On 30th July 2012 HMRC released a consultation document entitled “Reform of two anti-avoidance provisions: (i) the attribution of gains to members of closely controlled non-resident companies, and (ii) the transfer of assets abroad.” HMRC have asked for comments on this document by 22 October 2012. The document is of considerable significance in that it responds to criticisms made by the European Commission (“EC”) that two key pieces of anti-avoidance legislation, section 13 TCGA 1992 and sections 714-751 ITA 2007, go beyond what is reasonably necessary in order to prevent abuse or tax avoidance. The EC is of the view that this legislation is “disproportionate” and incompatible with the Treaty freedoms of the single market.
In their consultation document HMRC have acknowledged the need for change following the EC’s criticisms, which, as HMRC state in the document (paragraph 1.4), have led to the EC issuing infraction notices against the UK government in relation to these two pieces of legislation. HMRC state, however, that: “EU law has established that “abuse” may be counteracted where there is evidence of an intention to obtain an advantage through artificial creation of the conditions for obtaining it such that the purpose of the treaty provisions is not achieved“. HMRC go on to state that this has led to the development of the EU law concept of “wholly artificial arrangements” – the arrangements entered into must, for instance, not amount to the artificial transfer of profits. “Anti-avoidance (or abuse) rules may, therefore, address the transfer or holding of assets which move profits (or gains) without creating a real and genuine economic presence in the overseas territory, or result in the artificial holding of assets as an investment overseas” (at paragraph 1.6).
Changes to the legislation
The changes to section 13 TCGA will introduce a new test, the “business establishment test” which will distinguish between “the artificial enclosing of assets within a foreign company wrapper … and the placing of assets in a foreign company which carries on the genuine economic enterprise” (paragraph 2.6). The business establishment test will look at the activities being conducted by the offshore company and determine if a genuine economic activity is being conducted. To answer this question, the test focuses on activities which:
- consist in the provision of goods or services on an arm’s length basis (whether between third parties or connected parties), with a view to the realisation of profits on a scale commensurate with the size and nature of the establishment; and
- involve the use of employees, agents or contractors in numbers, and with competence, commensurate with the realisation of profits on that scale (paragraph 2.11).
For income tax, the changes to sections 714-751 ITA will include an additional exemption which will focus “on the character of arrangements entered into (in particular whether transactions are on arm’s length terms) and the extent of all overseas economic activity resulting from the transaction” (paragraph 3.3). The legislation will also be amended so that a company that is incorporated overseas, but is resident in the UK by virtue of its management and control, will no longer be regarded as resident outside the UK for the purpose of the transfer of assets rules.
It is welcome news that the UK has taken notice of the criticisms made by the EC. As readers are no doubt aware, the Treaty on the functioning of the European Union guarantees the residents of EU member states a number of fundamental freedoms including the free movement of goods, the free movement of labour, the freedom of establishment, freedom to provide services and the free movement of capital. The safeguard of these freedoms has much exercised the courts in recent years – in Cadbury Schweppes C-196/04 the ECJ upheld these fundamental treaty freedoms in the context of restrictive UK tax legislation. It is far from clear, however, whether the proposals in the consultation document go far enough. For example, in discussing the proposed changes to section 13 TCGA HMRC state:
“… there needs to be a “genuine establishment”, that is, an “actual establishment” pursuing “genuine economic activity” … the need is for activities, and not (just) the making and holding of investments. For example if activities that may amount to an establishment include acquiring and holding property, that property must be actively managed (and not through an independent agent).” (paragraph 2.14).
With respect, this appears to be an extension of the EU principles involved. The EU approach is to permit and encourage investment by a UK resident person in an EU country. That is, after all, the whole point and purpose of the Treaty freedoms. It is only where such an investment involves “wholly artificial arrangements” that the EU courts will consider the arrangements to amount to an artificial transfer of profits. The dividing line between what is and what is not “wholly artificial” may be a fine one, but “ordinary” passive investment, even if undertaken with the underlying motive to take advantage of a more favourable tax climate elsewhere in the EU, may well not be caught by the “wholly artificial arrangements” test.