Tolley’s Tax Digest

Topical Corporation Tax Issues for Large Companies

Eloise Brown CTA ATT

Practical, expert guidance including: Issue 125 | March 2013

• an overview of relevant draft legislation in Finance Bill 2013; • an overview of corporate tax reform measures and update on changes since introduction; • financing update including worldwide debt cap and changes to the 'deemed release' rules; • key international changes including an overview of FATCA; • and much more.

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Tolley’sTolley’s TaxTax DigestDigest || IssueIssue 125125 || March March 2013 2013 TopicalTopical Corporation Corporation Tax Tax Issues Issues forfor LargeLarge CompaniesCompanies

Contents Author Introduction 1 Eloise Brown CTA ATT Draft clauses for Finance Bill 2013 2 Eloise has many years' experience of advising a wide range Corporation tax rate 2.1 of clients, from standalone family owned companies to Annual Investment Allowance 2.2 fully listed groups, on their corporate tax affairs. She has worked on a wide range of transactions for corporate and Research and development 'Above the line' private equity clients on both buy and sell side and advised tax relief 2.3 on a variety of restructuring projects. She is a member of Controlled foreign companies 2.4 the Association of Taxation Technicians, a Chartered Tax Foreign currency assets and corporate Adviser and a member of the CIOT professional Standards chargeable gains 2.5 Committee. She has previously been a contributor to Tax Income tax withheld at source on interest Journal, Taxwise and led the development of content for payments 2.6 the initial launch of the Owner-managed Business and Corporate tax modules of TolleyGuidance. Worldwide debt cap 2.7 Group relief 2.8 Deferring payment of exit charges 2.9 FATCA 2.10 General anti-abuse rule ('GAAR') 2.11 Other measures 2.12 Corporate tax reform 3 Controlled Foreign Company ('CFC') Rules 3.1 Foreign Branch Exemption 3.2 Patent box 3.3 R&D tax relief – 'Above the line' tax credits 3.4 Distribution exemption 3.5 Financing update 4 The debt cap 4.1 Changes to the 'deemed release' rules 4.2 Income tax withheld at source on interest payments 4.3 UK implementation of the US 'Foreign Account Tax Compliance Act' (FATCA) 5 Overview of process 5.1 Definition of financial institutions 5.2 Custodial institution 5.3 Depositary institution 5.4 Tolley’s Tax Digest is produced and published by LexisNexis. Investment entities 5.5 Views expressed in this Digest are the author's and are not necessarily those Specified insurance company 5.6 of the author's firm or of the publisher. Exemptions 5.7 No responsibility for loss occasioned to any person acting or refraining from Residence 5.8 action as a result of the material in this Tax Digest can be accepted by the Financial accounts 5.9 author or publishers. Due diligence requirements 5.10 © Reed Elsevier (UK) Ltd 2013 Reporting requirements 5.11 Crown copyright material is reproduced with the permission of the Controller of HMSO and the Queen’s Printer for Scotland. Any European Penalties 5.12 material in this work which has been reproduced from EUR-lex, the official EU Financial Transactions Tax – update 6 European Communities legislation website, is European Communities Appendix 1: 'Above the line' credit for research copyright. and development – summary of calculation steps LexisNexis, a Division of Reed Elsevier (UK) Ltd, Halsbury House, 35 Appendix 2: Foreign Account Tax Compliance Act Chancery Lane, London WC2A 1EL (FATCA) and UK Regulations to implement US- Telephone: 020 7400 2500 Fax: 020 7400 2842 UK Treaty dated 12 September 2012 – overview of Printed and bound in Great Britain by Hobbs the Printers Ltd, Totton, process steps Hampshire

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Topical Corporation Tax Issues for Large Companies Tolley’s Tax Digest | Issue 125 | March 2013

1 Introduction delivered on 5 December 2012. The window for providing comments on the draft legislation closed on 6 February The tax affairs of large companies have perhaps never been 2013. Finance Bill 2013 will be published on 28 March 2013 in the spotlight as much as they are at the time of writing. following the Budget which will take place on 20 March This is manifest not only in the hearings of the Treasury 2013. Select Committee, but has permeated all the way through to the front pages of broadsheets and tabloids alike. The knock- A summary of some key points from the Autumn statement on effect for large companies is a nervous environment and draft legislation of relevance to large companies for tax planning. Public relations and reputation are more follows. than ever a priority for boards when deciding whether to proceed with tax planning proposed by tax or finance directors or their advisers. These are unprecedented and 2.1 Corporation tax rate fascinating times to be working in the world of tax for large The main rate of corporation tax will be reduced by a companies. further 1% from 24% to 23% in April 2013. It will reduce by an additional 1% than was previously announced in April However, large companies have far more to be concerned 2014, to 21% rather than 22%, signalling an additional move about than public and government scrutiny of tax planning. towards a single rate of corporation tax for all companies ‘Routine’ tax compliance and regulatory obligations are regardless of their size. increasingly complex. As well as perennial difficulties such as compliance with transfer pricing and keeping track of With a main rate of corporation tax of 21% the UK would, permanent establishment rules, both in the UK and in other by current comparison, have the lowest corporation tax jurisdictions, there has been a vast amount of new and rate in the G7 and the fourth lowest in the G20. amended legislation in recent years. The tax environment for larger companies is also challenging as a result of effects 2.2 Annual Investment Allowance of the current economic climate, for instance difficulties in meeting financial covenants and increasing operations in Another positive change is the temporary increase of new and emerging markets with fledgling tax regimes. the 100% Annual Investment Allowance from £25,000 to £250,000 for a two year period. The increased level of the Despite widespread public perception that HMRC is ‘soft’ allowance will apply for expenditure incurred on or after on large companies, and that it is all too easy for them to 1 January 2013. Annual Investment Allowance is available structure their tax affairs so as to avoid UK corporation tax on a wide range of expenditure, including plant and or achieve distastefully low tax rates, HMRC’s interest in machinery and fixtures, but not on cars. large companies seems as intense as at any time historically. Whilst undoubtedly some of the largest businesses have 2.3 Research and development ‘Above the Line’ been involved in aggressive tax planning, it is probably tax relief fair to say that the majority of businesses have to focus Following a period of consultation, draft legislation has more and more of their resources on increasing HMRC been published for the new ‘Above the Line’ (‘ATL’) administrative and reporting requirements. research and development tax relief. The new relief is considered in more detail later in this publication; however This issue of the Tax Digest aims to provide a broad overview in summary some of the key features of the relief are as of the key new and amended corporation tax legislation follows: and changes to HMRC practice affecting large companies from the last few years. Necessarily some of the content is • Tax credits available under ATL are at a rate of 9.1% about legislation which is currently in draft, and on which of qualifying R&D expenditure incurred on or after comments are still invited at the time of writing, such as 1 April 2013; the proposed ‘Above the Line’ R&D tax credit and GAAR. Updated legislation will be available on 28 March 2013 • The amount of repayable ATL tax credit available is following Budget day on Wednesday 20 March. The main capped at the amount of PAYE and NIC in respect of focus of this issue is UK corporation tax legislation although R&D staff for the accounting period; reference may be made to other taxes and jurisdictions • ATL tax credits are given as a pre-tax item in the where pertinent. Whilst the aim is to give an overview of profit and loss account; new, recent and proposed changes of broad appeal, some significant changes with a narrower or sector-specific appeal • ATL tax credits are taxable (hence more akin to a is included, notably the implementation of FATCA. grant than previous forms of R&D relief in the UK); and

• Companies in groups will have options to surrender 2 Draft clauses for Finance Bill 2013 the credit to other group members or to surrender the tax withheld on the credit to offset against other Draft clauses for inclusion in Finance Bill 2013 were first group members’ tax liabilities. published following the Autumn statement which was

1 Tolley’s Tax Digest | Issue 124 | February 2013 Transactions in Securities

There will be an initial option for companies to claim for Several other measures proposed by the consultation the new ATL relief or to continue to claim relief under the process are included in the draft legislation, in particular current large company research and development tax relief. the requirement for the issuers of funding bonds to provide This option continues until 31 March 2016 after which time the recipient with a certificate stating the gross interest the existing large company scheme will be withdrawn and ‘paid’ by issue of the funding bond, the amount of tax ATL will be the only option for claimant companies. withheld and the date of payment.

Amendments are made to the patent box legislation to This is discussed later in this publication. enable companies to benefit from both regimes. 2.7 Worldwide debt cap (Draft CTA 2009 ss 104A–104W.) The draft Finance Bill 2013 contains measures amending the ability of group treasury companies to opt out of the The draft legislation is discussed in more detail later on in debt cap regime. The reason for the amendment is to this publication. prevent companies which were not properly performing group treasury functions from making elections to opt out 2.4 Controlled foreign companies of the debt cap rules. The draft amended rules ensure that companies may only fully opt out of the debt cap regime if There are further amendments to the new CFC rules, which substantially all of their activities are treasury activities, and apply for accounting periods on or after 1 January 2013. all or substantially all of their assets and liabilities relate to The latest amendments include measures to bring profits such activities. If the ‘substantially all’ requirement is not from finance lease and hire purchase assets within the CFC met then companies will only be able to exclude the portion rules, and some anti-avoidance measures. of financing income and expenses to the extent relating to treasury activities. The new CFC regime is considered in further detail later in this issue. The proposed amendments have effect for accounting periods starting on or after 11 December 2012. 2.5 Foreign currency assets and corporate chargeable gains The debt cap is discussed further later in this publication. Following consultation, there are provisions in draft Finance Bill 2013 regarding the way in which companies with a 2.8 Group relief functional currency other than sterling calculate capital gains and losses. Currently, regardless of a company’s The draft Finance Bill 2013 includes measures restricting functional currency, chargeable gains / losses are computed the use of losses of UK permanent establishments of in sterling, however this approach leads to mismatches in companies resident in the European Economic Area (EEA). certain circumstances. The proposed new rule would require From 1 April 2013, losses will be restricted to the amount that UK companies with a functional currency other than of losses actually used. Currently losses are restricted sterling must compute chargeable gains / losses either: instead based on whether they could potentially be used (CTA 2010 s 107). This follows the ECJ’s decision in Philips Electronics UK Ltd which found that the current legislation • in the company’s functional or local currency; or contravenes EU law. • if the company has made a designated currency election, in the designated currency, where this Another draft amendment to group loss relief amends rules would otherwise apply. restricting group relief where there are ‘arrangements’ in place for a company to cease to be a member of the group The proposed new rules apply only to chargeable disposals in future. The current rules will be amended so that loss of shares and they will have effect for disposals on or after relief will not be denied in certain circumstances where the date of Royal Assent. a company leaves a group relief group as a result of commercial arrangements with public authorities. (Draft CTA 2010 s 9C.) 2.9 Deferring payment of exit charges 2.6 Income tax withheld at source on interest Draft Finance Bill 2013 includes measures amending the payments way in which HMRC collects corporation tax arising as a Finance Bill 2013 includes a number of measures on result of UK companies ‘migrating’ residence to another EU which the Government consulted in 2012 on requirements member state. Currently, companies are deemed to dispose for income tax to be withheld at source on payments of of their chargeable assets and intangibles at market value at interest. A number of measures which were proposed by the date of migration. There are also corporate ‘exit’ charges the consultation document have not been implemented, in respect of loan relationships and derivatives. The draft including the removal of the quoted Eurobond exemption measures enable companies migrating to another EEA for intra-group transactions, and the requirement for state to defer UK tax due on corporate exit charges until income tax to be paid in cash on the issue of funding bonds. they would otherwise be due, subject to meeting certain

