On 27 July 2010, the Government launched a consultation on reforming the taxation of profits arising from overseas branches of UK tax-resident companies with a view to introducing an exemption in relation to those profits (and a corresponding restriction of loss relief). The primary impetus for change is the desire to achieve greater territoriality in relation to corporation tax, a principle that is already reflected in the overseas dividend exemptions which were enacted with effect from 1 July 2009 and which derives its origins from a consultation process on foreign profits which began in 2007.
Currently, UK companies are subject to corporation tax on the profits of their foreign branches, with double taxation relief (“DTR”) given for the foreign tax paid on the same profits to prevent double taxation. Where the foreign tax paid is less than the UK tax, the company must pay the additional UK tax.
A number of questions are posed by the consultation document in relation to the perceived difficulties which need to be overcome to achieve an effective exemption. The key questions relate to:
- the scope of the exemption (and how closely it should be linked to the UK’s double taxation arrangements with overseas territories);
- the treatment of accrued and unrealised chargeable gains;
- preventing artificial diversion of profits (with proposals to align the exemption with the controlled foreign companies (“CFC”) legislation at Chapter IV of Part XVII of ICTA 1988);
- the extent to which losses arising from the activities of an overseas branch will continue to remain available;
The options available will also be assessed by their degree of fairness and simplicity. Detailed proposals and draft legislation will be published later in 2010, with legislation to be included in Finance Bill 2011.
Scope of the exemption
The Government is currently considering two options with regard to defining the scope of the exemption. The first option is to follow the allocation of profits required under the business profits article of the relevant double tax treaty. This route entails potential uncertainties when it comes to resolving issues that need to be dealt with under the mutual agreement procedure. However, it does have the virtue of following the income measure used for the purposes of double taxation relief.
The second option under consideration is drafting the scope of the exemption as a mirror image of the profit calculation used in relation to UK branches of overseas companies. The problem with this measure, however, is that it will not necessarily match the profit allocation determined by the applicable double tax treaty. This could lead to double taxation or double non-taxation (where the scope of the foreign profits exemption is wider than the profits taxable by the overseas territory under the treaty) and would require the retention of double tax relief rules alongside the exemption. As such the Government does seem to be currently favouring the option of following attribution for the purposes of the relevant treaty on grounds of simplicity and fairness. However, this does pose the question as to what happens where there is no treaty.
One major issue for insurance companies and banks, when it comes to determining the amount of branch profits, is how capital should be attributed to the branch. For banks this will affect the amount of interest expense that may be claimed against branch profits. The two authorised methods under the OECD guidelines are the “capital allocation” approach (which is rooted in the Basel I and II regimes) and the “thin capitalisation” approach. The Government’s view is that HMRC’s current thin capitalisation approach for UK branches of overseas banks effectively adopts a capital allocation methodology in any case (as its starting point is to take the bank’s overall capital ratio after attributing risk-weighted assets to the UK branch), however it notes that a discrepancy may occur where the capital ratio of the non-resident bank falls below a level which is comparable to other UK banks.
For insurance companies, the problem centres around how much investment income to allocate to the branch in the first place. The Government currently believes that the most appropriate method of attributing capital is the allocation method used for the purposes of double taxation relief. It points out that the alternative thin capitalisation method could require more assets than are held by the insurance company to be allocated to the branch.
The Government is also considering extending the scope of the exemption to cover chargeable gains on assets held by the overseas branch. This raises questions as to how to treat accrued but unrealised gains and how to apportion gains on assets used partly by branches and partly by headquarters.
A major area of the proposed reform will be how to frame the anti-avoidance rules needed to prevent the exemption being used as a means of circumventing the CFC legislation. A degree of conformity will be needed and the Government is considering three options which, by and large, attempt to limit the scope of the exemption to the profits which would not otherwise fall within the CFC apportionment were the overseas branch to be a subsidiary. An obvious problem arises from the fact that reformed CFC rules are not due until Finance Bill 2012 (whereas a foreign profits exemption is expected to be introduced by Finance Bill 2011). However, the CFC-type limitation to the branch profits exemption will be revised again in 2012 to bring them into line with the new CFC legislation. Three options are under consideration. Two options appear to merely limit the scope of the exemption, with branch profits falling outside the exemption being subject to corporation tax with credit for overseas tax (as is currently the case). The third option appears to envisage the CFC legislation being applied to the branch as if the branch were a subsidiary. This last option would appear to be more complex, and may result in the profits of the branch having to be recalculated on a different basis depending on how the scope of the exemption is defined in the first place. Conversely, the incorporation of exemptions similar to those in the CFC rules, offer the opportunity of a having a level playing field when it comes to the taxation of overseas branches and overseas subsidiaries.
The Government is also considering limiting the exemption to overseas branches in territories with which the UK has double tax arrangements containing a non-discrimination provision. There would seem to be an element of “doubling-up”, if the Government were to introduce CFC-type restrictions as well as a treaty-based qualification, and adding this extra condition to the exemption would also undermine the conformity of the branch profits exemption to the distribution exemption (in respect of which only dividends received by “small” companies are required to be received from treaty jurisdictions to benefit from the distribution exemption). Indeed, the Government does not believe that it is appropriate in any case to extend the branch profits exemption to small companies which have branches in non-treaty jurisdictions due to the potential for avoidance to which this might give rise. Plans for a specific anti-avoidance rule applying to small companies only are also being considered.
A symmetrical corollary of a branch profits exemption, is the disallowance of branch losses (at least in so far as the losses of subsidiaries cannot be used in analogous circumstances). The Government is therefore proposing to allow terminal loss relief but also accepts that there is a strong case for the exemption to be accompanied by rules allowing relief for losses beyond only terminal losses.
This will obviously be an area of concern for those enterprises which favour a branch model of business (principally in the banking, insurance and oil and gas sectors). The loss of current year loss relief and group relief in respect of losses made by overseas branches will disproportionately affect these sectors. Accordingly the Government intends to consult on allowing companies to elect out of the branch profits exemption or, alternatively, to allow loss claims to be made but for tax to be “clawed back” once the branch moves back into profit. The possible claw-back mechanisms the Government is considering includes taxing subsequent branch profit either with or without double tax relief until the tax saved by the losses used is recovered.
The use of brought forward branch losses is also being consulted upon. The proposed branch profits exemption would potentially delay the point at which brought forward losses are exhausted and the Government is therefore considering a number of options to redress the balance. At one extreme, brought forward branch losses could be cancelled. A “claw-back” treatment is also being considered which would essentially require a company to match all its brought forward branch losses with branch profits before it would be entitled to an exemption in respect of branch profits. A variation of the “claw-back” treatment under consideration is to apply the claw-back as if the branch profits exemption had always applied.