Far from the draft CFC legislation being on the home stretch after detailed consultation spanning the previous three years, there have in fact been significant changes to even those in the June 2011 consultation document.   In summary, the revised proposals appear to show that the Government is listening by attempting to simplify the exemptions and make the revised legislation more business friendly.

Baker Tilly analysis

Keen to get the legislation right, the latest consultation document shows a series of changes made in response to the previous consultation in June 2011.  The most significant amendment is the introduction of a Gateway test, which applies a principles-based approach to the CFC rules. This new test is aimed allowing low-risk foreign subsidiaries to not have to carry out detailed mechanical tests.  However, whether such an approach will be favoured in practice remains to be seen, particularly, where mechanical tests provide greater certainty and more easily defensible positions for businesses.

The exemption that will make a difference to the vast majority of businesses is the increased threshold for the Low Profits Exemption, where subsidiaries with accounting profits of less than £500,000 should be exempt from the CFC regime, provided there are no arrangements designed to take advantage of this exemption.

The work isn’t done yet however, as the latest consultation published with the draft 2012 legislation has a response date of February 2012, with the much-awaited final legislation due out in the Spring. 

In detail

The Gateway test is by the far the biggest change, introducing a principles-based approach, which changes the assumption that all foreign subsidiaries are within the scope of the regime unless an exemption can be found, to now expressly defining the profits that fall within the scope of the regime.  There are three conditions, which attach to the Gateway test, which if met, mean that this test cannot be relied upon:

1. the artificiality condition (by reference to significant people functions and their UK connection);
2. the non-tax  value condition (separation of assets/risks from activity which gives rise to substantial tax value); and,
3. the independent companies arrangement condition (i.e. would the arrangement have been entered into between independent persons).

A further significant change is the introduction of the Safe Harbour tests; the principal one being the Commercial Activities Safe Harbour.    This combines the previously proposed ‘Manufacturing Trade’ test and ‘General Commercial Activities’ test, and includes conditions relating to establishment, IP transfers from the UK and level of UK connection. There is also an Incidental Income Safe Harbour test, which exempts incidental finance income provided it is less than 5% of the trade and business profits. Sector specific safe harbour rules are included for banking and insurance companies.

Furthermore, there are Entity Level Exemptions;

• Profits Safe Harbour (10% mark-up on a defined cost base);
• Low Profits Exemption (£500,000 of accounting profits);
• Excluded Territories Exemption (principally excludes countries with a headline rate of tax greater than 75% of the UK’s main rate); and
• Temporary Period Exemption (period of grace following acquisition/reorganisation).

The Finance Company Exemption remains principally in its previous form, providing an effective tax rate of 5.75% for finance companies, though the Government is looking to extend the scope of this exemption by further limiting the total CFC charge arising on finance company profits to the aggregate net borrowing costs of the UK group members.  

Anti-avoidance provisions relating to profits arising from the exploitation of IP with a UK connection are contained within the Safe Harbour and Excluded Territories Exemptions.