2 Transactions in Securities Tolley’s Tax Digest | Issue 124 | February 2013 conditions and making a valid claim. Currently, tax due GAAR; and as ‘exit charges’ falls due on the normal due date of nine • the GAAR remains widely drawn, however there is months and one day following the end of the accounting still no clearance procedure proposed period. 2.12 Other measures The draft measure follows the decision of the ECJ in National Grid Indus BV which concerned Dutch corporate Other announcements which may be of interest include: exit charges. Following the decision, which found that the requirement for the exit charges to be paid straight away • REITs regime – amendments are included in the contravened EU law; the European Commission requested draft Finance Bill 2013. The draft amendments the UK to amend its equivalent law. provide that income which UK REITs receive as a result of investing in other UK REITs will be The provisions as drafted will apply to corporation tax treated as income of the investing REIT’s tax exempt due on or after 11 December 2012. They were subject to a property rental business. These will have effect for period of consultation which ended on 6 February 2013. accounting periods beginning on or after the date of The consultation document was issued along with the draft Royal Assent; legislation on 11 December 2012. • bank levy – the bank levy rate will increase from 0.105% to 0.130% and the half rate will increase to 2.10 FATCA 0.065 per cent. Both increases have effect from 1 Draft Finance Bill 2013 includes provisions which give January 2013; and effect to the intergovernmental agreement between the • tax reliefs for the creative sector – following a period UK and US relating to the US rules known as ‘Foreign of consultation, and subject to EU state aid approval, Account Tax Compliance Act’ (‘FATCA’). Subsequently, three new tax reliefs will be introduced aimed at the draft regulations and guidance were published on 18 creative industries, of animation, video games and December 2012, along with responses to the consultation. certain ‘high-end’ television production. Relief will FATCA requires financial institutions to take steps to be available for expenditure incurred on or after 1 identify US investors in non-US entities or accounts to the April 2013. These reliefs operate in a similar fashion US authorities. FATCA and the draft UK rules to effect the to existing reliefs such as R&D SME relief and film UK-US intergovernmental agreement are considered in tax relief. some more detail later in this publication.

(Draft TMA 1970 ss 59FA-59FM.) 3 Corporate tax reform 2.11 General anti-abuse rule (‘GAAR’) The roadmap for introduction of measures for reform of the UK’s corporate tax regime, issued in November 2010, Additional details regarding the proposed GAAR were will be complete with the enactment of measures included provided in the Autumn statement. Updated draft in draft Finance Bill 2013. The process has been lengthy legislation was published along with draft guidance and there has been close consultation with businesses and including a number of examples. the profession, meaning that for the most part there has been plenty of notice and time for practitioners to begin Key points to note are that: preparing for the new rules. Given the volume of new legislation, a broad overview of the new rules is included • the GAAR will apply to income tax, corporation tax, below. The outline of the new rules below is intended as a capital gains tax, petroleum revenue tax, inheritance guide only and cannot in the given space be comprehensive, tax, SDLT and the new annual residential property so practitioners should continue to familiarise themselves tax, but not to VAT. It will apply to National Insurance first hand with the legislation and HMRC guidance. contributions although this is not provided for by draft Finance Bill 2013; 3.1 Controlled Foreign Company (‘CFC’) Rules

• the GAAR is set to apply to arrangements entered 3.1.1 Introduction into on or after the date of Royal Assent (likely to be The new CFC rules in TIOPA 2010 Part 9A apply with effect July 2013); for accounting periods starting on or after 1 January 2013, • arrangements containing non-arm’s length terms following enactment of Finance Act 2012. This follows a are not specifically included as indications of ‘abuse’ number of previous interim reform measures made to the (this is a change from the previous draft); rules over the last few years. The overall principle of the changes to the rules is to only tax profits which have been • arrangements may not be caught if they were artificially diverted from the UK. entered into in accordance with prevailing practice at the time; As with the rules applicable to accounting periods starting • HMRC will have to obtain the opinion of the before 1 January 2013, there are a number of exemptions Advisory Panel before bringing any action under the

3 Tolley’s Tax Digest | Issue 125 | March 2013 Topical Corporation Tax Issues for Large Companies

available, some of which are completely new and others the Example 1 (From HMRC draft guidance) same or amended versions of the old rules. Notably there Assume the following structure where the are new exemptions for profits from intra-group financing. percentages relate to holdings of ordinary shares These give full or partial exemption for between 75-100% of that carry the same proportionate voting rights: a CFC’s intra-group financing profits.

Gateway tests have been introduced in addition to exemptions which aim to ensure only artificially diverted UK Ltd profits may be subject to a CFC charge. The introduction of the Gateway tests should make it easier for many businesses 65% to comply with the rules, as it is expected that many will fall out of the rules on application of the Gateway tests. NR 1

As under the previous rules, the effect of the CFC rules 75% is to attribute profits of CFCs to 'relevant persons', ie their UK resident parent companies, holding at least a NR 2 25% interest in the subsidiary. The profit attribution is made proportionately to the relevant person’s percentage holding of ordinary shares in the CFC. CFC apportioned On a purely mathematical basis, UK has only profits are taxed at rates equivalent to UK corporation tax, 48.75% of the voting power of NR2. It nonetheless less creditable overseas tax. has the power to secure that the affairs of NR1 are conducted in accordance with its wishes and as NR1 HMRC has published draft guidance on the new CFC rules has control of NR2, UK also has the power to secure on its website at www.hmrc.gov.uk/drafts/cfc-rules.htm. that the affairs of NR2 are conducted in accordance The draft guidance includes several flowcharts illustrating with its wishes. NR2 will therefore be a CFC within the operation of the new rules. the meaning of TIOPA 2010 s 371RB(1), by virtue of the shareholdings. 3.1.2 Definition of a CFC On the other hand, assume a slightly different A CFC of a UK company is a non-UK resident company structure (again the percentages relate to holdings which is controlled by a UK resident person / persons of ordinary shares that carry the same voting rights): (TIOPA 2010 s 371AA(3)).

The control tests are similar to those in the previous rules. A UK 1 company is controlled by another person or persons if they have legal and / or economic control over it. 35%

Legal control JV A person controls a company if they have power to secure that the company’s affairs are conducted in accordance 100% with their wishes, by:

• holding shares or voting power in relation to the UK 2 company or any other company; or 75% • by virtue of powers conferred on them by the articles 25% of association or other document regulating the company or any other company. CFC

(TIOPA 2010 s 371RB(1).) On a simple mathematical calculation, UK1 has 35% This is a broad control test. HMRC considers this to be not of the voting power of CFC and UK2 has 25% of the merely a mechanical test based on percentage ownership, voting power of CFC, giving a total of 60% which but that it should take into account the powers a person has would appear to give control to persons resident in to control a company. The following example is given in the UK. If, however, one person owned the remaining HMRC’s draft guidance. 65% of the shares in Joint Venture, that person would on their own on a purely mathematical basis have 65% of the voting power of the CFC. Clearly,

4 Topical Corporation Tax Issues for Large Companies Tolley’s Tax Digest | Issue 125 | March 2013

one cannot have 125% voting power in a company controls its subsidiary company and the subsidiary is a and the reason for the additional 25% is that UK2’s CFC if a 50% condition is met in the accounting period. The shareholding in CFC has effectively been counted condition is that assuming the company is a CFC, at least twice. 50% of its chargeable profits would be apportioned to its parent together with its UK resident subsidiaries. However, simply eliminating the apparent double counting will not necessarily provide the answer (TIOPA 2010 s 371RE.) as to who controls CFC. In the above scenario, for example, eliminating the double counting reduces the total shareholding in CFC of UK1 and UK2 to 3.1.3 The gateway 51.25% of the voting power (UK2’s 25% + UK1’s 35% The ‘gateway’ tests in Chapter 3 may apply to exclude x 75% (=26.25%)). Again, this would appear to give profits from the CFC rules even where they would otherwise control to persons resident in the UK. Yet UK1 and apply. There are different gateway tests for different types UK2 are clearly not in a position – even together – of income. The tests for Chapters 4 and 5 are discussed here. to secure that the affairs of CFC are conducted in accordance with their wishes. UK1’s minority interest Chapter 4 gateway in Joint Venture does not confer additional control over CFC. The other shareholder(s) of Joint Venture As long as one of the following gateway tests applies, could prevent that happening – whether or not any Chapter 4 (profits attributable to significant people of those shareholders themselves is in a position to functions) does not apply. exercise control. As such, CFC is not a CFC as it is not controlled by UK persons for the purposes of Part 9A. No tax avoidance motive (Condition A)

(From HMRC draft CFC guidance – ‘Chapter 18 – control’.) The first gateway test is a motive test which determines that an attribution of profits will only be required if there are arrangements:

Economic control • the main purpose of which is to reduce or eliminate any liability of any person to UK tax, of which as a In addition, a company is controlled by another person or consequence the subsidiary’s profits are higher than persons if it is reasonable to suppose that they are entitled they would be absent the arrangements; to receive the majority of its: • it may be expected that as a consequence of the • income available for distribution; arrangements, one or more persons will have reduced liabilities to any taxes; and • proceeds on disposal of the company’s share capital; or • it may reasonably be supposed that the arrangements • assets available for distribution on winding up. would not have been made but for that expectation.

A company is also defined as under the control of a UK (TIOPA 2010 s 371CA (2)-(4).) resident person in specified circumstances where UK resident persons hold 40% of the rights in the overseas This gateway test may apply to CFCs which relied on the company. ‘motive’ exemption under the previous rules, however the new gateway test is narrower than the motive exemption. (TIOPA 2010 s 371RC.) Non-UK managed assets or risks (Condition B) Attribution of rights and powers In determining whether a person has the interests specified No attribution of profits is required if the CFC does not have in the legal and economic control tests, the rights and any UK managed assets, or bear any UK managed risks powers of other persons are attributed to that person. These during the accounting period (TIOPA 2010 s 371CA (5)). include rights and powers which may be acquired at some future date, or those which may be required to be exercised Assets or risks are ‘UK managed’ if the acquisition, on behalf of or for the benefit of a person. Additionally, creation, development or exploitation of the assets, or the rights and powers of connected persons who are UK taking on or bearing of the risk, is managed or controlled resident persons are attributed to a UK resident person. to a significant extent by way of activities carried out in the UK by the CFC (otherwise than through a UK PE) or Accounting standards control test by companies connected with the CFC under non-arm’s length arrangements (TIOPA 2010 s 371CA (9) and (10)). There is a new control test based on an accounting definition. A parent company (in accordance with FRS2)

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Capability and commercial effectiveness (Condition C) –– carried on by the CFC; and

–– no trading profits of which pass through the No attribution of profits is required if the CFC has the capability CFC charge gateway, (i.e. the trading profits of being commercially effective without UK management of are exempt); or assets or risks. The capability of the CFC in this context includes the ability to use unconnected parties to provide goods or • profits which arise on an investment of funds held services (ie to outsource work to contractors etc). by the CFC for the purposes of a property business or overseas property business. (TIOPA 2010 s 371CA (6) and (7).) (TIOPA 2010 ss 371CB(3) and 371CB(4).) Non-trading finance profits (Condition D) However, the above cannot apply to exempt profits from Chapter 5 in relation to funds: No attribution is required of non-trading finance profits if the CFC’s assumed total profits consist only of: • held only or mainly because of a prohibition or restriction of the payment of dividends by the CFC; • non-trading finance profits; and • held with a view to paying dividends or other • property business profits. distributions more than 12 months after the end of the accounting period; (TIOPA 2010 s 371CA (11).) • held with a view to acquiring shares or making any capital contribution; ‘Assumed total profits’ means the CFC’s taxable total profits (defined in CTA 2010 s 4(3)), taken to be: • held with a view to acquiring, developing or investing in land more than 12 months after the end • after deduction of specific items of income; and of the accounting period;

• before deductions for amounts relievable against • held only or mainly for contingencies; or total profits. • held only or mainly for reducing a tax liability.

