UK CFC changes: Extension of transfer pricing principles

Recent examples of the government's changes to the tax regime include the introduction of corporation tax exemptions in relation to: • Most dividends received by UK parent companies from a non-UK subsidiary; and

• The profits of the non-UK permanent establishments of a UK company.

The latest development in this respect is the modernisation of the UK's controlled foreign company (CFC) regime, the draft legislation for which was published in the recent Finance Bill, and is expected to be passed into law later this year.

The UK has had CFC rules since 1984 which, broadly, are designed to ensure that profits cannot be diverted from the UK to a low tax jurisdiction. For multinational enterprises (MNE) that were headquartered in the UK, these rules meant it was difficult for them to establish a subsidiary company in a favourable jurisdiction, which could act as an IP holding company or a finance company for the group. The result was that, in the 2000s, a number of high profile MNEs (such as WPP) migrated their corporate headquarters offshore.

In response to this, the UK's new CFC regime is designed to apply only to profits that have a connection with the business operations of the MNE in the UK. It achieves this by relying on OECD concepts, the practical application of which should be familiar to transfer pricing specialists. The most important of these concepts for the purpose of the new CFC regime is the extension of significant people functions (SPF) in the course of applying the Gateway test originally. It is quite amusing that, in applying SPF concepts, the UK tax authorities were attempting to create a clear set of rules that were intended to facilitate a straight-forward implementation process. From a transfer pricing perspective, SPF concepts are riddled with potential practical complications, not least of which is the challenge of determining the appropriate functional analysis for notional entities.

With the legislation coming on stream we wait to see how aggressively HMRC will apply the legislation and to what extent taxpayers may find it useful to extend aspects of their transfer pricing policies regarding the preparation of a functional analysis to mitigate against potential exposure on this issue.

The CFC regime can potentially apply, in essence, whenever a UK resident company has a 25% or greater interest in a CFC. A CFC is a non-UK resident company that is controlled by a UK resident person or persons. Control, for these purposes, is widely defined.

In determining whether a person (P) controls a CFC (C) you need to consider the following tests:

• Does P have legal control of C, that is, the power to secure that C's affairs are conducted in accordance with P's wishes;

• Does P have economic control of C, that is, it is reasonable to suppose that more than 50% of the proceeds of a sale, winding up of, or distribution by, C would be paid to P?

• Do two persons together have legal or economic control of C and, if so, is one of them UK resident with more than 40% of the legal or economic rights and is the other one non-UK resident with more than 40%, but less than 55%, of those rights? or

• Does P have control of C for accounting purposes?

The scope of the CFC regime is therefore potentially very wide. However, its scope is immediately reduced by a number of entity level exemptions which, if they apply, have the effect of taking a CFC out of the scope of the legislation.

Each of the following five entity level exemptions is complicated in its application and a close analysis of their detailed provisions will be needed to determine if a CFC falls within their scope. However, we have summarised below the essence of when each exemption should apply.

The exempt period exemption applies to allow companies that become CFCs (for example because they have been acquired by a UK entity or their parent company has migrated to the UK) a 12 month grace period. During this period the CFC regime will not apply provided that a restructuring is undertaken to ensure that the CFC charge does not apply after the 12 month period has expired (perhaps because another one of the entity level exemptions apply).

This 12 month period is generally perceived to be unnecessarily short, and an application can be made to HMRC to extend it.

There is a targeted anti-avoidance rule (TAAR) which can operate to disapply this exemption in certain circumstances.

Very broadly, this exemption is intended to exempt CFCs that are resident in jurisdictions with an effective rate of corporation tax that is at least 75% of the UK's prevailing corporation tax rate (which is scheduled to be reduced to 22% for the year 2014 to 2015). A white list of acceptable jurisdictions will be produced, although certain other conditions, designed to prevent tax avoidance, will need to be met before the exemption can apply.

The purpose of this exemption is to exempt a CFC that has profits of £50,000 ($78,000) or less, or profits of £500,000 or less (only £50,000 or less of which is generated from non-trading activities). A TAAR will apply to prevent tax avoidance.

This exemption is designed to exempt a CFC whose profit margin is 10% or less of its operating expenditure.

This exemption should exempt a CFC that pays tax in its local jurisdiction of at least 75% of the amount of tax it would have paid in the UK.

If none of the entity level exemptions apply then you will need to consider the extent to which the profits of the CFC pass through the Gateway.

