Since HM Treasury launched a consultation on reforming the United Kingdom’s regime for the taxation of companies’ foreign profits 13 months ago, the subject of taxation generally has become a political hot potato, with the Government forced rather hurriedly to revise a number of proposed reforms to the tax system amid a shower of hostile headlines. The proposed foreign profits reforms provoked a similar reaction, with several major UK companies deciding to “migrate” their head offices out of the United Kingdom by incorporating new ultimate holding companies resident elsewhere, and others announcing that they were actively considering taking such steps. The Treasury therefore issued a technical note on 12 July 2008, partly to provide an update on the consultation process but also to provide reassurance to businesses unsettled by the breadth of the proposals and the uncertainty surrounding the UK tax system more generally.

The centrepiece of the original discussion document, the introduction of a tax exemption for foreign dividends, was widely welcomed by UK corporates. Whilst the current credit-based system for taxing foreign dividends generates relatively little revenue for the Treasury, it causes considerable costs and complexity for UK-parented groups in structuring their affairs to achieve this result by maximising credit on foreign dividends. The quid pro quo for the exemption, however, was a strengthened “controlled company” (CC) regime to replace the existing controlled foreign company (CFC) rules. The existing entity-based CFC regime would be replaced by an income-based regime, which would subject to tax in the United Kingdom almost all a group’s “passive” income (such as interest, royalties and rents).

It was this change in approach which caused particular concerns for UK corporates, particularly for those whose business and profits in large part involved the exploitation of intellectual property (IP) overseas, as it had the potential to tax profits deriving from the exploitation of IP which has very little UK nexus, that is outside the scope of the existing CFC rules (including embedded royalties). The proposed reforms undoubtedly played a large part in the decision of Shire Pharmaceuticals and United Business Media to establish new holding companies that were incorporated in Jersey and resident in Ireland, so as to ensure that foreign subsidiaries (and in particular IP exploited abroad by them) could be held outside the UK chain of ownership (and thus outside the UK tax net) in the event that these proposals came into force.

The proposals also involved a tightening of the rules governing the deductibility of interest, and replacement of the requirement to obtain Treasury consent to certain transactions involving foreign shares (a hangover from the days of exchange controls) with a reporting requirement.

The July 2008 Technical Note

The technical note recognises that the proposed CC rules were too wide and should not apply to embedded royalties or IP with no UK connection. However, it is clear that Government and business have not, as yet, been able to agree on precisely how wide the new rules should be, with the Government expressing concern that the introduction of a dividend exemption without a strengthened CC regime will create avoidance opportunities. The Government has, however, signalled that it is prepared to consider addressing the concerns of business by amending the existing entity-based rules, rather than moving to an income-based approach.

Additionally, the Government has indicated that it does not intend to proceed with the proposal to disallow interest deductions in situations where it is reasonable to assume that one of the main benefits of the arrangement in question is to secure a tax advantage—the test for allowability will remain a subjective one looking to the taxpayer’s actual purpose in being party to the loan relationship. The 2007 discussion document also proposed a cap on interest deductions by reference to the overall indebtedness of the worldwide group, and the Government has indicated that this will be relaxed in situations where the group is in a short-term cash-rich position (for example, following a sale).

The Government has, however, rejected a proposal that it move forward with the dividend exemption now and bring in anti-avoidance measures at a later date, citing concerns over lost revenue that would result from behavioural changes. Consequently, it has indicated that it is unlikely that reforms will come in to force in 2009, as originally proposed. The only possible exception to this may be in respect of the reform of the Treasury consent procedure, which may be introduced in any event.

Vodafone Decision

Although the Government has indicated only that it will not be legislating in 2009, legislation is unlikely in 2010, which is expected to be a general election year. Moreover, the Government’s scope to offer concessions along the lines sought by business is limited by the fact that the public finances are currently running at a substantial deficit.

Nonetheless, it seems equally clear that doing nothing is not an option either. July 2008 also saw the release of the judgment of the High Court in the Vodafone 2 case, which held that the existing CFC rules are incompatible with the right to freedom of establishment and must be disapplied, as least as regards EU-resident subsidiaries.

This had been widely expected following the decision of the European Court of Justice (ECJ) in Cadbury Schweppes two years ago. The ECJ held that the rules could only be justified if they were limited in scope to apply only to “wholly artificial” arrangements which do not reflect economic reality, and referred the question back to the UK courts to determine if the existence of the “motive test” exemption from the CFC charge effectively applied such a limitation.

The High Court decided that the motive test did not meet the ECJ’s requirement that the taxpayer ought to be able to escape the charge by providing objective evidence as to the economic reality of the arrangement. This was primarily because the motive test is a purely subjective test looking at the motivation for the establishment of the structure in question. As it proved impossible to read the motive test in a manner which complied with European law as expounded by the ECJ, the CFC rules as a whole offended European law and must be disapplied.

The Government introduced modest reforms to the CFC rules in late 2006 to allow companies to exclude from the CFC charge income of a CFC deriving from work undertaken by it that provided “net economic value” to the group as a whole. It will doubtless also continue to fight its corner by taking Vodafone and Cadbury Schweppes to the higher courts. It does, however, seem clear that a substantial overhaul of the existing CFC regime is going to be necessary sooner or later.