Introduction

Following intense lobbying from industry, the Government has announced it is re-considering its proposals for the reform of the UK taxation of overseas profits. There have been fears that the proposals would spark a mass exodus by multi nationals currently headquartered in the UK. Earlier this year Shire plc and United Business Media announced that they would be moving their holding companies to Ireland for tax and financial reasons. Reports followed that many others were considering a move offshore. The impetus for the moves was attributed to dissatisfaction with the proposals. Is this true? Will the announcement stop the feared mass exodus?

Original proposals: At the heart of the original proposals are two interlinked reforms:

  • UK companies would be exempt from UK tax on dividends from shareholdings of 10 per • cent or more in overseas companies. This would bring the UK system into line with most other European tax regimes and was welcomed.
  • UK companies would be taxed on “passive” and “mobile” income of such overseas • companies under a revised controlled foreign companies (“CFC”) regime. The scope of this regime was the main issue. For groups in technology rich sectors, the particular concern was that the regime would subject to UK tax all profits generated by intellectual property (“IP”) rights held in overseas subsidiaries. One of Ireland’s chief attractions is that it does not have a CFC regime.

Announcement on 21 July 2008: The Government is re-visiting the CFC proposals and will consult further on both an income regime and a revised form of the current entity regime. The Government will not seek to tax income from IP activity under a revised regime unless it has or had a connection with the UK. This will be considered in the wider context of improving the UK as an IP destination. The Government is still interested in introducing a dividend exemption but has rejected calls for this to be introduced ahead of the other reforms. Their concern is that the ability to bring dividend income into the UK tax free would, in the absence of revised anti-avoidance measures, increase the likelihood of the artificial diversion of UK profits overseas. Their current stance is that none of the reforms will be introduced until 2010 at the earliest.

The future: The positive news is that the Government’s willingness to consult further and their revised stance on IP indicates they are listening to industry. However, much remains up in the air. Developing an exclusion from a CFC regime for income from IP with a UK nexus will involve difficult assessments of where and how multi-national groups develop IP. There is no general indication to what extent the CFC proposals will otherwise be modified. It is not known whether or how the Government will finally take on board the decision in the European Court of Justice (“ECJ”) that CFC rules are incompatible with EU law unless confined to wholly artificial arrangements. There is much disappointment at the Government’s refusal to press ahead with a dividend exemption.

The dissatisfaction with the current reforms may not fully explain why groups seem more alive to moving offshore given that the UK has long had some disadvantages. There is a perception that the UK tax regime is becoming more complex and hostile. Aggressive and frequent changes to the tax rules have generated an environment of uncertainty. What was previously regarded as acceptable tax planning is being condemned as tax avoidance. A significant non-tax bar to moving overseas has recently been removed in that companies are no longer required to have a UK base to be included in the FTSE index.

Achieving a workable compromise on the reform of overseas profits could turn the tide of opinion and restore confidence in the UK tax regime. Whilst the Government’s announcement is a positive sign that this can be achieved, there is frustration with the slow progress. In the last few weeks three UK listed groups, the Henderson Group, Charter and Regus, announced that they are moving their holding company location overseas. Regus cited the on-going lack of certainty in this area as one of the reasons for the move. The Government may need to step up the pace of the consultation process if further departures are to be avoided.

Pending the outcome of the current debate, multi national groups may wish to take stock of their position. This note considers the tax factors influencing the choice of holding company location under the current regime and under the possible future regime and the feasibility of moving overseas in a tax efficient manner.

Choosing a location – how does the UK currently compare?

For groups with significant overseas activities the decision where to locate their holding company is a blend of complex factors. This note considers the tax issues only but, whilst usually an important factor, tax issues may be outweighed by other considerations.

What is the rate of tax? The rate of UK corporation tax of 28 per cent is comparatively high. The Government has said that it will reduce the rate over time but it is unlikely the rate would be cut to a level competitive with jurisdictions such as Ireland and Switzerland.1

Is there an exemption for tax on dividends and profits on sale? The rate of tax may not be determinative if the regime provides an exemption, as some European regimes do, from tax on overseas dividends and profits on sale of subsidiaries.2 The UK has gone some way towards this by the introduction in 2002 of an exemption for gains realised on the sale of at least a 10 per cent holding in a trading company (the substantial shareholding exemption). The qualifying conditions are complex but the exemption can be relied on in many cases. The UK currently taxes overseas dividends but with a complex credit system (see Box 1).

Are undistributed overseas profits chargeable to tax in the holding company regime? The UK has a complex CFC regime which taxes undistributed profits of overseas subsidiaries in low tax jurisdictions. Many feel the regime goes beyond the original aim of preventing the artificial diversion of UK profits to low tax jurisdictions. Some jurisdictions such as Ireland do not have such rules.