The Gateway is the construct used in the legislation to try to restrict those profits that fall within the CFC charge to those that have been artificially diverted from the UK. In very broad terms, only profits that have a connection with ongoing activities in, or assets held in, the UK should pass through the Gateway and so potentially be subject to charge.

This "all out, unless brought in" approach is a change to the legislation in place now because the starting assumption is that the profits of a CFC will not be subject to charge, and it is only those profits that pass through the Gateway that fall within the scope of UK tax.

The Gateway is contained in chapters 4 to 8 of the legislation. The legislation draws a distinction between business profits and finance profits, and separates out non-trading finance profits from trading finance profits. For most MNEs (other than banks or insurance companies) chapters 4 (business profits) and 5 (non-trading finance profits) will be most relevant. Chapter 6 (trading finance profits) will be of particular interest to banks and other financial institutions. Chapters 7 and 8, which deal with captive insurance companies and solo consolidation, are of specialist interest only, and so will not be considered further in this note.

Each chapter of the Gateway is unfortunately complicated, and a detailed summary is beyond the scope of this article. Recognition of this in the legislation includes (at chapter 3) a series of simpler tests that are designed to distil the key elements of the Gateway and, if satisfied, can ensure that the profits of the CFC in question will not pass through the Gateway without the need to consider the provisions of the Gateway at all.

In outline, the Gateway applies as follows:

In essence, in applying this chapter you need to identify the assets and risks that are relevant to generating the profits of a CFC and then you must determine the SPFs relevant to the economic ownership of these assets or to the assumption and management of these risks.

To the extent that these SPFs are carried out in the UK then you have to assume that they are carried out by a permanent establishment (PE) of the CFC in the UK (excluding SPFs actually carried on by the CFC through a UK PE) and you then have to determine the profits of the CFC attributable to that PE. The profits attributed to this notional PE (other than profits arising from assets or risks only 50% or less of which are attributable to this notional PE) will, on the face of it, pass through the Gateway, and so fall within the scope of the CFC charge.

The attribution of profits to the notional PE will be potentially quite challenging in practice. A good starting point will be to prepare a traditional transfer pricing functional analysis to properly identify the assets and risks relevant to generating the profits of the CFC. The SPF concept is in line with the revised Commentary on Article 7 (commonly referred to as the business profits article) of the OECD Model Tax Convention on Income and Capital (the Commentary)). Paragraph 2 of Article 7 corresponds to the arm's-length principle and it provides that profits attributable to a PE are the profits "which it might be expected to make if it were a distinct and separate enterprise engaged in the same or similar activities under the same or similar conditions and dealing wholly independently with the enterprise of which it is a permanent establishment". One practical concern is that it is not immediately clear how much weight the Commentary carries with HMRC for the purposes of this new regime as different double tax treaties may have different interpretations or place different emphasis upon certain aspects in the application of the business profits article. An example is the extent to which it is appropriate to attribute debt capital to a PE which, for the UK-USA double tax treaty, is particularly important, with guidance being quite explicit on this point in a way that other UK double tax treaty guidance is not.

As the OECD Commentary acknowledges, the organisation of modern business is highly complex and determining the applicable facts from the documentary evidence is never clear cut. For example, under a traditional transfer pricing analysis between two distinct enterprises, it is almost always possible to examine actual records of accounts and legal contracts to inform the functional analysis process in a way that is not necessarily the case with a notional entity. Consequently this creates a reliance on constructing notional financial and legal documentation although the Commentary provides that this should be based, as far as is practical, on substantive commercial arrangements as they may be deemed to exist between a notional PE and a CFC. The economic weighting for the SPFs may also become quite involved with regards to identifying a hierarchy for key decision making and functions within a potentially complex MNE business model. SPFs are functions that are related to the ability to exercise the assumption of economic risk and extend to functions concerned with the ownership or economic manipulation of assets. It is often difficult in practice to separate out distinct functions within a MNE as decision making matrices are often fluid. Seniority and/or the economic importance of people functions can be useful pointers but these should not be confused with the provision of an advisory or supervisory function, which are not of themselves necessarily SPFs. An example would be decisions or policy making within the exercise of corporate governance arrangements. It can be difficult to establish the various economic rights and obligations between various parts of an MNE, particularly in the absence of any contractual arrangements that explicitly set out how these rights and obligations flow, and by definition this will be the case for notional entities. This is especially challenging where the asset and risk classes are dominated by intangible items. There may be an increased danger that a notional profit attribution may not be viewed in the same way by the taxpayer and HMRC and this may lead to potential re-characterisation of SPFs and consequently the re-allocation of risks and assets.