(TIOPA 2010 s 371SB.) (TIOPA 2010 s 371CB(5).)

On the assumptions that: Incidental amounts

• the CFC is a non-close UK resident company Chapter 5 does not apply where the amount of non-trading throughout the accounting period; finance profits is ‘incidental’ (no more than 5%) to trading • it has made all possible claims or elections to obtain and property business profits, or exempt dividend income maximum relief; and in a holding company and its 51% subsidiaries, or both (TIOPA 2010 s 371CC). • it is not a member of a group or consortium.

There are further more detailed rules in TIOPA 2010 ss (TIOPA 2010 s 371SC.) 371CC and 371CD.

‘Non-trading finance profits’ means broadly any amounts 3.1.4 Exemptions which are included in ‘assumed total profits’ on the basis that they would be chargeable to tax as non-trading profits In addition to the gateway tests, CFCs may be exempt from loan relationships or company distributions (TIOPA from the rules altogether if an exemption is available. The 2010 s 371VG (1)). exemptions applicable for accounting periods starting on or after 1 January 2013 are as follows: Chapter 5 gateway • low profits; Investment of funds • low profit margin;

Non-trading finance profits are excluded from the scope of • excluded territories; Chapter 5 so far as they are: • high tax; and

• profits arising on an investment of funds held by the • exempt period. CFC for the purposes of a trade:

6 Topical Corporation Tax Issues for Large Companies Tolley’s Tax Digest | Issue 125 | March 2013

Financing exemptions are discussed later below. • any expenditure which gives rise to income of a person related to the CFC, either directly or indirectly. The low profits exemption The low profit margin exemption may apply for instance to The low profits exemption is available where a CFC’s CFCs whose function is to provide services to other group accounting profits or the assumed taxable total profits for companies, for instance on a cost-plus basis resulting in a the accounting period are less than £50,000, or £500,000 low accounting profit margin. provided non-trading income is not more than £50,000.

Anti-avoidance legislation aims to prevent groups from Amounts are reduced proportionately for short accounting benefiting from the low profit margin exemption where periods. they have made arrangements, the main purpose of which is to benefit from the exemption. (TIOPA 2010, s 371LB.) (TIOPA 2010 ss 371MA-371MC.) In determining accounting profits, the following are ignored: The excluded territories exemption • dividends which would be exempt; As in the rules for accounting periods starting before • property business profits or property business 1 January 2013, there is an exemption where CFCs are losses; and resident in an ‘excluded territory’, although the new rules • capital profits or losses. are quite different. In order for the exemption to apply, all of the following must apply: The following are included: • the CFC must be resident in an ‘excluded territory’ for the accounting period; • amounts accruing during the accounting period to the trustees of a trust of which the CFC is a settlor or • the income condition must be met; beneficiary; or • the IP condition must be met; and • the CFC’s share of any income accruing during the • the anti-avoidance provision does not apply. accounting period to a partnership in which the CFC is a partner. ‘Excluded territories’ are those territories specified in The Controlled Foreign Companies (Excluded Territories) (TIOPA 2010 s 371VD.) Regulations 2012.

The ‘assumed taxable total profits’ for the purpose of this (TIOPA 2010 ss 371KB.) exemption is discussed above.

The income condition is that there are limited amounts The ‘group mismatch’ rules are applied as an anti-avoidance of specified types of income. This is tested in relation to a measure. Anti-avoidance rules also prevent the low profits ‘threshold’ amount, which is the greater of: exemption from being available in the following circumstances:

• 10% of the CFC’s accounting profits for the • where groups split profits between different companies accounting period; or in order to benefit from the exemption; and • £50,000 (reduced proportionately for short • the CFC’s business is wholly or mainly the provision accounting periods). of UK intermediary services.

The categories of income specified are as follows: (TIOPA 2010 s 371LC.)

• Category A income – The gross amounts of income The low profit margin exemption (before any deductions for expenses or transfers to The low profit margin exemption is a new exemption which had reserves) which is: no equivalent under the previous CFC regime. The exemption –– exempt from tax in the CFC’s territory of applies where the CFC’s accounting profits (taken before residence (other than dividends); interest deductions) for the accounting period are no more than 10% of its operating expenditure, excluding the following: –– subject to a reduced rate of tax which aims to encourage investment in the CFC’s territory • the cost of goods purchased by the CFC, other than of residence; or goods used by the CFC in its territory of residence; and –– subject to tax in the CFC’s territory of residence

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in respect of which a person connected with (TIOPA 2010 s 371KJ.) the CFC is entitled (directly or indirectly) to a repayment of or credit for the tax (TIOPA The excluded territories exemption is not available if the 2010 s 371 KE.) CFC is involved, at any time during the accounting period, • Category B income – Notional interest which: in an arrangement the main purpose of which is to obtain a tax advantage for any person. –– is deducted from any of the CFC’s relevant income for tax purposes in the CFC’s territory (TIOPA 2010 s 371KB(1)(d).) of residence, or any territory in which the CFC has a permanent establishment; but The high tax exemption –– is not deducted for the purposes of calculating the CFC’s assumed taxable total profits, The high tax exemption applies if the local tax paid by the CFC amounts to at least 75% of the UK corporation tax unless this amount exceeds the CFC’s relevant non- which would have been payable on the corresponding local income. Relevant non-local income means gross profits. This is similar to the ‘lower level of taxation’ test non-trading income received directly or indirectly under the previous regime. The computational rules are set from a person or a permanent establishment outside out in steps in TIOPA 2010 s 371NB. the CFC’s territory of residence. (TIOPA 2010 s 371KF.) The high tax exemption is not available where the CFC is subject to ‘designer rate tax provisions’. • Category C – Trust and partnership income as defined in TIOPA 2010 s 371VD: (TIOPA 2010 ss 371NA-371NE.) –– amounts accruing during the accounting period to the trustees of a trust of which the CFC is a settlor or beneficiary, or Example 2 (adapted from HMRC draft –– the CFC’s share of any income accruing guidance) during the accounting period to a partnership A CFC resident in territory X has assumed taxable in which the CFC is a partner. total profits of £100,000 in the accounting period (TIOPA 2010 ss 371KH and 371VD.) to 31 March. The CFC pays £7,000 tax in respect of those profits in territory X and in addition pays • Category D – Gross amounts of income brought £11,000 tax in territory Y where it trades through into account for determining the CFC’s accounting a permanent establishment. The £7,000 tax paid in profits for the accounting period, which: territory X is net of tax relief given by country X –– arises from a provision between the CFC and for the tax paid in territory Y. The comparison to be a company connected with it by means of an made in accordance with the steps at TIOPA 2010 s arrangement; 371NB is as follows:

–– is reduced in the CFC’s territory of residence A = corresponding UK tax, B = local tax amount for tax purposes on the basis that the income is more than it would have been had the two The computation of the corresponding UK tax is as companies been unconnected; follows:

–– there is no corresponding adjustment for £ tax purposes in the income of the company connected with the CFC. £100,000 @ 23% 23,000 Less tax paid in territory Y (11,000) I.e. this would include one-sided transfer pricing adjustments. 12,000 (A)

Category D income also includes the tax which falls to be Tax paid in territory X 7,000 (B) paid in the CFC’s territory of residence at a reduced rate by virtue of an official ruling. As (B) is less than 75% of (A), the CFC will not therefore benefit from the exemption. (TIOPA 2010 s 371I.) (From HMRC draft CFC guidance – ‘Chapter 14 – The IP condition prevents the excluded territories exemption the tax exemption’.) from applying if the CFC’s profits included profits from intellectual property of which a significant part was transferred from the UK within the previous six years.

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This example is continued in HMRC’s draft guidance with The legislation sets out steps for determining profits variations to illustrate different scenarios. attributable to SPFs which are to be taken in accordance with the OECD Report principles: The exempt period exemption • Step 1 – Identify the ‘relevant assets and risks’ from A CFC is exempt from the rules for the first 12 months after which amounts included in assumed total profits are it becomes a CFC (or longer at the discretion of HMRC). generated.

The rules specify how to apply the exempt period exemption • Step 2 – Exclude relevant assets and risks to the extent where a company becomes a CFC part way through an that their impact on assumed total profit is negligible. accounting period. When a company first becomes a CFC, • Step 3 – Identify SPFs carried out by the CFC group the accounting period must be split for the purpose of which are relevant to the economic ownership of applying the exemption. assets or assumption and management of risks included in relevant assets and risks. In order for the exemption to apply the company must • Step 4 – Determine the extent to which SPFs identified continue to be a CFC and to be fully exempt in the at Step 3 are UK SPFs. UK SPFs are those which subsequent accounting period after the exempt period. are carried out in the UK by the CFC or connected companies. Anti-avoidance rules prevent the exemption from being available in the following circumstances: • Step 5 – Assume the UK SPFs identified at Step 4 are carried on by a UK permanent establishment of the CFC, and assume the non-UK SPFs identified at Step • an arrangement is entered into at any time, the main 4 are carried out by the CFC itself. purpose or one of the main purposes of which is to obtain a tax advantage for any person; • Step 6 – Exclude from relevant assets and risks any assets and risks where less than 50% of the asset or • the arrangement is linked to the exempt period risk is attributable to the deemed UK permanent exemption applying; and establishment. • the arrangement involves the CFC holding assets • Step 7 – The provisional Chapter 4 profit is the giving rise to non-trading finance profits or financing amount of profit attributable to the deemed UK profits, or holding intellectual property giving rise to permanent establishment from Step 5, subject to any income. amounts excluded under Step 8.

And / or: • Step 8 – exclude amounts attributable to the following:

• an arrangement is entered into at any time the –– assets or risks held by the CFC, where the consequence of which is to benefit from the exempt CFC adds substantial non-tax additional period exemption by manipulating the length of the value. This applies provided there is no UK company’s accounting periods. tax reduction as a result (TIOPA 2010 s 371DD (‘economic value’)).