Does the regime have other complex anti-avoidance rules? The UK has other complex anti-avoidance rules, such as the transfer pricing regime, which impact in particular on financing and intra group transactions. Whilst many regimes have similar rules some such as Ireland do not.

There are more general concerns that the complexity of the UK rules is making the UK regime unworkable for business. Frequent change to the rules sometimes with no clear rationale is creating an uncertain tax basis. HMRC’s proposal, at least in some of the more complex anti-avoidance areas, to shift away from detailed prescriptive rules to principles based rules may go some way to removing this concern if this achieves greater clarity of underlying policy.

Will a tax deduction be available for financing costs? This is an area where the UK is currently attractive. Jurisdictions which provide an exemption from tax on dividends often impose a restriction on the available deduction for interest expense on loans taken out to fund subsidiaries. The UK does not currently have any such restriction.

Can profits be repatriated to shareholders without any withholding tax? Another positive factor is that, unlike many other jurisdictions, the UK does not impose withholding tax on dividends payable to shareholders. Although exemptions may apply under applicable double tax treaties, relying on this is often unattractive to shareholders as a claim has to be made for the exemption to apply.

Can the holding company receive payments without withholding tax? Many regimes impose withholding on income payments such as dividends, interest and royalties. Payments between EU companies may be exempt and in other cases double tax treaties may provide relief. The UK is well placed in this respect with a large network of double tax treaties.

Choosing a location – what does the future hold?4

Overseas dividends – The original proposal was that overseas dividends would be exempt from UK corporation tax for large and medium sized UK companies which hold at least 10 per cent of the shares in the overseas payer. Small UK companies5 with at least a 10 per cent holding in the payer would remain taxable on overseas dividends with a simplified credit system6. The Government was considering a number of options for companies with less than a 10 per cent holding.7

Update: The Government has now said that it is in favour of as wide an exemption as possible and that this may not be confined to cases where the payee has a 10 per cent share holding. However, the Government will not, as many had lobbied for, introduce this measure ahead of the other reforms.

Revised CFC regime: The current CFC regime applies to bring within the UK corporation tax charge profits of an overseas tax resident company where that company is controlled by UK persons and is subject to tax at a rate of less than 75 per cent of the UK tax which would be due. A UK company which has an interest of more than 25 per in the CFC cent is taxed on its proportionate share of the CFC’s total profits.

The original proposal was for an income regime whereby UK companies would be taxed on specified passive and mobile income of an overseas company which is controlled by UK persons (a “CC”). Unlike currently, the regime would apply regardless of the level of local taxation. The charging threshold was to be lowered so that any UK company with an interest of 10 per cent or more in the CC would be taxed on its proportionate share of the specified income. The current concept of “control” was to be extended to allow tracing through vehicles such as partnerships, trusts or hybrid entities.

The passive profits rules would apply to UK CCs in an attempt to avoid allegations that the rules are discriminatory under EU law. There would be a system of compensating adjustments similar to that which applies under the transfer pricing system.

Passive income would comprise dividends, interest, annuities and other purchased income streams, royalties, rents and “other income of a similar nature”. The main exemptions were for (a) income from genuine active finance, insurance and property investment activities and (b) certain interest income received by the CC from overseas group companies/affiliates. Chargeable gains would be caught where they relate to the disposal of assets that would normally give rise to passive income (such as intellectual property rights) or gains resulting from the conversion of passive income streams into capital assets.

Mobile income is intended to cover income which lends itself to the artificial location of profits and includes: (a) sales income derived from dealing in goods for delivery to or from the UK or to or from affiliates/associates and (b) intra group or UK derived sales or service income from “wholesale, distributive, financial or service businesses”.

Update: The Government has said it will consult on an income regime and, as industry seems to prefer, a revised form of the current entity regime. Future proposals will not seek to tax income from IP activity unless such activity is or was connected with the UK. The Government has also indicated they may drop the proposal to include chargeable gains in the new regime.

Tax relief for interest: The proposal was for the total amount of borrowing costs for which the UK group could obtain a tax deduction, for internal and external borrowings, to be restricted to an amount equal to the total external borrowing costs of the entire worldwide group. It was also proposed to extend the rules which deny a tax deduction for interest on a borrowing entered into with the main purpose of securing a tax advantage. The changes would (a) require the purpose of the whole of any scheme or arrangement of which the borrowing forms part to be taken into account and (b) introduce an objective element in that the purpose is taken to be securing a tax advantage if “it is reasonable to assume that one of the main benefits [of the borrowing or scheme or arrangement] is a tax advantage”.

