Four long years ago, back in June 2007, Gordon Brown replaced Tony Blair as leader of the British Labour Party and started his ill-fated Prime Ministerial career. Also that month, of rather less interest to the public, the UK Treasury began a consultation on the taxation of the foreign profits of UK companies, including the tax regime applicable to CFCs.


Now, in 2011, Gordon Brown's political career is long over, yet the foreign profits consultation process – and associated legislative tinkering - drags on.  In keeping with Governmental promises in the 2011 budget, Finance Bill 2011 (31 March 2011) introduced several "interim" measures to temper the CFC rules (in particular, the introduction of additional exemptions from the CFC charge, including those applicable to certain IP and other holding companies, intra-group transactions with little or no UK nexus and CFCs having profits in an accounting period of up to £200,000). Then, 30 June 2011 saw the publication of yet a further 110 pages of Treasury proposals for the fully revised CFC tax regime.  It is expected that this final piece of the reform (supplementing the interim CFC reforms as well as the prior dividend, branch taxation and hugely onerous "worldwide debt cap" rules reforms) will be in place by this time next year - around the fifth anniversary of the consultation's inception.

And after all the years and the prolonged engagement with taxpayers, what brave new world do we face? According to the latest proposals, "The new CFC regime will operate in a similar way to the current regime...."

However, to be fair, although there will be similarities, it is also clear that there will be important differences. A key development in relation to non-UK resident group finance companies is the proposal for a partial exemption from the CFC charge, giving an anticipated effective rate of UK tax for such companies of 5.75%.

On the other hand, practitioners are resigned to the apparent complexity we can expect the new rules to have (a hallmark of the recent tax law "simplification" rewrites). By way of illustration, how easy will it be to draft and interpret legislation designed to indentify "the sources of non-routine profitability" and "the day-to-day active decision makers and other value-adding functions associated with those sources"? These concepts are suggested as part of a possible "principles-based territorial business exemption," which is promoted as being more straightforward to use than the proposed "General Purpose Exemption". Unfortunately the end result of the consultation seems unlikely to result in a simplification of the tax system.

One thing which HMRC (still smarting from the ECJ's ruling in the 2006 Cadbury Schweppes case) have been at great pains to make clear is the intention of the new rules to comply with EU rules on the freedom of establishment and movement of capital and the new publication is liberally seasoned with references to the focus of the new rules on the artificial diversion of profits away from the UK, as well as making clear that the new rules will apply equally to CFCs within and without the EC.  Whether the new rules are in fact fully compliant with EU law remains to be seen.  This is a difficult area to judge, given the apparent change of sentiment on direct tax issues at the European Court of Justice in recent months.


This section is by way of background and those familiar with the existing regime may wish to skip on to the Key Reform Issues section.

Broadly speaking, a UK corporate investor in a non-UK resident company which is established in a lower-tax jurisdiction is at risk of being subject to tax in the UK on the profits of the investee company regardless of whether those profits are remitted to the UK.  In order to suffer such a charge, the UK company must be directly or indirectly in control of the non-UK resident company, which must be subject to an effective rate of tax in their jurisdiction of residence of less than 75% of the tax which would be paid in the UK on the same measure of profits. "Control" for these purposes is very broadly defined, to include majority economic and voting rights and even a 40% interest in a JV situation.  UK resident investors who enjoy this control are liable to have apportioned to them a proportion of the non-UK resident's profits for an accounting period and (where such an investor has apportioned to them 25% or more of those profits) pay tax in the UK accordingly. 

The UK CFC regime has always carried with it various exemptions designed to protect legitimate overseas activities and to concentrate the regime on the perceived avoidance of UK corporation tax.  These exemptions have been eroded over the years – notably of late as a result of the introduction in 2009 of the UK dividend exemption (another strand of the foreign profits taxation overhaul).  Previously, where a CFC pursued an "acceptable distribution policy" (broadly the return by the non-UK resident – in a taxable manner – to the UK of 90% or more of chargeable profits in any given accounting period), then the UK investor was exempt from charge under the regime. As the majority of distributions received from overseas are now exempt from UK tax in the hands of UK corporate recipients, this exemption has been removed.  Those which remained prior to the 31 March 2011 interim additions were the exempt activities test (which protects genuine overseas trading activities from charge), the low profits test (which takes investees realising £50,000 or less of profit in a 12 month period out of the regime), the excluded countries regulations (which take out of the regime qualifying companies resident in jurisdictions deemed to have tax bases and rates equivalent to those in the UK) and the motive test (which is a fall-back defence against the charge where it is possible to establish that there is no tax avoidance motive in the use or existence of the non-UK resident). 


