On December 9 2008, the UK Treasury published 48 pages of draft legislation on taxation of the foreign profits of companies, including 25 pages on the so-called 'interest cap' together with 76 pages of guidance.

The UK package comprises five main elements:

• a long awaited and much welcomed dividend or distribution exemption encompassing both foreign and domestic dividends or distributions.

• a proposed 'interest cap' regime to accompany the new dividends or distribution exemption

This, at a high level, compares tax-based intra-group finance expense evaluated on a company by company basis then aggregated, with a worldwide consolidated net finance expense, but in both cases excluding external finance expense payable by companies in charge to UK corporation tax. Insofar as the aggregated tax based intra-group finance expenses are more than the worldwide consolidated accounts net finance expense (in either case excluding external finance expense of UK taxable companies), there is a gross disallowance. There is then a system of compensating adjustments whereby UK taxable companies in receipt of intra-group financing income can exclude that intra-group financing income from UK corporation tax, up to the amount of the gross disallowance.

• A proposal for an extension of the paragraph 13, schedule 9 Finance Act 1996 "loans for unallowable purposes rule" to introduce a group version thereof when the basic anti-avoidance provision does not apply.

• Consequential amendments to the UK controlled foreign companies (CFC) regime, to abolish acceptable distribution policy (ADP) dividends with effect from commencement of the new dividend exemption regime and to prospectively (over a two year transitional period) abolish all the CFC exempt holding company regimes, that is, local holding companies, so called 'international holding companies' and superior holding companies.

• The long awaited and much welcomed abolition of the Treasury Consent provisions, but with a proposal for a replacement by a quarterly retrospective reporting requirement for transactions or events as designated with a value of more than £100 million ($139 million).

This article will focus on the proposed new dividend or distribution exemption, and the attendant interest cap rules and will not deal with the revised CFC regime, or "Super Paragraph 13" or the repeal of the Treasury Consent provisions and the substitution of a new quarterly reporting requirement.

The proposed dividend or distribution exemption

This is structured as a series of five alternative exemptions from a newly introduced charge in the Corporation Tax Act 2009 bill, that charge covering all dividends or distributions which are not part of a schedule D case 1 trading computation or a UK property business computation.

Only large or medium-sized companies qualify, that is, small companies do not. This would appear to raise EC treaty issues. Access to one or more of the five exemptions is nonetheless subject to possible exclusion by falling foul of one of five prescribed anti-avoidance provisions.

There is also a blanket prohibition from accessing the dividend or distribution exemption if the dividend or distribution is deductible in another jurisdiction.

The five categories of exemption are:

• where the recipient controls the payer;

• where there is a distribution in respect of non-redeemable ordinary shares;

• a portfolio holding version of the distribution exemption, defined as where the holding comprises 10% or less of the issue share capital of the payer and where the holder is also entitled to 10% or less of the profits and 10% or less of the assets on a winding up;

• there is then a free-standing motive test, that is, if the taxpayer passes the motive test, then, subject to falling foul of one of the five prescribed anti-avoidance provisions, the dividend or distribution exemption is accessible;

• there is an exemption for dividends in respect of shares accountable as liabilities.

The five prescribed anti-avoidance situations are:

• where the distribution is made as part of a scheme, the main purpose or one of the main purposes of which is to obtain a tax advantage other than a negligible tax advantage and either the scheme involves quasi-preference shares; or

• there is a payment for the distribution by the recipient or any person connected with the recipient; or

• there is a scheme involving payments not on arm's-length terms, which are not within the ambit of the Schedule 28AA ICTA1988 transfer pricing provisions, or

• as regards the control exemption, any of the profits available for distribution at the time the dividend was paid arose at a time when the recipient did not control the payer; or

• there is a scheme involving distributions forming part of an arrangement providing for an interest-like return for the recipient, taken together with any connected person.

Interest cap

The proposed interest cap provisions are much lengthier and more complex. As noted above, the cornerstone of the interest cap proposal is a comparison of an aggregated tax based tested amount defined basically as the gross intra-group finance expense of each relevant company in charge to UK corporation tax in a 75% group relief group, as compared with the net International Accounting Standards (IAS) consolidated accounts based finance expense in the consolidated accounts of the worldwide group of which the UK tested amount companies form part. In the case of the tested amounts and the worldwide consolidated group accounts based available amount, external interest paid by tested companies is excluded from both the tested amounts and the available amount, provided an anti-avoidance provision (paragraph 22 of Schedule 2) does not apply.

There are a number of fairly major issues with the proposal. First, the comparison of gross intra-group finance expense in the tested amount, without any recognition of external interest receivable by UK tested companies, introduces an inherent imbalance between the tested amounts and the available amount, which is net of such external financing, received by tested companies in charge to UK corporation tax.

Secondly, the tested amounts are on a Taxes Act and tax computation basis, whereas the available amount is on an IAS consolidated accounts basis. Clearly, this will introduce further imbalances where, for example, as a result of the revised late paid interest rules, relief for interest accrued is deferred until cash paid. This suggests, at the very least, the need for carry forward of the relevant available amounts, such as is available in broad terms in the US earnings stripping regime, and the German 30% of earnings before interest, taxes, depreciation and amortisation (EBITDA) interest cap regime.

Thirdly, the requirement for the available amount to be computed by reference to IAS could be burdensome for many groups who do not adopt IAS in their worldwide consolidated accounts, for example, US and Japanese groups, and unlisted UK groups. Happily, the Treasury and HM Revenue & Customs have indicated that they are receptive to something along the lines of a list of approved equivalent GAAPs, perhaps similar to the December 12 2008 notice issued by the European Commission, in which US, Japanese, Chinese, Indian and South Korean GAAPs were accepted by the Commission as equivalent to IAS.