Update: The Government is considering modifying the cap on interest deductions to exclude cases where a group would fall foul of the restriction due to a temporary influx of cash such as on a sale of part of the business. The Government is dropping limb (b) of the proposed extension to the unallowable purpose rules.

Treasury consent: The proposal is to repeal the rules whereby UK companies must obtain the consent of HM Treasury before certain transactions involving the transfer of shares in or the issue of shares by overseas subsidiaries are carried out. The Government is consulting on what reporting requirements may be required.

Update: The Government will consult further on targeted reporting requirements in place of the current regime.

Reform – what are the pros and cons?

Dividends and Treasury Consents: The exemption for overseas dividends and the abolition of treasury consents are welcomed as reducing the administrative burden on business. Whilst the existing credit system for the taxation of dividends can be managed to achieve tax mitigation, the complexity can result in some tax leakage and large administrative costs. (See Box 1.) Industry is disappointed that the Government is not currently proposing to press ahead with this reform pending the outcome of the debate on the other issues.

Interest: The interest cap still requires further clarification as to the policy underpinning the proposal. The Government continues to state that the cap is aimed at cases where the UK group bears more debt than is required to finance the worldwide group and at upstream loans used to repatriate overseas cash into the UK. However, if the exemption for overseas dividends is introduced, one of the main reasons for using upstream loans would disappear.

The Government is addressing a significant concern by excluding temporarily cash rich groups from the cap. It remains to be seen if they will take on board the other issues raised by industry. For example, there is concern that the cap should not operate by reference to arm’s length interest or at least that there should be an override for genuine commercial cases where tax is not the prime factor.

CFC regime: There is no indication in the recent announcement as to how the Government now envisages the overall scope of a new regime. The concern is that the current and the proposed revised regime go beyond the stated aim of preventing the artificial diversion of profits overseas. Under the original proposals, the Government’s policy seemed to be to tax in the UK all forms of passive income regardless of the circumstances. Industry will be looking for the regime to be focused on “wholly artificial arrangements” within the meaning of the ECJ decision in the Cadbury Schweppes8 case (see Box 2).

In more specific terms, the extent to which income from IP and from intra group financing activities should fall within the regime are the two most controversial areas. The Government has to some extent addressed this by the announcement of an exemption for IP activity with no UK nexus. However, the precise scope of the exemption remains to be seen. It may be difficult to formulate the required level of connection with the UK in the context groups with worldwide IP activity. It is not clear whether any exemption will cover cases where IP was developed initially in the UK but was transferred out of the UK for full value. As regards financing income many will want to see a wider exemption to cover all cases where such income is received on loans made in relation to active business activities.

The other main concerns with the income regime as originally proposed are:

  • Scope of profits caught: Business is lobbying for the proposed regime to include some or all of the existing filters/exemptions which were not included in the original proposal.
    • Currently the regime does not apply unless the CFC is resident in a low tax jurisdiction. •
    • There is an exemption where the CFC (a) has a business establishment in its country of • residence, (b) its business affairs are effectively managed in that country and (c) its main business does not consist of precluded activities (these correspond to mobile income).
    • There is no CFC charge under a motive test where it was not a main purpose to achieve • a reduction in UK tax and a reduction in UK tax was not a main reason for the CFC’s existence in that period.
    • CFCs located in countries named on a “white list” are exempt provided that the • CFC’s income from outside the home jurisdiction does not exceed 10 per cent of its commercially quantified profits. CFCs in certain countries are subject to an additional requirement that they must not be entitled to specified tax benefits in the local jurisdiction.
  • Control test and threshold: The proposal was for an extended definition of control. This was to block structures currently used to avoid the CFC rules. It is to be expected this will be retained whichever form the new regime takes. Business is lobbying for the 25 per cent charging limit to be retained and it is rumoured HMRC may concede this.
  • Administration: Switching to an income rather than an entity based regime could increase the administrative burden as groups would have to keep records of income and capital gains streams in all CCs. In the Government’s view “many multinationals already have reporting processes in place which capture most of the information required”. However, it is not clear that this is the case for many businesses and businesses were hoping for a reduction in the compliance burden. Those with smaller shareholdings in the overseas company (perhaps of only 10 per cent if the threshold remains so low) may find it difficult to access the relevant information. 
  • K companies: The extension of the regime to UK CCs should not increase the overall UK tax bill through the compensating adjustment mechanism. However, again this involves an additional compliance burden. UK groups who may have no or little overseas activity would have to comply with the regime. Also it is doubtful whether this would in fact bring the regime into compliance with EU law given that the rules would have no substantive effect on UK companies as a result of the compensating adjustments mechanism.

How to move offshore - migration

A move offshore could be achieved by moving the tax residence of the UK holding company overseas. Careful consideration would need to be given, however, to whether migration would trigger any tax exit charges.