The central points of the latest proposals are as follows.


A "CFC" will be a UK-controlled non-UK resident company which suffers tax at a lower effective rate than a UK resident company with the same profits would suffer (with the threshold probably being set at 75% of the UK effective rate).  This is broadly familiar, but part of the consultation's focus is on possible revisions to the way in which "control" is defined, potentially to take into account a principles-based or accounting standards approach (or to maintain a more mechanical approach akin to the existing test). 


A range of new and/or improved exemptions, designed in general terms to exempt companies "undertaking genuine commercial activities that do not artificially divert profits from the UK", will then potentially take CFCs out of the regime, as follows.

A de minimis low profits exemption (perhaps the £200,000 provided for in the interim

  • measures, perhaps £500,000, perhaps a sliding scale depending on the size and turnover of the affected group);
  • A "white list" of excluded jurisdictions, perhaps some with further conditions to obtain exemption for a particular company in that jurisdiction;
  • A temporary period exemption for existing companies which are brought under UK control (through, e.g., acquisition);
  • Territorial business exemptions ("TBEs") protecting genuine overseas trading operations and non-UK profits where management is local. These are likely to consist of a "low-profit margin" safe harbour, a manufacturing trade exemption, and a general commercial activities exemption where there is no artificial diversion of profit from the UK. These exemptions may also extend to certain holding companies of local trading companies. In the alternative, the "principles based" territorial business exemption referred to in the introduction above is also being mooted;
  • Specific finance company rules, including a "Finance Company Partial Exemption" which is expected to reduce the UK corporation tax charge on overseas intra-group finance income to an effective rate of 5.75% by 2014. How to obtain this partial exemption, as well as the possibility of a full exemption in certain situations, is one of the subjects of the consultation;
  • A general purpose exemption ("GPE") applying to profits to the extent that they are commensurate with the CFC's own activities and have not been diverted from the UK for tax purposes, or to the extent they have not been diverted from a connected company taxed in the UK and are not investment income other than such income which is "incidental" to the CFC's activities; and
  • Sector-specific rules for insurers and banks, exempting "genuine overseas" insurance and banking operations.

The consultation document considers intellectual property-holding CFCs in some detail. However, it appears that the application of the exemptions (particularly the TBEs and the GPE) in relation to IP companies may be the subject of HMRC guidance rather than specific statutory rules. This reliance upon guidance is a recent recurring theme of recent tax policy and is generally unpopular.

It is intended that the CFC rules will be applied to branches within the UK's new branch exemption regime, replacing the anti-diversion rule in that new regime.


The new CFC rules are expected to charge only the proportion of the CFC's profits which have been "artificially diverted" from the UK, a change to the existing "all or nothing" system, where 100% of the profits of a CF that doesn't benefit from an exemption become subject to the regime (albeit with a credit for foreign taxes). UK resident companies with an interest in a CFC of at least 25% will then be subject to charge on the appropriate proportion of the relevant profits.

It is anticipated that the reforms will apply to UK resident companies' accounting periods beginning after Finance Bill 2012 receives Royal Assent (i.e. from mid-2012).


While it is too early to make a prediction on how the final legislation will unfold, the Government's stated aim to make the UK a more appealing place to conduct business is welcome and it is hoped that this will be carried through to the new rules.  As it presently stands, one clear beneficiary will be multinational groups using offshore financing companies, which will benefit from a significant partial (or potentially full) exemption.  As with all such measures, however, the practical application of this apparent generosity is likely to be tempered by general "anti-avoidance" provisions and it may in any case be as much as a year before it becomes clear how the final legislation will shape up.