There are additional specific exclusions that can apply to take profits of a CFC outside the scope of the Gateway. Most important of these is the trading company safe harbour, which should ensure that genuine non-trading profits do not pass through the Gateway. The safe harbour is disapplied by a TAAR in the case of tax avoidance.

This chapter is one of the most important for MNEs that are looking to establish a group finance company in a favourable tax jurisdiction, which can be utilised to fund the MNE's international operations. It needs to be considered together with the finance company exemptions (explained in more detail below).

Again, the key question is whether the profits arise in respect of assets or risks connected to a UK SPF. The chapter will also apply where they are derived from a capital contribution from a UK person, arrangements put in place in lieu of dividends and certain finance leases.

In summary, Chapter 6 only applies to profits arising from free capital, which is funding provided to the CFC in relation to which it is not entitled to a deduction against any of its finance profits.

The finance company exemptions are designed to reduce the effective rate of tax for MNEs on their overseas finance companies. They apply to exempt a proportion of the finance profits of a CFC which arise from its qualifying loan relationships (QLR), provided the CFC has a reasonably permanent business presence in its jurisdiction of residence. The QLRs of a CFC are, very broadly, its loan relationships with connected companies, the debits of which are not taken into account in any other way in determining a liability to UK tax.

A CFC has to claim a finance company exemption for it to apply, and there are two exemptions that can be claimed: a full exemption for profits from certain qualifying resources; and a partial exemption that will exempt 75% of the profits of the finance company (reducing its effective rate of tax to 5.75% (based on the headline corporation tax rate of 22% from 2014).

Qualifying resources for these purposes are, very broadly, resources that are available to the CFC from its own activities only.

The reaction of MNEs, to date, to the new CFC regime appears to one of cautious optimism.

MNEs have two principal concerns with the existing regime: how it applies to their overseas finance companies, and how it applies to their overseas IP holding companies. The government hopes the finance company exemptions will entice MNEs who have migrated to return to the UK. There is also cause for some optimism that it will now be simpler for MNEs to locate their IP holding companies in a favourable jurisdiction without the CFC regime applying, except where such IP has a connection with the UK (including where it was created in the UK). More ambitiously perhaps, there is some scope for arguing that the UK is beginning to position itself as an interesting jurisdiction for MNEs to locate their holding companies more generally.

The principal downside to the legislation is that it is overly complicated. It is hoped that the government will revisit this, to see what simplifications can be made without unacceptably eroding the UK's tax base.

In any event, given the importance of the SPF concept, the application of transfer pricing principles and preparation of transfer pricing type documentation will likely be helpful in determining the appropriate level of exposure that MNEs may have to this new legislation.

Biography
		Batanayi Katongera Olswang Tel: +44 207 067 3360 Email: batanayi.katongera@olswang.com Website: www.olswang.com Batanayi Katongera heads up the Olswang transfer pricing practice and specialises in advising multinational companies on their transfer pricing policies. He has a particular focus on successfully planning and managing transfer pricing controversies for clients and acts for clients across a broad spectrum of industry sectors including financial institutions, private equity firms and media and technology (including life sciences and telecommunications) companies. He works alongside Olswang's international tax team that extends across offices in Germany, Spain, France and Singapore and also supports the corporate team on the transfer pricing aspects of transactional work including management and institutional buy-outs/buy-ins. Katongera's focus on transfer pricing controversy work extends to negotiating advance pricing agreements and advance thin cap agreements which enable clients to obtain greater certainty regarding their transfer pricing policies. More recently this has also involved exploring collaborative mediation between clients and HMRC.

Biography
		Matthew Wentworth-May Olswang Tel: +44 20 7067 3372 Email: matthew.wentworthmay@olswang.com Website: www.olswang.com Matthew Wentworth-May's experience includes advising on M&A transactions, business restructurings, joint ventures, venture capital funds and international tax issues. He is part of Olswang's premier tax litigation team, and advised on the first substantive SDLT case to be heard by the Tax Tribunal. He regularly comments in professional journals on tax matters as well as speaking at external conferences. He is also a regular contributor to the leading UK Supreme Court blog (www.ukscblog.com).