(TIOPA 2010, ss 371JA-371JG.) –– UK functions, provided the CFC would have used independent parties to carry out those 3.1.5 Profits attributable to UK SPFs (Chapter 4) functions if they were not carried out by a connected company (TIOPA 2010 s 371DE Where none of the above exemptions are available and (‘independent companies’ arrangements)); and gateway tests not met, the profits of CFCs are attributed to their UK parent companies in accordance with their –– trading profits, subject to conditions (outlined relevant interest in the CFC. below) (TIOPA 2010 s 371DF).

Attributable profits are those arising from a ‹significant people function› (SPF) located in the UK. Services within Trading profits the definition which are provided by connected companies under intercompany arrangements must be taken into Trading profits are excluded from attributable profits where account for this purpose. the following conditions are met:

Profits attributable to SPF are defined and calculated • the CFC has local premises from which its activities according to the 2010 OECD Report on the Attribution of are mainly carried on (TIOPA 2010 s 371DG); Profits to Permanent Establishments (‘OECD Report’). SPFs • no more than 20% of income is derived from UK are broadly functions requiring an active decision making residents or permanent establishments, either process relating to assets or risks.

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indirectly or directly (TIOPA 2010 s 371DH); • loans funded from qualifying resources;

• no more than 20% of management costs relate to UK • the 75% exemption; and employees (TIOPA 2010 s 371DI); • matched interest. • the profits are not derived from the transfer of intellectual property from connected companies in The calculation of profits of a qualifying loan relationship the UK (TIOPA 2010 s 371DJ); and for the purpose of the financing exemptions is detailed in • no more than 20% of trading income is from goods the steps in TIOPA 2010 s 371IF. exported to the UK, with the exception of goods exported from the CFC’s country of residence. Loans funded from qualifying resources Exemption is available for profits of a qualifying loan There is an anti-avoidance rule aiming to prevent groups relationship to the extent that a qualifying loan relationship from restructuring existing activities to benefit from this is funded from ‘qualifying resources’. Qualifying resources exclusion (TIOPA 2010 s 371DL). include:

3.1.6 Non-trading finance profits (Chapter 5) • profits from lending to group members used solely To the extent that the gateway test for Chapter 5 in Chapter for the purpose of the CFC group’s business in the 3 (discussed above) is not met, the following profits are relevant territory; or included as attributable profits (unless exempt – financing • irredeemable issues of shares to third parties by the exemptions are discussed below): parent company.

• capital investment funds provided from the UK The amount of profits from a loan relationship which are (TIOPA 2010 s 371EC); exempt is proportionate to the amount of the loan funded • loans provided to UK connected companies, if it is a from qualifying resources. A claim cannot also be made for reasonable assumption that they were made instead the 75% exemption (discussed below). Therefore unless at of payment of dividends for the purpose of reducing least 75% of the loan is funded from qualifying resources tax liabilities (TIOPA 2010 s 371ED); or then it will not be beneficial to claim the qualifying resources exemption. • leases to UK connected companies, if it is reasonable to assume that the UK companies would otherwise (TIOPA 2010 ss 371IB-371IC.) have purchased the asset and that the main reason or one of the main reasons the lease is made relates to a tax liability or potential tax liability (TIOPA 2010 75% exemption s 371EE). Where a qualifying loan relationship does not fall within the 'loans funded from qualifying resources' exemption, 3.1.7 Financing exemptions 75% of the profits of that loan relationship are exempt. CFCs can elect for financing exemptions under Chapter 9 to apply in respect of qualifying loan relationships. (TIOPA 2010 s 371ID.) Qualifying loan relationships are creditor relationships of the CFC where the ultimate debtor is a qualifying company. Matched interest A qualifying company is one that: The matched interest exemption applies to all the qualifying loans of a CFC. It applies to the balance of profits from • is controlled by the UK resident person(s) who qualifying loan relationships which are not exempt under controls the CFC; and the qualifying resources exemption or the 75% exemption • is not UK resident. (‘leftover profits’).

There are specified types of loan which are excluded. This Leftover profits are fully exempt if the group’s income includes loans funded by UK insurers or banks, and loans exceeds or equals its ‘tested expense’ amount for debt cap which reduce the CFC chargeable profits. purposes. If this is not the case then the amount of the net interest expense is attributable profits. Any balance of leftover profits is exempt. (TIOPA 2010 s 371IF–31IH.)

On making a valid financing exemption election, the profits from qualifying loan relationships are not within Chapter 5 attributable profits discussed above. The exemptions available are:

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3.2 Foreign Branch Exemption • aggregation of the relevant profits amounts and relevant losses amounts for each company, resulting 3.2.1 Introduction in its ‘foreign permanent establishments amount’; With effect from 19 July 2011, UK resident companies can and elect for profits attributable to their overseas permanent • ‘exemption adjustments’ are made in the company’s establishments to be exempt from UK corporation tax. This corporation tax computation, to ensure that the is a key new measure introduced in recent years as part of foreign permanent establishments amount is not corporate tax reform. included within the company’s taxable profits.

Key points to note about the foreign branch exemption HMRC explains the operation of exemption adjustments include: as ‘identifying components of what would (in the absence of CTA09/S18A) be the chargeable profits calculation that • the election also has the effect that losses of the are (because of S18A) left out of account in calculating permanent establishment are not available for offset chargeable profits’ (INTM281080). against UK profits;

• the election applies on a company by company basis, The calculation of attributable profits or losses is carried out so each member of a corporate group may make the for each ‘relevant accounting period’ (ie each accounting election separately without having any effect on period in respect of which the election is made. other group member companies;

• once made, the election is irrevocable and applies in (CTA 2009 s 18A.) respect of all future profits and losses of all overseas permanent establishments of the company making the election; Example 3 – Foreign Permanent Establishments Amount • the election applies from the beginning of the accounting period following the period in which the UK Ltd has three overseas branches, A, B and C. election is made; Its Foreign Permanent Establishments Amount is calculated as follows: • the amount excluded from the company’s UK corporation tax computation is the amount of A B C profits or losses attributable to the permanent establishment, according to the principles in the Branch income 1,000 300 20 OECD’s 2010 Report on the Attribution of Profits to Permanent Establishments (‘OECD Report’); Branch expenses (800) (250) (100)

• on entry into the regime, permanent establishments Relevant profits amount / with opening losses will have to match those losses (Relevant losses amount) 200 50 (80) fully against profits before profits become exempt; and Foreign Permanent Establishments Amount 170 • for accounting periods starting on or after 1 January 2013, investment income and gains will not be exempt unless ‘effectively connected’ to the trade or property business. 3.2.3 Attribution of profits and losses to a foreign permanent establishment If no election is made, a permanent establishment’s profits Where a foreign permanent establishment is in a ‘full treaty and gains are subject to UK corporation tax on an arising territory’, that is a territory with which the UK has a double basis, with credit for overseas tax. taxation agreement containing a non-discrimination article, the relevant profits amount or relevant losses amount is 3.2.2 Effect of exemption calculated by reference to that double tax treaty (CTA 2009 If the election for exemption of a company’s foreign s 18A(6)(a) and (7)(a)). permanent establishments is made, the amount of profits or losses which are exempt is determined in accordance with Where a foreign permanent establishment is not in a full CTA 2009 s 18A. In summary the steps are: treaty territory, the relevant profits amount and relevant losses amount are calculated in accordance with the OECD • calculation of attributable profits or losses (for ‘Model Tax Convention on Income and on Capital’ (July each territory, resulting in either a ‘relevant 2010) (‘OECD model’) (CTA 2009 s 18A(6)(b) and (7)(b)). profits amount’ or ‘relevant losses amount’ (this is considered in further detail below)); Note that companies which are ‘small’ / ‘micro’, defined in accordance with Annex to the EC Recommendation

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2003/361/EC, cannot benefit from the branch exemption in taxable profits – for instance, because of the anti-diversion relation to foreign permanent establishments which are not rule in CTA 2009 s 18G (discussed below). in a full treaty territory (CTA 2009 s 18P(1)). (CTA 2009 s 18C(1).) The attribution of profits to foreign permanent establishments should be carried out in accordance On taking effect of the exemption election, there is a disposal with the OECD Report on the Attribution of Profits to event for capital allowances purposes. The disposal value Permanent Establishments published in 2010 (‘OECD is determined by CAA 2001 s 62A and is generally the tax Report’). This report, referred to previously in discussion written down value. of the Controlled Foreign Company regime, sets out guiding principles for the attribution of profits to foreign (CTA 2009 s 18C(2).) permanent establishments under the Authorised OECD Approach (‘AOA’). 3.2.6 Income arising from immoveable property 3.2.4 Chargeable gains With effect for accounting periods starting on or after 1 January 2013, income arising from immoveable property The rules regarding exemption of profits or losses described which is used for the purpose of the business carried on above apply in a similar way to chargeable gains and by a company through its foreign permanent establishment allowable losses. Where gains or losses accrue on assets can benefit from the exemption. owned by the company, these are included in a relevant profits amount or relevant losses amount attributable to the permanent establishment to the extent that the territory (CTA 2009 s 18CA.) in which that permanent establishment is situated may exercise taxing rights in accordance with the relevant 3.2.7 Profits and losses from investment businesses double tax treaty. Exemption adjustments are then made With effect for accounting periods starting on or after 1 to the taxable total profits to give effect to the amounts January 2013, following Finance Act 2012, investment computed in the company’s tax computation. income and gains will not be exempt unless ‘effectively connected’ to the trade or property business. ‘Effectively (CTA 2009 s 18B.) connected’ is defined in accordance with the OECD Model.

Note that the foreign branch exemption is not available (CTA 2009 s 18CB.) in respect of chargeable gains of closely held companies. For accounting periods starting on or after 1 January 3.2.8 Payments subject to deduction of income tax at 2013, this rule is amended so the exemption is available source in respect of gains arising on the disposal of assets used for the purpose of a trade carried on by the close company Provisions in CTA 2009 s 18D aim to prevent companies through a foreign permanent establishment. This extends from avoiding obligations to withhold income tax at source to gains accruing on the disposal of currency or of a debt on certain payments. If a payment made by a UK resident within TCGA 1992 s 252(1) representing money used for the person to a foreign permanent establishment would have purpose of a trade carried on by the close company through been subject to the deduction of income tax at source if a foreign permanent establishment. made to a company resident in that territory, then the payment is not treated as exempt for the purpose of the (CTA 2009 s 18P(2).) foreign branch exemption.

3.2.5 Capital allowances (CTA 2009 s 18D.) Capital allowances are generally available for qualifying 3.2.9 Election and commencement expenditure provided for qualifying activities. Qualifying activities must be within the charge to UK tax. As the The exemption applies from the ‘relevant day’. This is profits and losses of a foreign permanent establishment in the day on which the accounting period following the respect of which a foreign branch exemption election has one in which the election is made is expected to begin. been made is treated for capital allowances purposes as For elections made on or after 1 January 2013, companies being no longer within the charge to UK tax, it cannot claim can make the election before the beginning of their first capital allowances in respect of plant and machinery used accounting periods, in which case the ‘relevant day’ for the purpose of the permanent establishment’s activities includes the beginning of the company’s first accounting (CAA 2001 s 15(2A)(b)). period (CTA 2009 s 18F(2).)

