In November 2010, the UK Government announced various proposals in a consultation document relating to international tax issues and intellectual property (IP), designed to enhance the competitiveness of the UK tax system.
These proposals, when added to the changes already made to reduce the UK's headline corporation tax rate (to 24% by 2014/15) and the participation exemption for dividend income, should make the UK a viable alternative to more established regimes for holding companies and IP ownership. However, given the complexity of the UK's regimes when compared to those in, say, Luxembourg or the Netherlands, this is likely to mean that the UK will be an attractive place for locating such holding functions if there are other commercial reasons to be in the UK. The UK is, however, unlikely to be a chosen destination for tax considerations alone.
The latest reforms can be subdivided into the following key areas:
- changes to the rules on IP, specifically the introduction of a "patent box" and changes to the R&D tax credit regime;
- changes to the UK's Controlled Foreign Company (CFC) rules; and
- exemption for foreign branch profits.
Intellectual Property taxation and R&D Credits
Further proposals for the corporation tax treatment of innovation and IP have been proposed.
The key change proposed in this area is the introduction of a "patent box" in the UK. This was announced in the 2009 Pre Budget Report and has been fleshed out in the November 2010 consultation paper.
This will introduce an optional 10% corporation tax rate on profits arising from patents. This new tax would be effective from 1 April 2013 and applicable to income from patents first commercialised after 29 November 2010. It is not entirely clear what the cut off date for "first commercialisation" is in this respect.
The patent box will apply to both royalty income and income embedded in the price of patented products. This approach prevents artificial separation of IP rights from the rest of a trade.
However, determining embedded income is bound to be difficult and subjective. In order to reduce excessive compliance (i.e. having to prove an arm's length determination of the patent income under transfer pricing principles), a more simple formulaic approach is therefore proposed.
The 10% tax rate is to apply to net income after associated expenses. Deductible expenses will include pre-commercialisation expenses. However, this presents a potential conflict as such expenses would then only be tax deductible at 10%, whereas the Government wants businesses to continue to obtain full tax relief under the UK's R&D tax credit rules. Consultation is ongoing as to how to align these two priorities.
Consultation is also ongoing as to avoid encouraging pure passive holding of IP (as opposed to R&D and innovation) and tax avoidance.
Businesses have queried why the scheme has been focused exclusively on patents, with other IP formats, such as trademarks and copyright (for example, software), being excluded.
R&D tax credits/reliefs.
The proposal here is that there is to be further investigation of what, if any, alterations can be made to the structure of the UK's R&D tax credit/relief schemes that would improve their ability to actively encourage research. The ongoing consultation will also be looking at what items not currently eligible for reliefs should be included and, conversely, what items should be excluded. Finally, there will be some consideration of whether the current R&D definition is adequate, or if the definition should be enshrined in statute.
This follows the Dyson report published in March 2010 , which proposed that the R&D tax credit/relief schemes should be focused on high tech companies, small businesses and start ups, should have an increased credit rate of 200% (compared to the current 175% for the SME credit), and there should be improvements as to the ease of claiming credits under the rules.
Controlled Foreign Companies
Reform of the UK's CFC rules dates back to the Government's package of reforms of foreign company taxation launched in June 2007.
Many of the Government's proposals, which build upon responses to a consultation document produced in January 2010, are seen to be in line with what businesses have been asking for. Most notably, the controversial proposal for an earn-out charge in relation to intellectual property transferred abroad has been abandoned. These new proposals will be enshrined in the Finance Act 2012, although interim changes are set to be introduced in the meantime, with the consultation ongoing until 22 February 2011.
Long Term Proposals
The long term reforms are as follows:
- a mainly entity-based CFC system will be retained but will operate to bring within the CFC charge only artificially diverted profits;
- a number of exemptions will be introduced to minimise compliance and focus on higher risk entities;
- specific sector rules will be introduced where needed (e.g. banking);
- a partial finance company exemption will be introduced for dealing with monetary assets; and
- specific rules will be introduced to deal with IP.
The proposals put forward in the November 2010 consultation document particularly focus on two key areas: monetary assets and IP.
The current thinking is to exempt from the CFC rules group finance companies that are not excessively funded by equity, testing this at a minimum debt-to-equity ratio of 1:2, although this may change – the final ratio is not expected to be announced until the 2011 Budget. Under this scheme, with the ratio set at 1:2, a fully equity funded company could find that two-thirds of its finance income would be excluded from the CFC charge. This means that, as from 2014 when the main rate of UK corporation tax rate has fallen to 24%, such a company would find that the effective rate of corporation tax is only 8%, as only a third of its income would actually be charged corporation tax. It is also proposed that this finance company exemption should be extended to apply to excess cash held by trading companies in low tax jurisdictions.
There are additional proposals to exempt treasury operations involving the day to day management of monetary assets for companies where such activities make only a small margin. However, these proposals have not yet been fully developed as yet – particularly with respect to mixed entities that also carry out high risk treasury operations.