Fourthly, the proposals do not necessarily (or indeed usually do not) give an arm's-length outcome. They are mechanistic, as indeed are the US earnings stripping and German 30% of EBITDA interest cap regimes. Accordingly, notwithstanding the foreign precedents, many businesses and corporate bodies are apprehensive of embracing a new regime which does not give rise to an arm's-length result. This could be particularly relevant in the case of outbound competent authority requests by UK taxpayers suffering disallowances under the new regime. Article 9 of the OECD Model Tax Treaty, in its second paragraph requiring member states to use best endeavours to procure a corresponding adjustment via a mutual agreement procedure, provides that transactions between associated enterprises not at arm's length should give rise to corresponding adjustments, attainable via the competent authority process where possible. Within the EU, if the competent authority process does not produce an agreed result, taxpayers have access to the arbitration convention. A key question is what response HMRC will give to inbound competent authority claims consequent upon one or more disallowances under the new interest cap regime?

Fifthly, the regime involves a considerable annual compliance burden, in that tested amounts must be computed company by company as regards companies in charge to UK corporation tax in a 75% UK group relief relationship, and after comparison with the worldwide consolidated IAS-based available amount, any gross disallowance may then be allocated against intra-group finance income whether received from related UK or overseas companies, but only up to the amount of the gross disallowance. Annual returns are required for both the gross disallowance and the allocation thereof to UK taxable intra-group finance income. This is a considerable annual burden to lay alongside the saving afforded (apart from small companies) by not having to do underlying double tax relief calculations in years when foreign dividends were brought up to the UK.

HMRC have started consulting on a number of 'gateway tests', intended to screen out of the full rigour of the legislation groups that are (in the author's phraseology) self evidently not within the twin policy objectives of the legislation viz prohibition of excessive leverage in the UK subgroups of inbound groups, and upstream lending from foreign subsidiaries to the UK.

Any permissible relief via the gateway tests from the annual compliance burden would of course be welcome. However, to avoid EC Treaty issues, it is understood that the gateway tests have to be a surrogate for the legislation. Every effort should nonetheless be made to make these gateway tests as simple and widely encompassing as possible.

Take the simple example of, say, an entirely UK domestic group which has raised third-party finance through a finance subsidiary, say, a listed bond issued by a special purpose PLC. These funds are then on-lent to a sister trading subsidiary of the UK group holding company. The effect of the legislation now is to shift the loan relationship (trading) debits on the onloan of the external finance from the trading company to the finance company, where they are unlikely to attract future tax relief, as carried forward non-trade debits or deficits. This is also of particular concern to PFI companies. Nor is it clear which of the gateway tests (inbound or outbound) as proposed such entirely domestic groups would access. This is however understood to be being addressed.

What other countries do

The vast majority of other OECD countries either have or are also introducing a foreign dividend exemption; Japan is an example of a jurisdiction in the process of doing so. The big exception, is of course the US, apart from the 5.5% entry effective tax rate back in 2005/2006 for repatriation of foreign profits. The list of European countries with a dividend or at least a 95% dividend exemption encompasses Austria, Belgium, France, Germany, Italy, Luxembourg, The Netherlands, Portugal, Spain and Sweden.

The countries with a regime with a similar policy objective or objectives to the UK's interest cap proposals are far fewer, the main examples being France, Germany, Italy, Sweden and the US. The French 1989 Charasse rule, modified in subsequent years, for example, to encompass legal mergers, is basically an anti-churning rule, preventing the deduction for French corporation tax purposes of interest on loans for intra-group transfers of assets including subsidiaries into a French tax group.

The Swedish anti-debt pushdown rules effective from January 1 2009 are somewhat similar to the French rules, but do allow commercial justification of an intra-group loan related to an intra-group acquisition.

The German and Italian rules are broadly similar to each other, capping deductible interest at 30% of EBITDA. As noted above, however, they do (as do the US earnings stripping rules- see below) allow for carry forward of disallowances, something which the proposed UK rules do not.

The US earnings stripping rules, which the Obama administration may well tighten, have a safe harbour of 1.5 to 1 for debt to equity. From a UK perspective, this could broadly be equated to a gateway test. The rule for disallowance is however by reference to 50% of "adjusted taxable income", rather than 30% of EBITDA, as for Germany and Italy. In addition, the US earnings stripping regime allows a carry forward not only of intra-company or affiliate guaranteed third-party interest in excess of the 50% of adjusted taxable income threshold, but also of excess 'limitation', where in a particular year the US subsidiary or sub-group of the US inbound group does not suffer an earnings stripping disallowance. Again, no carry forward of "available amount" is currently envisaged in the UK interest cap regime.

Welcome for exemption

Clearly the proposed dividend/distribution exemption is to be welcomed and the draft legislation seems a workmanlike document which should, overall, achieve the desired results. However, the debt cap proposals, once one gets past the issue of not wishing to have any non arm's-length additional interest deductibility test in an ideal world, require a bit more heavy lifting before, within EC treaty and OECD model based bilateral treaty constraints, they can be regarded as narrowing down after the gateway tests, to catch only those policy situations understood to be excessive leverage and upstream loans.

Peter Cussons (peter.cussons@uk.pwc.com) is a partner of PricewaterhouseCoopers in the UK