time constraints,” Timms continued. “Proposed amendments to be made during the passage of the bill for these straightforward areas will also be published on HMRC’s website.”

The areas concerned include:

  • Rules allowing groups to state they are satisfied that their tested expense amount, if calculated, would be less than their available amount for any particular period of account of the worldwide group.
  • The definition of the available amount will be amended to include capitalized interest.
  • The calculation of the UK measure and worldwide measure – providing a method whereby the comparison is made using the functional currency rather than sterling.
  • Provision will be made to cater for exempt financing income received by charities, non-departmental public bodies, educational establishments, local authorities and health service bodies.
  • Where a company brings into account a loan relationship debit on a paid basis, rules to disregard any amounts accrued but unpaid for periods of accounts of the worldwide group before the debt cap applies.
  • A consequential amendment to Schedule 28AA to make clear that this Schedule applies before the debt cap to any amount of financing expense of financing income.
  • A consequential amendment to ensure that profits of a controlled foreign corporation apportioned to a UK group company are not doubly taxed in respect of any finance expense amount payable to that CFC.

In Janaury 2010, The UK government published a discussion document on proposals for reforming the UK tax treatment of CFCs.

The proposals set out in the discussion document are intended to enhance the competitiveness of the UK, while providing adequate protection of the UK tax base. The discussion document sets out the overarching framework of the new rules and proposals for how monetary assets and intellectual property could be treated.

The reforms aim to address growing concern from business that the UK's CFC rules are too complex and reverse a steady flow of companies shifting their tax bases to jurisdictions considered to have more business-friendly tax regimes such as Ireland, Luxembourg and Switzerland.

In an attempt to achieve this, the discussion document sets out proposals for a more targeted CFC regime to catch profits being artificially diverted to low-tax jurisdictions, rather than a "one size fits all" approach.

The discussion document also outlines possible approaches to reform the treatment of intellectual property with the aim of more effectively targeting situations "where there is a risk of erosion of the UK tax base."

The current CFC rules generally target income from IP on the grounds that it is passive income from a mobile asset. The government is therefore concerned that there is a risk that UK tax can be avoided through the artificial movement of intellectual property (IP) into a low tax jurisdiction. Business, however, has emphasized that many offshore IP companies undertake genuine and effective management activity with the aim of maintaining or increasing the value of their IP, and that a new CFC regime should reflect the extent to which active management of IP takes place offshore.

One proposal for a new regime would be to identify companies that carry on sufficient IP management activity offshore and to exempt these companies from the CFC rules. However, the paper also suggests that an additional tax charge be applied in certain circumstances, for example where IP is transferred out of the UK before its value can be accurately determined.

The discussion document also highlights the need for the new CFC rules to interact efficiently with current UK transfer pricing rules, and points out that the proposed "patent box" regime announced in last month's pre-budget report, which will offer a reduced rate of corporate tax on patent income, will have a bearing on the reforms.

Financial Secretary to the Treasury Stephen Timms said: “Modernizing these rules is crucially important to maintaining and enhancing the UK’s attractiveness as a base for global business. This report, drawing on our discussions with businesses, is a key step in designing a system that better recognizes the way multinationals operate today, while protecting our tax base.”

This reform is the second part of the foreign profits package. The first part was introduced in Finance Act 2009 and included an exemption for foreign dividends and an interest restriction measure.

The consultation period for this discussion document began on January 26 and ran to April 20, 2010. The government released a further document on the proposals along with draft legislation later in 2010.

The Finance Bill 2011 included interim improvements to the CFC rules, including:

  • an exemption for certain intra group trading transactions;
  • an exemption for CFCs with a main business of intellectual property (IP) exploitation under certain conditions;
  • low profits exemption of GBP200,000 as long as non-trading income does not exceed GBP50,000;
  • a statutory three-year exemption for certain foreign subsidiaries.

Following further consultation, major changes to the CFC rules are expected to be announced in the Finance Bill 2012 and to apply from later in the year. The major points of the changes are:

  • tax exemption of overseas activities as long as the activities are not designed to artificially reduce the UK tax base;
  • partial exemption for finance companies - up to three quarters of finance profits to be exempt;
  • the regime is to apply to foreign branches of UK companies and foreign subsidiaries;
  • capital gains, including property income, will be excluded;
  • low profits exemption of GBP500,000 as long as non-trading income does not exceed GBP50,000;
  • low profit margin exemption if the adjusted accounting profits are below 10%;
  • exemption if the profits are derived in a territory where they will be subject to at least 75% of UK tax.

The government has designed a 'gateway' to assist companies in establishing if the profits from the foreign subsidiary fall outside the scope of the CFC rules. The latest version of the gateway was published on February 29, 2012, and can be found at: http://www.hm-treasury.gov.uk/controlled_foreign_companies.htm.

 

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FOREIGN PROFITS AND CFC REFORMS
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