The Government has identified three sources of profits from IP that it wishes to focus on for CFC purposes:
- profits from IP developed in the UK that is transferred to a low tax country;
- profits from IP held offshore but effectively managed in the UK; and
- profits arising where UK funding is used to invest in IP that is held overseas, but a return on that investment is not received in the UK.
Additionally, the Government considers that there should be a de minimis rule, so that trading entities which earn only small profits from IP with a UK connection should be excluded, as should trading entities with incidental or ancillary IP.
There are two steps to the proposed regime for dealing with these IP-sourced profits.
Step 1 is to define entities that hold IP with a substantial UK connection that could pose a risk to the UK tax base. This definition would broadly follow the above categories, more specifically:
- IP transferred from the UK within the last 10 years;
- IP where significant amounts of activity to maintain and/or generate the IP value are undertaken in the UK (excluding discrete subcontracted functions if these, in aggregate, are not significant)
- IP that is effectively held offshore as an investment.
Step 2 is to assess whether these forms of IP have given rise to excessive profits that are being artificially diverted from the UK.
In particular, for the first two forms of IP mentioned above, the following approach is suggested for Step 2:
- a safe harbour would be applied (e.g. allowing a maximum return on costs/assets), to remove low-risk entities;
- secondly, profits will need to be allocated accounting for various business models to determine if profits are excessive; and
- finally, the rules would need to determine what proportion of the excessive profits has been artificially diverted from the UK.
A separate approach is suggested for investment IP, where a UK CFC charge would apply if the entity fails to have a suitable debt-to-equity ratio (in the same way as for finance companies).
As noted earlier, further work and consultation is ongoing with a view to finalising the new CFC rules for legislating in 2012.
Interim Reforms for CFCs
Despite the ongoing work at a more general level as to the future look of the UK's CFC regime, the Government has recognised a need for more urgent reforms of the CFC rules in the immediate future.
The following interim measures are therefore to be introduced in the 2011 Finance Act:
- an exemption for a CFC carrying on intra-group trading activities where there is minimal connection with the UK and little risk that UK profits have been artificially diverted;
- an exemption for a CFC with a main business of IP exploitation where the IP and the CFC have minimal connection with the UK;
- an exemption which runs for three years for foreign subsidiaries that, as a consequence of a reorganisation or change to UK ownership, come within the scope of the CFC regime for the first time (essentially an extension of the current period of grace regime);
- an extension of the exemption for companies with small chargeable profits by increasing the de minimis from £50,000 to £200,000 – but only for groups containing companies that are larger than those falling within the European Commission's definition of a "Small and Medium-Sized Enterprise"; and
- a retention of the rules for superior and non local holding companies until the full reforms become law in 2012.
Finally, the UK Government is considering the introduction of a new opt-in exemption regime for foreign branches. Once elected, branch trading profits, investment income connected with the branch and branch capital gains, will be exempt from corporation tax.
This will be an elective scheme, and once an election is made, it will be irrevocable and will apply to all of a company's branches, including future branches. However, the exemption will not apply to shipping and air transport as these activities are not generally taxed on branches under double tax treaties.
A company may elect after a specified date (probably 1 January 2012) and, under transitional rules, this will mean that the profit or loss of each foreign branch will be deducted from the company's worldwide profits, leaving a net amount subject to UK corporation tax.
The exemption will not be applicable for small companies with a branch in a non treaty state. However, it will be available to large and medium companies wherever the branch is located. The amount of exempt profits to be attributed to the branch shall be determined according to the applicable double tax treaty (if it contains a non discrimination clause) or, in the absence of an appropriate treaty, the OECD model treaty. It is intended to introduce specific rules for allocating capital, and associated finance costs, to branches, subject to the provisions of the relevant business profit article of the appropriate tax treaty.
The transitional rules will further provide that companies which have elected to take part in this regime will not be entitled to relief for their foreign branch losses, and branch profits will only become exempt once the tax losses of the branch in the 6 years immediately preceding the election, or, where losses are very large (greater than £50m has been suggested), all branch losses, have been matched by profits.
This elective regime will also be subject to the UK's CFC rules, which will apply to exempt branches in much the same way as foreign companies to prevent the artificial diversion of profits to exempt foreign branches. Prior to the introduction of the new CFC rules in 2012, a CFC type regime will be established for foreign branches with more limited carve outs and it is anticipated that further anti-avoidance rules will be introduced.
The UK reform of the taxation of foreign profits has been on the horizon for a number of years following various adverse cases in the European courts and the increased competition amongst foreign tax systems. It is welcome to see the UK Government take a more business friendly approach to this issue. It is also clear in the current economic climate that any moves to make the UK corporate tax system competitive have to be sensible in protecting the tax base.
The resulting package, set out in the November 2010 consultation document and draft legislation issued in December, seems like a sensible approach, showing a strategic move towards modifying the tax system to meet not just the needs of HM Revenue & Customs but also those of business. Although the UK may remain below other jurisdictions in terms of its pure tax competitiveness, it is hoped that, for those businesses that have a commercial advantage in doing so, the new package of measures should not defer them from setting up shop or remaining in the UK.