The CFC reform process, which is approaching its seventh anniversary, is coming to a reasonably happy conclusion. The approach, albeit indirect, is to define those cases where the CFC rules should apply.

The CFC rules are anti-avoidance provisions intended to counter the use of overseas 'money-box’  structures. In the absence of such rules it would be a relatively simple matter for a UK resident company to set up subsidiaries resident overseas with a view to retaining low taxed profits in those jurisdictions. These profits may or may not have been effectively diverted from the UK. Absent the CFC rules, such profits would not be liable to UK tax unless they were distributed to the UK parent (although the new dividend regime will, even then, exclude some from the charge to tax).  In simple terms, the CFC legislation requires UK parent companies to self-assess the CFC profits that fall within the charge to UK tax.

Reason for change

The legislation is, as is the case with most anti-avoidance legislation, complex and wide-ranging. A number of cross-border provisions have been challenged and the High Court granted an application for a Group Litigation Order, in, July 2003, to manage claims challenging the UK CFC provisions on the basis that they are contrary to EU law. This, and other developments, led to major changes to the transfer pricing rules and an extensive consultation on a range of other corporate tax reforms. We now have the proposed detailed CFC rules in Draft Finance Bill 2012.

Turn and turn again

Initial proposals were set out in a discussion document in January 2010. The intention was that the new regime would focus on artificial diversion of UK profits. The intention was that objective exemptions would exclude companies where there is a low risk of diversion, and a new motive test was to be introduced. In November 2010, details of the proposals for long term CFC reform were published, along with a set of interim measures, enacted in Finance Act 2011. Proposals for new CFC rules were mainly entity based and intended to operate by bringing within the CFC charge only the proportion of overseas profits that have been artificially diverted from the UK. A further consultation document was then published on 30 June 2011, outlining the detailed proposals and options to be considered.

And now

The Draft Finance Bill proposals, broadly, require the taxpayer to:

1. Identify subsidiaries which are CFCs. Regrettably, the approach taken is such that no foreign subsidiary company will fall outside the scope of the regime.
2. Ascertain the extent to which the subsidiary has profits within the scope of the regime. Here, the objective of targeting only profits which are artificially diverted from the UK is well achieved by a combination of ‘gateway tests’ together with some ‘mechanical safe harbours’.
3. If the company’s profits are not removed from charge under 2 above, then it will be necessary to ascertain whether any of the other ‘entity level exemptions’ apply.

There is in addition, a separate partial exemption (5.75% rate) available for overseas intra-group financing.

We have raised a number of concerns regarding the latest proposals in representations to HM Treasury.  In particular, our view is that it would be more sensible to start by having a targeted filter in the form of a narrow definition of CFC. The absence of such a narrow filter means that compliance obligations are uncertain and, potentially, the rules will require taxpayers to provide evidence as to why any non-UK subsidiary is not within the scope of the charge.

We await the publication of the Finance Bill on the 29 March with keen interest.