Changing tax residence: This would require the parent to be effectively managed in the overseas location.9 No change would be needed to the day-to-day operations and staff could remain in the UK.

However, all decisions of a strategic nature would need to be taken by the board at meetings held outside the UK. Careful consideration would need to be given to putting in place procedures to ensure that the board (including non-executives) do in fact meet and make decisions overseas. As this is one area HMRC are likely to attack if possible, care would need to be taken that satisfactory evidence is maintained. At a recent conference HMRC indicated that in their view the holding of formal board meetings overseas is not necessarily sufficient to establish that a company is effectively managed overseas depending on the level of the directors activities in the UK. Whilst it is doubtful that their view is sustainable as a matter of law, it is clear that groups need to be prepared to face scrutiny and possible challenge. From this perspective it would be helpful if at least some of the directors are resident in the overseas jurisdiction. Constraints may have to be placed on the level of activities and amount of time UK board members spend in the UK.

Would migration trigger any tax exit charges? The UK taxes accrued gains on capital assets as at the time of departure from the UK and similar charges can apply in other areas (such as under the intangibles assets and loan relationships rules). As regards capital gains, the company may be able to obtain the benefit of exemption under the substantial shareholding regime. However the qualifying conditions are complex and would need to be looked at carefully.

Arguably the UK’s exit charge could be challenged as being contrary to EU law. The ECJ has decided that an equivalent charge on individuals is discriminatory. A recent decision of the Attorney General in a Hungarian case provides further support that a similar view would be taken as regards UK exit charges on corporates.10 However, so far as we are aware, no UK companies have to date sought to challenge the exit charge on this basis. As things stand it would be unwise to take this stance unless prepared to litigate the matter.

How to move offshore – new overseas holding company

The alternative would be to introduce a new non-resident holding company (“NewCo”). However, whilst this would provide flexibility as regards making new acquisitions into and carrying out new business under the overseas holding company, without further action, the existing group would remain under the umbrella of the existing UK holding company (“OldCo”). Careful consideration would need to be given to the feasibility of transferring the existing group to NewCo.

Procedure and commercial considerations: This could be achieved either by the shareholders transferring their shares in OldCo to NewCo or under a cancellation scheme of arrangement. In each case the shareholders would receive new shares in NewCo corresponding to their existing holdings in OldCo.

The insertion of a new holding company is a relatively complex exercise and the group would need to give careful consideration to commercial considerations.

For example due diligence would be required on financing documentation, pension arrangements, share schemes and change of control provisions, to ensure that the insertion of the new holding company did not have any adverse commercial impact.

Would the insertion of NewCo trigger any tax charges? With care it should be possible to ensure that the re-structuring is effected without triggering any immediate tax charge for the UK shareholders. The shareholders should not be regarded as disposing of their shares in OldCo for chargeable gains purposes; in effect any accrued gains are rolled over into the new shares in NewCo and would be brought into charge only on a disposal of those new shares. For this treatment to apply to any UK tax resident shareholder with more than a 5 per cent shareholding, the transaction must be effected for bona fide commercial purposes and not for the avoidance of tax. Advance clearance that this requirement is satisfied can be applied for.

There would be no stamp duty charge if a cancellation scheme is used. It may be possible to avoid stamp duty on a transfer scheme with careful structuring.

Residence of NewCo: Measures would need to be put in place to ensure that NewCo is not resident in the UK. This requires that NewCo is managed and controlled outside the UK. This test is applied in a similar manner to the effective management test. Again, careful consideration would need to be given to the management and evidential procedures to be put in place.

Can the existing group be transferred to NewCo? The transfer of members of the existing group to NewCo would be a potentially taxable event. The substantial shareholding exemption may apply to exempt any chargeable gains but the conditions are complex and would need detailed review.

On-going issues for shareholders – taxation of dividends: An attraction of the UK for shareholders is that, unlike many other European jurisdictions, the UK does not impose withholding tax on dividends. Exemption may apply under an applicable double tax treaty but often shareholders do not wish to be burdened with the administrative requirements of making the necessary claim for the exemption to apply. Also under current law, UK tax resident shareholders may suffer a higher tax charge on dividends received from overseas companies than on dividends received from UK companies. However the tax treatment for overseas dividends is shortly to be aligned with that for UK dividends so this will become less important.11

The company may want to consider circumventing this issue by putting in place a dividend access scheme.12 Broadly such schemes enable shareholders to elect to receive dividends from OldCo. For Shire plc this was done under an arrangement whereby a trustee holds any dividends received on trust for such electing shareholders but other structures can be used. However, this is feasible only assuming that OldCo has sufficient profits to meet the dividend requirements.