Notional capital allowances are given automatically in the Once made, the election is irrevocable, unless revoked profit attribution calculation where an exempt branch has before the ‘relevant day’. With effect for elections made on

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or after 1 January 2013, an election is also revoked if the • Condition B – it was not the main reason, or one of the company ceases to be UK resident (CTA 2009 s 18F(6)–(8)). main reasons, for the company carrying on business through the foreign permanent establishment to Finance Act 2012 also removed the requirement that the achieve a reduction in UK tax by a diversion of company making the election must be UK resident. This profits from the UK. means that with effect for elections made on or after 1 January 2013, non-UK resident companies which are For these purposes, ‘UK tax’ means corporation tax, income migrating tax residence to the UK may make the election tax or capital gains tax (previous CTA 2009 s 18H(13), for foreign branch exemption. The relevant day in relation repealed). to non-UK resident companies is the day the company comes within the charge to UK tax. According to HMRC guidance, the facts and circumstances of each accounting period are considered for each condition (CTA 2009 s 18F(2A).) separately. The foreign permanent establishment may fail the conditions in one accounting period, but pass them 3.2.10 Anti-diversion rules in another (INTM286030).This is the case in particular in relation to whether a reduction in UK tax under Condition The anti-diversion rules aim to prevent companies from A is ‘minimal’, which is not defined in the legislation. How diverting UK profits to foreign permanent establishments this would be determined by HMRC is discussed at some in order to obtain exemption. Prior to Finance Act 2012, length in INTM286040. there was a specific anti-diversion rule applicable to foreign permanent establishments. This rule was repealed by If Condition A of the motive test is met, but Condition B Finance Act 2012 with effect for accounting periods starting is not, only amounts which relate to ‘tainted transactions’ on or after 1 January 2013. Instead, foreign permanent are excluded from the exemption. Tainted transactions are establishments in respect of which the foreign branch those which achieve a reduction in UK tax. In such cases, exemption election is made are within the new CFC rules amounts relating to tainted transactions are calculated on a described above. There are some modifications to the rules just and reasonable basis. for the purpose of the foreign branch exemption.

(Previous CTA 2009 s 18I (repealed).) Accounting periods beginning before 1 January 2013

The anti-diversion rule applicable for accounting periods There is a transitional ‘safe harbour’ rule. These rules starting before 1 January 2013 applies where the foreign apply where a foreign permanent establishment was permanent establishment’s adjusted relevant profits are carried on before the foreign branch exemption rules came subject to a ‘lower level of tax’. The lower level of tax test is into effect. Under these rules, Condition B of the motive met if the effective tax paid by the permanent establishment test is assumed to be met if gross income attributable is less than 75% of the UK corporation tax which would to the foreign permanent establishment for the relevant otherwise apply to the foreign permanent establishment’s accounting period does not increase by more than 10%, and profits. ‘Adjusted relevant profits’ is the relevant profits there has been no major change in the nature or conduct amount, less chargeable gains. of the foreign permanent establishment’s business in the period starting with the pre-commencement year and (Previous CTA 2009 s 18G (repealed).) ending at the end of the relevant accounting period. The meaning of ‘major change in the nature or conduct of the In this circumstance the branch exemption would not be foreign permanent establishment’s business’ is similar to available, unless one of the following applied: the equivalent in the corporate ‘change in ownership’ loss restriction rules.

• the foreign permanent establishment’s ‘adjusted relevant profits’ are less than £200,000 (previous CTA (FA 2011 Sch 13 Paras 32-33.) 2009 s 18G(7)(a), repealed); or Accounting periods beginning on or after 1 January 2013 • a motive test is met. With effect for accounting periods starting on or after The motive test is met if Condition A and B applies: 1 January 2013, the new controlled foreign company rules which are discussed above apply to exempt foreign permanent establishments. There are some modifications • Condition A – in so far as any relevant transactions to the rules for this purpose. Under the rules, the amount reflected in the profits attributable to the foreign of the permanent establishment’s ‘diverted profits’ are not permanent establishment achieved a reduction in treated as exempt. UK tax, either the reduction was minimal or the reduction was not a main purpose or one of the main purposes of the transaction; and ‘Diverted profits’ are defined by reference to a modified version of the CFC charge gateway test in TIOPA 2010 s

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371BB. The controlled foreign company exemptions also ONAs as an alternative. This has the effect that ONAs for apply, subject to a number of assumptions, including: specified territories are streamed separately. This means that for instance where a company has profitable permanent • a foreign permanent establishment is assumed to be establishments in aggregate in one territory, this would a separate company from its head office company; not be affected by permanent establishments in another territory with ONA. The streaming election is irrevocable. • that separate company is a deemed controlled foreign It must be made at the same time as the main election for company resident in the permanent establishment foreign branch exemption under CTA 2009 s 18A. territory;

• the assumed total profits and assumed taxable total (CTA 2009 ss 18L-18N.) profits of the deemed controlled foreign company are the controlled foreign company’s ‘adjusted relevant The streaming election must be made at the same time profits’ amount; that the election for the branch exemption is made, and is • the deemed controlled foreign company is connected irrevocable (CTA 2009 s 18L(3)). with its head office company and is also connected or associated with any person with which the head 3.2.12 Planning for the foreign branch exemption office company is connected or associated; and Whilst undoubtedly the foreign branch exemption is a real • any person who has an interest in the foreign permanent opportunity for UK companies, careful planning will need establishment’s head office company also has an to be carried out before deciding whether to elect into the interest in the deemed controlled foreign company. regime, in particular because the election is irrevocable. Even after careful planning on the basis of past and current (CTA 2009 s 18I.) fact patterns, there may be no guarantee that it would be beneficial to make the election, since all future losses of the foreign permanent establishment would then not be 3.2.11 Loss transitional rules relievable against the UK company’s profits. Where a company elects for the foreign branch exemption, there is generally no relief for losses of the foreign permanent It is impossible to make any blanket statements or establishment against the company’s profits. Where a foreign assumptions as to which circumstances may or may not permanent establishment has net losses which accrued in indicate that making an election would be beneficial. the previous six years before it enters into the foreign branch exemption, there are transitional rules which prevent it The clearest case for businesses and advisers to give from obtaining relief for these losses. Net losses are losses consideration to making the election is where local tax paid excluding chargeable gains and allowable losses. This is by the foreign permanent establishment is less than the termed the ‘opening negative amount’ (‘ONA’). Where equivalent UK tax. For foreign permanent establishments this applies, profits attributable to the foreign permanent operating in high tax jurisdictions, it is likely the election establishment arising after a company enters into the foreign would not be advisable as in the absence of the election branch exemption will not be exempt until all of the losses UK tax should be sheltered by double tax relief. However, have been matched with profits (CTA 2009 ss 18J-18K). whilst the position may in some instances be clear cut, potential issues to be borne in mind when carrying out The ONA is calculated in a number of steps as follows: analysis and planning for the branch exemption election include the following: • Step 1: Identify the earliest ‘adjusted foreign permanent establishments’ amount (ie the adjusted • the election is irrevocable – this may make advisers net loss not including chargeable gains or allowable wary of advising either way, and equally businesses losses) which is a loss in the previous six years. may find it difficult to get conclusive advice;

• Step 2: Add to the Step 1 amount the adjusted foreign • relief is not available for foreign permanent permanent establishments amounts the profits and establishment losses, so not suitable if losses forecast; losses of the subsequent accounting period, but without the result exceeding nil. • there may be ‘opening net losses’ which must be utilised before the election may take effect; and • Step 3: Repeating Step 2 for subsequent accounting periods, if there is a resulting net loss for the last • making the election means the company must affected accounting period then there is a ONA of calculate the attributable profits and losses of its that amount. foreign permanent establishments in accordance with double tax treaties / OECD principles. This may be a very complicated exercise and specialist (CTA 2009 s 18J.) input may be required, the expense of which needs to be weighed up against potential benefits. Companies may make a ‘streaming election’ to stream

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3.3 Patent box ‘qualifying IP rights’ (discussed below), or an exclusive licence in respect of any such rights, at any time during the 3.3.1 Introduction accounting period. The patent box legislation was enacted in Finance Act 2012 and is in CTA 2010 Part 8A. This follows a period To meet Condition B, the company must have held such of consultation which began with the publication of rights previously, and: ‘The Taxation of Innovation and Intellectual Property’ in November 2010 along with other documents containing the • has received income in respect of an event relating Government’s corporate tax reform roadmap. The patent to those rights when the company was a qualifying box allows qualifying companies to elect for a 10% tax rate company and a patent box election had effect; and to apply to profits from qualifying patents from 1 April 2013. The relief will be phased in over the four financial • has received income which falls to be taxed in the years starting on 1 April 2013, with the full benefit not accounting period. available until periods commencing 1 April 2017. Condition B enables income from qualifying IP rights / HMRC guidance, which is an updated version of the exclusive licences to be brought into account in subsequent technical notes originally published alongside draft accounting periods, even if the company no longer holds Finance Bill 2012, is included in the Corporate Research those rights. HMRC gives the following example in and Intangibles Manual starting at CIRD200000. CIRD210100.

In overview, in order for a company to benefit from the patent box rate, it must be a ‘qualifying company’. Broadly, Example 4 (From CIRD210100) a qualifying company is one which owns qualifying IP ‘For example, a company may be involved in rights and / or an exclusive licence in relation to qualifying proceedings relating to possible infringement of its IP rights, and it must make a valid election. Companies in patents but by the time the action is successfully groups must additionally meet an active management test. concluded the patents may have expired. In such a case the company is treated as a qualifying The calculation of the patent box benefit gives a 10% rate company when the income arising from the action on profits associated with profits attributable to patent box is brought into account, provided that at the time by means of an additional deduction in the corporation tax of the infringement the company was a qualifying computation. In arriving at the amount of patent box income company that had made an election under S357A.’ eligible for the 10% rate, adjustments are made to strip out an element of profits which would have been earned (CIRD210100) regardless of the existence of the patent / IP rights (‘routine return’), other IP income and unrelated expenditure. In addition to meeting Conditions A and B, companies in As with any new legislation, there are plenty of challenges groups must meet the ‘active ownership’ test in Condition C. for companies and advisers. The process is often likely to start by deciding whether to make the election, given the 3.3.3 Exclusive licence potential extra costs of supportive administration and record keeping. In addition companies and advisers will Companies which own an exclusive licence to a right may have to consider options for carrying out the calculations, also be qualifying companies for patent box purposes. The for instance whether to elect for streaming treatment or meaning of exclusive licence is in CTA 2010 s 357BA and whether it is mandatory. For some companies, determining may be illustrated by the following example. ownership of qualifying patents may be a complicated and arduous data gathering exercise. Companies should allocate sufficient resources to this as early as possible to Example 5: Exclusive licence enable them to file tax returns and computations accurately and hopefully to maximise the benefit of the patent box. Techno Ltd has developed and patented a component for satellite technology. Dishy Ltd manufactures satellite boxes and holds a licence to the component 3.3.2 Qualifying company which Techno has developed. The licence agreement Companies are ‘qualifying companies’ if they meet includes the following: specified conditions in CTA 2010 s 357B. Companies must meet either Condition A or Condition B, and companies in • Dishy Ltd may use the component developed groups must meet Condition C. by Techno Ltd for use in making its new generation of satellite boxes;

