In our 2 December 2010 memorandum (UK Tax Update: Proposed New „Patent Box‟ Regime, Controlled Foreign Company (CFC) Reforms and Changes to the Tax Treatment of Overseas Branches), we mentioned that the UK Government was planning to introduce a new overseas branch exemption for certain UK companies. Since then, the Government has published draft legislation for this new exemption, together with a technical note to clarify certain aspects of, and to address matters not already covered by, the draft legislation. The final version is due to appear in Finance Bill 2011. This memorandum explains how the overseas branch exemption is intended to operate.
Who may elect to apply the overseas branch exemption?
Most UK companies will be able to elect to apply the new overseas branch exemption. The election will not be available to companies carrying on long-term insurance business or mainly investment business. Similarly, it will not be available to small companies with branches in an overseas territory with which the UK does not have a double tax treaty with a non-discrimination provision, nor will it be available to close companies (broadly, companies with five or fewer participators) in respect of their capital gains.
An election to exempt all overseas branch profits from UK corporation tax generally becomes effective from the company‟s first accounting period following that in which the election is made, unless it is revoked within 12 months from the end of that period. An election cannot be revoked after this time. Where a UK company‟s overseas branch made losses within one or more of its six accounting periods prior to that in which the election is made, aggregate losses from those earlier periods (to the extent there are any residual aggregate losses after offsetting any overseas branch profits from later intervening periods) must be carried forward and offset against any overseas branch profits accruing in the accounting period following that in which the election is made, and then against successive accounting periods until those residual aggregate losses are fully extinguished. Under these circumstances, the election becomes effective for the period in which the losses are fully extinguished.
Effect of an election
Once an election becomes effective, profits attributable to the overseas branch (after deduction of any losses attributable to that branch) will be exempt from UK corporation tax. Conversely, overseas branch losses will not be relievable against the UK company‟s own profits. Where there is a double tax treaty between the UK and the country in which the branch is situated, profits attributable to that branch will be determined according to the Business Profits Article of that treaty on the assumption that the overseas branch is a distinct and separate enterprise engaged in similar activities under similar conditions, and dealing wholly independently with the UK company. If there is no treaty, or the relevant treaty does not contain a non-discrimination provision, profits attributable to the overseas branch will be determined according to the Business Profits Article of the July 2010 OECD Model Convention. The chief difference between the Business Profits Article of the relevant treaty and that of the July 2010 OECD Model is that the latter requires overseas branches to recognize internal interest and royalties in calculating the branch‟s profits or losses.
Capital gains and losses will not be included in the calculation of overseas branch profits and losses for the purpose of the exemption. This is because the July 2010 OECD Model and most double tax treaties permit gains from alienation of an overseas branch‟s moveable business property to be taxed in the country where the branch is located.
The exemption will not be available to a UK company if its overseas branch falls foul of an “anti-diversion” rule similar to that under the current UK CFC rules. Broadly, this means that if the foreign tax in an overseas branch is less than 75% of the equivalent UK corporation tax that would be payable in respect of the branch‟s profits, the exemption will not be available, unless the branch‟s profits for a 12-month accounting period are less than £200,000 (or £50,000 in the case of small UK companies), or if a “motive test‟ is satisfied. As with the current UK CFC rules, the “motive test” is satisfied if, broadly, the achievement of a reduction in UK tax is not the main reason either for the UK company to carry on business through an overseas branch, or for the UK company to undertake transactions attributable to the overseas branch‟s profits.
There is currently no explicit rule in the draft legislation requiring companies to minimize the proportion of profits subject to tax in the branch jurisdiction, and the Government is considering whether such a rule is required to prevent UK companies from obtaining unintended tax advantages through use of the new exemption. The Government is also considering whether further specific anti-avoidance rules will be required, particularly with regard to leasing arrangements and transfers of branch businesses between group companies.
Capital allowances and corporate intangibles
The draft legislation does not yet address how capital allowances, intellectual property and other corporate intangibles will be allocated to an overseas branch. The Government is considering whether these areas should be addressed and, if so, how. The idea is to ensure appropriate treatment of capital allowances according to the branch‟s use of qualifying assets for its activities, and also where there is a change of use of qualifying assets from the UK company to an overseas branch (or vice versa). Simiarly, the Government seeks views on how intellectual property deductible debits and taxable credits should be allocated to the branch, and whether reliance on the “attribution tests” of the relevant double tax treaty is sufficient.