To meet Condition A, the company must have held any • Dishy Ltd is the only party with the right to use the Techno Ltd component in the UK; and

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• Dishy Ltd may bring infringement proceedings • performs a significant amount of management to defend its right to Techno Ltd’s component. activity (‘Condition A’); or

Dishy Ltd should have an ‘exclusive licence’ for the • meets the development condition in CTA 2010 s purpose of patent box in relation to the patented 357BC, outlined above, itself (‘Condition B’). component developed by Techno Ltd. ‘Management activity’ is defined as formulating plans and Note that if Dishy Ltd’s right to bring infringement making decisions relating to the qualifying IP rights (CTA proceedings were conditional upon the consent of 2010 s 357BE(3)). Techno Ltd, this may preclude it from having an ‘exclusive licence’ for this purpose, although HMRC 3.3.7 Patent box calculation considers that in practice the condition will still be met even if the licensor has priority in deciding The patent box 10% tax rate is delivered by means of an whether to take action, provided that in the event additional deduction in the company’s corporation tax that it decides not to, the licensee is permitted to computation. The formula is: take the action (CIRD210120). RP x (MR-IPR) MR 3.3.4 Qualifying IP rights Where: To meet the definition of ‘Qualifying IP rights’ in CTA 2010 s 357B(4), rights must be within the types listed in CTA 2010 s 357BB and must also meet the ‘development’ condition in RP = Relevant intellectual property profits CTA 2010 s 357BC. MR = Main rate of corporation tax IPR = the 10% IP rate of corporation tax (ie the patent box rate) Rights to which the regime applies according to CTA 2010 s 357BB include the following types of rights, and exclusive 3.3.8 Phasing of regime licences to them: The full benefit of the patent box rate will be phased in as follows: • patents granted by the UK Intellectual Property Office (IPO); FY commencing Percentage of benefit available (%) • patents granted by the European Patent Office (EPO); 1 April 2013 60 • ‘supplementary protection certificates’; 1 April 2014 70 • regulatory data protection; and 1 April 2015 80 1 April 2016 90 • rights similar to patents, such as plant variety rights. 1 April 2017 onwards 100

3.3.5 The development condition The way in which the phasing of the benefit operates is The development condition in CTA 2010 s 357BC must shown in the following example. This also proves that the also be met in order for rights to be qualifying IP rights. patent box formula gives an effective tax rate of 10%. Broadly, this stipulates that the either the company itself or a group company must make a significant contribution to the creation of the rights, or perform a significant amount Example 6 – Patent box deduction of activity in its development, or a product incorporating it. Dragon Limited has trading profits for corporation tax purposes of £60 million in the year ended 31 ‘Significant’ is not defined in the legislation. HMRC March 2014. Its relevant intellectual property profits guidance states that all relevant circumstances will be taken (‘RP’) are calculated as £10 million for the period. into account, for instance costs, time or effort incurred, or considering the value or impact of the contribution £ £ (CIRD210190). Trading profits 60,000,000 3.3.6 The active ownership condition Patent box deduction: RP 1,000,0000 The active ownership condition must also be met by 60% of RP (phased) 6,000,000 companies in groups. In order to meet the condition, all Adjusted RP x (23-10)/23 -3,391,304 or almost all of the qualifying IP rights/exclusive licences PCTCT 56,608,696 held by the company must be IP in respect of which the company either: Corporation tax at 23% 13,020,000

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Reconciliation of effective tax rate on patent box out above. Items to be added back are the ‘uplift’ or credit income: amount of R&D tax relief, and debits in respect of trading loan relationships and derivative contracts. Items to be £ deducted are credits in relation to finance income which are taken into account in calculating trading profits. Adjusted RP 6,000,000 Less: patent box deduction -3,391,304 There is an additional adjustment for R&D expenditure RP less deduction 2,608,696 which applies in certain circumstances. Broadly, where there is a ‘shortfall’ in R&D expenditure in the period of Corporation tax on RP less deduction the patent box claim as compared with the average annual at 23% 600,000 amount in the four years prior to the first patent box claim, the amount of the ‘shortfall’ is added to R&D expenditure Effective tax rate on patent box income in calculating the adjustments to trading income described of £60m 10% above (CTA 2010 s 357CH).

3.3.10 Total gross income of the trade 3.3.9 Relevant IP profits The ‘total gross income of the trade’ (‘TI’ in the legislation) The relevant IP profits of a company’s trade are calculated is the amount of income specified under five ‘Heads’ in in accordance with the steps set out in CTA 2010 s 357C. CTA 2010 s 357CA.

• Step 1: Calculate total gross income of the trade (‘TI’) for • Head 1: amounts recognised as revenue in the the accounting period (TI is discussed further below). company’s P&L or income statement under GAAP and brought into account as credits for corporation • Step 2: Calculate the proportion of ‘RIPI’ to TI, tax purposes in calculating the profits of the trade in expressed as a percentage. RIPI is the amount of the accounting period. TI which is also ‘relevant IP income’. Relevant IP income is discussed further below. Amounts which would have been recognised under GAAP if it had been applied must also be included, • Step 3: Application of the percentage at Step 2 to the where a company’s accounts are not drawn up profits of the trade for the accounting period. under GAAP.

• Step 4: Deduction of the ‘routine return’ amount • Head 2: amounts which are not already brought (considered below) to leave residual profits into account under Head 1 of damages, insurance attributable to intellectual property. proceeds or other compensation.

The result of Steps 1 to 4 is termed the ‘qualifying • Head 3: amounts not recognised in revenues under residual profit’ (QRP). GAAP principles which are brought into account as • Step 5: This step provides for the deduction of a trading receipts under CTA 2009 s 181 in calculating marketing royalty from QRP where the company has trading profits on a change of accounting basis. made an election for ‘small claims’ treatment. • Head 4: any amounts not recognised in revenues If a company elects for small claims treatment then under GAAP principles of credits brought into the amount of relevant IP profits for the company is account for tax purposes on realisation of intangible determined as the lower of 75% of QRP, and the ‘small assets under the corporate intangibles rules in CTA claims threshold’ (£1,000,000). (CTA 2010 s 357CL.) 2009 Part 8 Ch 4. This includes all credits relating to intangible assets (CIRD220120). • Step 6: In cases where the company does not make a small claims treatment, the company deducts the • Head 5: profits from the sale of pre-2002 patent rights ‘marketing assets return figure’ in accordance with which are taxed in the accounting period under CTA CTA 2010 s 357CN (discussed below). 2009 s 912.

• Step 7: Profits generated before the grant of a patent Total gross income excludes finance income. Finance are added to the cumulative total of the above steps. income for this purpose includes: This may only apply where a company has made an election under CTA 2010 s 357CQ. • trading loan relationships credits;

See Example 7 overleaf. • amounts treated as arising from financial assets under GAAP;

In calculating the relevant IP profits of the trade, certain • any return economically equivalent to interest, using specified items are added or deducted under CTA 2010 the disguised interest rules definitions in CTA 2009 s 357CG. This takes place prior to Step 3 in the steps set s 486B; and

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Example 7 – Relevant IP profits of the trade Step 1: Total gross income of the trade (‘TI’) is calculated as £1,000,000.

Step 2: RIPI is calculated as £500,000.

Step 3: Apportionment of trading profit in ratio of RIPI to TI (50%):

Trading profits computation Apportionment of trading profit

£ £ £ £

Turnover 1,000,000 500,000 Less: expenses

R&D 200,000 100,000 Materials 100,000 50,000 Marketing and advertising 50,000 25,000 Other costs 100,000 50,000

-450,000 -225,000

Taxable trading profit 550,000 275,000

Step 4: Residual profit

Deduction of routine return (see Example 8 below)

£

Apportioned trading profit 275,000 Less routine return -6,250

Residual profit (‘Qualifying residual profit’) 268,750

The company has no marketing assets and all of its QRP of £268,750 falls into the patent box.

• trading credits in respect of derivative contracts • Head 2: worldwide licence fees or royalties received under CTA 2009 s 573. by the company from another person in respect of qualifying IP rights. Licence fees and royalties 3.3.11 Relevant IP income received in respect of rights which are not qualifying IP rights are included where these are granted for the The patent box rate can apply to ‘relevant IP income’ same purpose as the patent rights. which fall into one of the ‘Heads’ specified in CTA 2010 s 357CC. These are as follows (‘Qualifying IP rights’ includes • Head 3: income from the disposal of qualifying IP exclusive licences to such rights throughout.): rights. • Head 4: income derived from infringement or • Head 1: income from the sale of any of the following: alleged infringement of qualifying IP rights.

–– items protected by a qualifying IP right held • Head 5: income received by way of insurance, by the company (discussed above); compensation or other damages which is not under Head 4 but is treated as relevant IP income. –– items incorporating at least one item protected by a qualifying IP right held by the company; and (CTA 2010 s 357CC.)

–– items wholly or mainly designed to be HMRC gives an example to illustrate the difference between incorporated into the above two items. Heads 4 and 5 in CIRD220240. This demonstrates that in These types of income qualify regardless of where a scenario where a UK company receives damages for they are generated worldwide – even if they arise in infringement of patents registered in the UK and the US, the territories where there is no patent protection. UK element qualifies under Head 4 whilst the US element

18 Topical Corporation Tax Issues for Large Companies Tolley’s Tax Digest | Issue 125 | March 2013

falls under Head 5. This is because the infringement of the involved would be taken into account in context of US patent would not be in relation to a qualifying IP right. the overall patent box claim (CIRD220440).

• Step 2: Multiply the amount arrived at in step 1 by 3.3.12 Routine return 10%.

The amount of ‘routine return’ is deducted at Step 4 to • Step 3: Multiply the amount arrived at in Step 2 by arrive at qualifying residual profits. The aim of this is to X%. This is the percentage calculated in Step 2 of the strip out the amount of profit a business would have made ‘relevant IP profits’ calculation discussed above. anyway even without access to IP / other intangible assets.

There are three steps specified in CTA 2010 s 357CI to arrive Example 8 – Routine return at the amount of routine return. These are as follows: Continuing from Example 7 above:

• Step 1: Calculate the aggregate ‘routine deductions’ £ taken into account in arriving at the trading profits for corporation tax purposes for the accounting Apportioned trading expenses 225,000 period in question. Routine deductions are defined Less - R&D costs excluded from under six ‘Heads’ in CTA 2010 s 357CJ as follows: routine deductions -100,000

–– Head 1: Capital allowances deducted in Routine deductions 125,000 arriving at taxable trading profits. Apply specified rate (10%): 12,500 –– Head 2: Premises costs for instance rent, repairs and maintenance. At 50% (see example 7 above) 6,250 –– Head 3: Personnel costs, including employers National Insurance contributions, share scheme deductions, pension deductions and amounts paid in respect of externally 3.3.13 Marketing assets return provided workers in accordance with the As discussed above, for companies which do not elect for definition in CTA 2009 s 1128. ‘small claims’ treatment under CTA 2010 s 357CL, then an –– Head 4: Plant and machinery costs such amount of ‘marketing assets return’ must be excluded in as leasing costs, maintenance, operational arriving at ‘relevant IP profits’. This is at Step 6 of the relevant expenses etc. IP profits calculation in CTA 2010 s 357C described above.

–– Head 5: Professional services such as audit The formula specified for arriving at marketing assets and accountancy, costs of administration and return is ‘notional marketing royalty’ (‘NMR’) minus management of the company, consultancy (other ‘actual marketing royalty’ (‘AMR’) (CTA 2010 s 357CN). than Clinical Research Organisation costs).

–– Head 6: Miscellaneous services such as Where: computing costs, fuel, water and power etc. The following types of deductions are specifically • AMR exceeds NMR, or excluded from ‘routine deductions’ by CTA 2010 s • the difference between NMR and AMR is less than 357CK: 10% of ‘qualifying residual profits’ for the accounting –– Head 1: loan relationship or derivative period, contracts debits. then the marketing assets return amount is taken to be nil. –– Head 2: R&D expenses – this is the amount of actual R&D expenditure plus any R&D tax ‘Notional marketing royalty’ is defined in CTA 2010 s relief given. 357CO. It is essentially the amount that a third party would –– Head 3: R&D / patent allowances under the pay for the right to exploit ‘relevant marketing assets’. capital allowances legislation. Relevant marketing assets are marketing assets which are exploited in return for income included within ‘relevant –– Head 4: Deductions for employee share IP income’, which fall within the following meaning of acquisitions in so far as these relate to R&D ‘marketing assets’ in CTA 2010 s 357CO: activities. In determining whether an amount should be • assets in respect of which a trader could take ‘passing included in routine deductions, HMRC confirms that off action’; where there is any doubt over whether an item is a • signs or indications which may serve to designate routine deduction or not, materiality of the amount the geographical origin of goods or services; and

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• customer information used for marketing purposes • Step 1: Divide all amounts of trading income for the (note this does not include customer information period into two streams of income, between amounts used for other purposes for instance to enhance which are ‘relevant IP income’ and all other amounts. products or services – see CIRD220500). This should include transfer pricing adjustments but exclude finance income.

‘Actual marketing royalty’ is defined in CTA 2010 s 357CP. It • Step 2: Allocate amounts deducted in arriving at is the amount of the return attributable to marketing assets trading profit in the corporation tax computation accrued to third parties. AMR is calculated by applying the from each stream of income on a just and reasonable percentage calculated in Step 2 of the ‘relevant IP income’ basis. calculation to the total of amounts paid to acquire or exploit relevant marketing assets, where these are included as a This should exclude debits on loan relationships or debit in the corporation tax computation for the accounting derivative contracts or tax relief in respect of R&D period in question. ‘Relevant marketing assets’ has the expenditure. same meaning here as for notional marketing royalties in • Step 3: Deduction of amounts allocated at Step 2 from CTA 2010 s 357CO. the relevant IP income stream, giving the amount to carry forward to Step 4. HMRC gives an indication of its approach to the marketing • Step 4: Deduction of the ‘routine return’ amount assets return computation in CIRD220490. According to (considered below) to leave residual profits this, HMRC considers that a pragmatic approach should attributable to intellectual property. be taken to computing the marketing assets return figure if NMR is likely to be minimal and within 10% of the The result of Steps 1 to 4 is termed the ‘qualifying QPR, or the company is paying an arm’s length. In such residual profit’ (QRP). (Equivalent step as in Step 4 circumstances HMRC considers it should not be necessary of CTA 2010 s 357C.) to insist that the company carries out a computation of • Step 5: This step provides for the deduction of a NMR. The manual gives the example of a company selling marketing royalty from QRP where the company has goods or providing services to other companies or bodies made an election for ‘small claims’ treatment. who make purchasing decisions on the basis of technical or regulatory requirements. If a company elects for small claims treatment then the amount of relevant IP profits for the company CIRD220490 also provides an opposite example where is determined as the lower of 75% of QRP, and the NMR would need to be computed where there would be ‘small claims threshold’ (£1,000,000). (CTA 2010 s likely to be significant proportion of profits derived from 357CL.) marketing activities. The example given is of a company (Equivalent step as in Step 5 of CTA 2010 s 357C.) with a valuable brand selling to other businesses, for instance hotels purchasing luxury items on behalf of guests. • Step 6: In cases where the company does not make a small claims treatment, the company deducts the ‘marketing assets return figure’. This step differs 3.3.14 Streaming from the equivalent Step 6 in CTA 2010 s 357C. Streaming is an alternative method of estimating a Under streaming, instead of deducting a proportion company’s profits from qualifying IP rights. Either the of the amount of notional marketing royalty, it is the company may elect for streaming under CTA 2010 s total of actual marketing royalty amounts which are 357D(1), to apply CTA 2010 s 357DA as an alternative to deducted from QRP. the steps in CTA 2010 s 357C, or in certain circumstances • Step 7: Profits generated before the grant of a patent mandatory streaming may apply. The conditions for are added to the cumulative total of the above steps. mandatory streaming to apply are set out below. This may only apply where a company has made an election under CTA 2010 s 357CQ. (Equivalent step Where a company elects for streaming, the streaming as in Step 7 of CTA 2010 s 357C.) election is made in relation to each trade of the company and it has effect for the accounting period in which it is 3.3.15 Mandatory streaming made and for subsequent accounting periods. Mandatory streaming applies if any of three Conditions A, Under streaming, companies must divide trading income B or C set out in CTA 2010 s 357DC are met. The conditions into one stream consisting of relevant IP income and another are: stream for all other trading income. Trading expenses must be allocated between the two income streams on a just and • Condition A: Amounts taken into account in reasonable basis. The legislation sets out the following calculating trading profits include substantial steps to arrive at profits from qualifying IP rights in CTA amounts that are not fully recognised as revenue in 2010 s 357DA: accordance with GAAP, for instance transfer pricing adjustments or release of accounting provisions.

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• Condition B: The total gross income of the trade • the existing R&D tax relief regime (termed the includes a substantial amount of licensing income ‘super-deduction’ regime) will continue to operate that is not ‘relevant IP income’. alongside the new regime for a transitional period. The super-deduction scheme will then be abolished • Condition C: The company receives a substantial for accounting periods beginning on or after 1 April amount of ‘relevant IP income’ from the grant of 2016. It will not be possible to claim under both licences held by the company itself through exclusive regimes in respect of the same expenditure. licences, and the trade generates income that is not ‘relevant IP income’. This condition is intended to bring conduit arrangements within mandatory One of the key benefits of the new regime for large streaming. CIRD230140 gives the example of a companies as opposed to the existing super-deduction company holding an exclusive licence in respect regime is to increase the visibility for management and of a qualifying IP right which is then licenced onto R&D teams of the benefit of the relief, for which the policy another party for a substantial amount of income. objective is to encourage investment in R&D activities in the UK. In addition, ATL allows loss-making companies to obtain a cash payment (although the amount of credits ‘Substantial’ is defined in CTA 2010 s 357DC(2). Income is available are subject to a number of restrictions). substantial if it is greater than the lower of:

3.4.2 Eligibility for ATL • £2 million; or ATL will be available to large companies in respect of • 20% of the total gross income of the trade for the qualifying R&D expenditure. It will also be available to accounting period. SMEs to the extent that they can only claim under the existing large company super-deduction regime. R&D will But the amount of income is not substantial for the purpose be defined in the same way as it is under the current regime of mandatory streaming if the lower of these two amounts (interpretation rules in draft CTA 2009 s 104W). is £50,000 or less (CTA 2010 s 357DC(3)). As under the current regime, the definition of SME is based 3.3.16 Losses on the size test in EC Recommendation 2003/361/EC (CTA Where the calculation of relevant IP profits gives a negative 2009 s 1119). ‘Large’ companies for this purpose are any figure, there is a ‘relevant IP loss’ (CTA10/S357C(3)). companies which do not meet the definition of SMEs.

The amount of relevant IP loss must be offset against Specifically, SMEs will be able to claim under ATL in respect relevant profits of other group companies. Any balance is of the following categories of expenditure for which SMEs then carried forward to offset against future patent box can claim under the existing large company scheme but not profits in the same company. the SME scheme:

3.4 R&D tax relief – ‘Above the Line’ tax credits • sub-contracted R&D; 3.4.1 Introduction • subsidised qualifying expenditure; or Draft Finance Bill 2013 includes draft legislation for the • qualifying expenditure on contributions to new ‘Above the Line’ (‘ATL’) Research and Development independent R&D. (‘R&D’) tax credit. The legislation will have effect for qualifying R&D expenditure incurred on or after 1 April (Draft CTA 2009 s 104A(3).) 2013. A summary of the draft rules follows, however needless to say this is subject to change following further In order for relief to be available for sub-contracted R&D, comments on the draft legislation published at the Autumn the work must be contracted to the SME by a large company statement, which were invited until 6 February 2013. or any person otherwise than in carrying out a ‘chargeable’ trade. A chargeable trade is a trade, profession or vocation Key features of the proposed new relief are: carried out wholly or partly in the UK, profits of which are chargeable to UK income or corporation tax. • the benefit of the ATL credit is offset against R&D expenditure rather than against corporation tax; The expenditure must either be undertaken by the SME in- house and consist of: • the rate of ATL credit will be 9.1%;

• ATL credits are taxable; • staffing costs (CTA 2009 s 1123);

• the amount of credits available is limited to the • software or consumable items (CTA 2009 s 1125); amount of the claimant company’s PAYE/NIC liabilities in respect of staff carrying on R&D • qualifying expenditure on externally provided activities; and workers (CTA 2009 s 1127); or

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• relevant payments to subjects of clinical trials (CTA charge that would be due as if the amount were ring 2009 s 1140). fence profits should also be deducted. If any amount is deducted at this step (termed the Or the work may be undertaken by: ‘Step 5 amount’), it is treated as discharging any future corporation tax liability of the company, or • a qualifying body (see CIRD82250 for a list of may be surrendered for group relief. (Draft CTA qualifying bodies); 2009 s 104P.)

• an individual; or • Step 6: Any other amounts owed to HMRC are deducted from any amount remaining after Step 5. • a partnership, each member of which is an individual. • Step 7: The amount remaining at Step 7 is the amount (Draft CTA 2009 ss 104C-104D; see also CTA 2009 ss 1063- which may be repaid to the company by HMRC. 1067.) This amount is subject to a number of restrictions where the The conditions relating to ‘qualifying subsidised company is not a going concern, there is an enquiry into expenditure’ are very similar. the tax return by HMRC, or there are unpaid PAYE / NIC liabilities for the period. (Draft CTA 2009 s 104Q.) SMEs can also claim ATL in respect of the excess over the cap on R&D aid in CTA 2009 s 1113. The cap limits the Please see Appendix 1 for a flowchart setting out these steps. amount of relief on any R&D project to 7.5m euros. The way in which the amount of aid is calculated over the life of a project is set out in CTA 2009 s 1114. Example 9 – ATL for profitable company £000 £000 3.4.3 Calculation of ATL relief Net profit 30,000 As under the current R&D reliefs, the process of calculating Less: R&D relief under ATL will begin with considering whether R&D expenditure -5,000 the company is carrying on R&D for tax purposes, and Other operating expenditure -10,000 ascertaining the amount of qualifying R&D expenditure for R&D ATL credit 455 the claim period, as discussed above. -14,545 Once the amount of qualifying R&D expenditure has been calculated, the amount of ATL credit is calculated. Based on Taxable profit / loss 15,455 the draft legislation the percentage rate of ATL credit will Corporation tax at 23% 3,555 be 9.1% in most cases, unless the company carries on a ring fence trade (as defined by CTA 2010 s 277) in which case the ATL credit -455 percentage rate will be 49%. (Draft CTA 2009 s 104M.) CT payable 3,100 Draft CTA 2009 s 104N sets out steps for arriving at the amount of payable ATL credit as follows:

• Step 1: ATL credit is offset against the company’s Example 10 – ATL for loss making company corporation tax liability for the period. £000 £000 • Step 2: The amount remaining after Step 1 is capped at the amount of staff PAYE / NIC costs taken into Net profit 30,000 account in respect of the qualifying R&D for the period. Less: R&D expenditure -15,000 • Step 3: Any amount remaining after Step 2 is offset Other operating expenditure -20,000 against any unpaid corporation tax liability for other R&D ATL credit 1,365 periods. -33,635 • Step 4: The company may surrender any amount remaining at this step to a group member. Taxable profit / loss -3,635 • Step 5: From the amount remaining after Step 4, there Corporation tax at 23% (carried forward) 314 must be deducted a notional amount of corporation tax at the main rate that would be due as if the Payable ATL credit 1,051 amount were profits of the period. For ring fence trade companies, the amount of supplementary CT payable 1,365

22 Topical Corporation Tax Issues for Large Companies Tolley’s Tax Digest | Issue 125 | March 2013

3.4.4 Recap – existing large company scheme tax relief 3.5.3 Meaning of distribution For the transitional period until the current ‘super- To be within the distribution exemption regime, the deduction’ R&D regime for large companies is abolished, receipt must be within the definition of ‘distribution’. This companies will have to consider whether to remain in the is defined in accordance with CTA 2010 s 1000(1). The current regime or elect into ATL relief. By way of reminder, following types of distribution are included within the key features of the existing large company R&D relief are meaning of ‘distribution’ for the corporation tax acts under as follows: CTA 2010 s 1000(1):

• the existing regime provides a 130% deduction • dividends; from Taxable Trading Profits for qualifying R&D • other distributions out of assets in respect of shares; expenditure incurred (CTA 2009 s 1074(7)); • issue of redeemable shares and debentures; • there is no payable tax credit available under the existing large company R&D regime; • certain transfers of assets/ liabilities; and

• with effect for accounting periods ending on or after • bonus issues following the repayment of share 1 April 2012, there is no longer any de minimis amount capital. in order to make a claim for R&D relief. Prior to this, claims were only possible if a company had incurred Distributions paid out of reserves created on a capital a minimum of £10,000 in the accounting period (pro- reduction – CTA 2010 s 1027A and First Nationwide rated for periods longer or shorter than 12 months); and There was previously doubt over the treatment of dividends paid out of reserves created on a capital reduction because • the company does not have to own any Intellectual of the view expressed by HMRC in the earlier hearings of Property created as a result of the R&D activities in the First Nationwide case. order to claim the relief (unlike under the existing SME R&D relief). The case concerned dividends paid from share premium by a Cayman Islands company out of its share premium (CTA 2009 Pt 13 Ch 5.) account (this is possible for Cayman-incorporated companies but not under English company law). The case 3.5 Distribution exemption was first heard in 2009 by the First Tier Tax Tribunal, and having progressed through the Courts it was last heard in 3.5.1 Introduction the Court of Appeal in 2012. The distribution exemption regime in CTA 2009 Part 9A has had effect in relation to distributions received by UK Initially, HMRC held that the receipt was not a dividend companies and UK permanent establishments of non-UK within CTA 2010 s 1000(1)A as it was paid out of commercial companies on or after 1 July 2009. Under the regime the profits. If it were a dividend then it would be treated as vast majority of distributions are now exempt from UK capital in nature. This would not be within the definition taxation, which along with measures such as patent box, of distribution because a repayment of share capital is foreign branch exemption, improved CFC regime, and excluded from the definition by CTA 2010 s 1000(1)B(a). more established measures such as SSE, adds another key However HMRC later changed its view. The treatment is benefit to the UK’s corporate tax regime. now confirmed by CTA 2010 s1027A. This provides that distributions paid out of reserves created on a capital The below is intended as an update on recent changes to reduction, which includes from share premium account, is HMRC’s view following the First Nationwide case, together treated for corporation tax purposes as made out of profits with a brief recap of the regime to put this into context. available for distribution. In order for CTA 2010 s 1027A to apply to distributions made following capital reductions 3.5.2 Overview of the distribution exemption regime by non-UK companies, CTA 2010 s 1027A(4) must apply to the reduction of share capital. This provides that the capital Some key features of the UK distribution exemption are: reduction rules in the overseas territory must correspond to the equivalent UK company law. • distributions received by UK companies are chargeable to UK corporation tax unless exempt, and More recently HMRC confirmed its view in a guidance note no anti-avoidance rules apply; ‘Guidance on tax treatment of payments of UK companies • there is no distinction between the treatment of UK from companies registered in an overseas territory (‘foreign and non-UK source distributions; and companies’)’ issued in late 2012. The guidance note states:

• the exemption applies to both income and capital ‘Following the judgment of the Court of Appeal in distributions. the case of HMRC v First Nationwide [2012] EWCA 278, HMRC’s view is that if a dividend payment is a

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distribution permitted in accordance with the law that Distributions in respect of non-redeemable ordinary shares governs the foreign company then in the absence of Distributions paid in respect of ordinary, non-redeemable any evidence calling into question the legal form of the shares are exempt distributions. Ordinary and non- payment it will be treated as a dividend for the purposes redeemable shares are defined in CTA 2009 s 931U. of section 1000(1) A CTA 2010.’

(CTA 2009 s 931F.) HMRC’s guidance also includes useful confirmation on other matters concerning distributions received by UK companies from overseas companies. This includes confirmation that Distributions in respect of portfolio holdings payments made under arrangements in some territories to This permits distributions from minor shareholdings consolidate their results for tax or administrative purposes of preference and redeemable shares to be exempt should generally be treated as distributions. distributions (CTA 2009 s 931G).

3.5.4 Exemptions Distributions made from relevant profits For medium or large companies (ie companies which are To the extent paid from ‘relevant profits’ (broadly profits not small or micro as defined in EC Recommendation available for distribution), distributions may be exempt. 2003/361/EC (6 May 2003), a distribution may be exempt from tax if all three of the following conditions are fulfilled: When only part of a distribution is made from relevant profits, it is treated as two separate distributions. There are • the distribution is not interest or similar treated as a rules ensuring that the balance is taxable or specifying the distribution under CTA 2010 s 1000(1)E & F; order in which exemptions are applied where only part of • no deduction is given in another territory in respect the distribution is exempt under CTA 2009 s 931H. of the distribution; and (CTA 2009 s 931H.) • the distribution must fall into an exempt class (listed below). Dividends in respect of shares accounted for as liabilities

Once the conditions for exemption have been considered, This exemption applies to dividends paid in respect of it then needs to be considered whether any anti-avoidance shares which would be required to be accounted for as measures apply. An overview of these is provided below. liabilities under CTA 2009 s 521C, but conditions in s 521C must be met, primarily they must not be held for an (CTA 2009 s 931D.) unallowable purpose or produce a return economically equivalent to interest. 3.5.5 Exempt classes Where payments fail the conditions in CTA 2009 s 521C Distributions from controlled companies – typically this then they are instead subject to tax under the disguised would include intra-group dividends. Finance Act 2012 interest rules. amended CTA 2009 s 931E with effect for distributions paid on or after 1 January 2013. (CTA 2009 s 931I.)

For this exemption to apply, for distributions paid before 1 3.5.6 Anti-avoidance provisions January 2013, either: There are both targeted and general anti-avoidance • the recipient must control the payer; or provisions applicable to exempt distributions.

• the recipient, together with another person must General anti-avoidance measures, aiming to prevent tax control the payer; and the recipient and the other avoidance schemes with a general tax avoidance motive, person meet 40% tests regarding holding of interests, generally apply to all classes of exempt distribution. There rights and powers (TA 1988 s 755D(3) and (4)) are five general anti-avoidance measures.

‘Control’ is defined in accordance with TA 1988 s 755D. A condition of all the measures other than the measure relating to schemes involving diversion of trading income (CTA 2009 s 931E.) in CTA 2009 s 931Q, is that a distribution is not exempt if it is made as part of a tax advantage scheme. For distributions paid on or after 1 January 2013, Finance Act 2012 amends the second condition above so that the Assuming that there is a tax advantage scheme for CTA relevant definition of control is in TIOPA 2010 s 371RB (ie in 2009 ss 931N-931P as per above, in summary the other the new CFC rules).

24 Topical Corporation Tax Issues for Large Companies Tolley’s Tax Digest | Issue 125 | March 2013

conditions for each anti-avoidance section to apply are set 4 Financing update out in the legislation as follows: Despite the introduction of new measures to restrict interest deductibility in recent years, the UK still offers a • schemes in the nature of loan relationships (CTA competitive regime in this respect when compared with 2009 s 931M); other jurisdictions. Corporate tax reform measures have • schemes involving distributions for which in addition offered new opportunities, in particular the deductions are given (CTA 2009 s 931N); opportunity from the new controlled foreign company rules to achieve beneficial tax rates on financing income. • schemes involving payments for distributions (CTA 2009 s 931O); A comprehensive review of the UK’s tax regime in respect • schemes involving payments not on arm’s length of financing costs and income is outside the scope of this terms (CTA 2009 s 931P); and publication, but some discussion of key new measures • schemes involving diversion of trade income (CTA introduced over recent years, primarily the debt cap rules, 2009 s 931Q). is included below, along with updates on some other recent developments.

In addition to the general anti-avoidance provisions, there are targeted anti-avoidance provisions applicable to 4.1 The debt cap three of the exempt classes discussed above. These aim to The ‘debt cap’ rules were introduced by Finance Act 2009 prevent schemes which attempt to ensure that distributions with effect for accounting periods which began on or fall within a particular exempt class. The classes to which after 1 January 2010. The rules aim to restrict the amount a targeted anti-avoidance rule applies are the controlled of deductible finance expense for UK companies to the companies exempt class, ordinary shares exempt class and amount paid to the amount of external debt paid by the UK portfolio holdings exempt class. company’s worldwide group.

There is a purpose test common to all three targeted anti- The rules are in addition to existing rules which operate avoidance measures. This is that the distribution must be to restrict the amount of, or to deny relief for, tax relief for made as part of a scheme the main purpose, or one of the interest payments, including: main purposes, of which is to secure that distributions of the payer received by the recipient fall into an exempt class • unallowable purpose (CTA 2009 s 441); by virtue of that section. • late interest rules (CTA 2009 s 372);

In summary, the other conditions applicable to the • thin capitalisation rules (TIOPA 2010 Pt 4); and respective exempt classes are: • tax arbitrage (TIOPA 2010 Pt 6).

• controlled company exempt class – the dividend must be paid in respect of pre-control profits (CTA 4.1.1 Changes to the legislation in Finance Act 2012 and 2009 s 931J(3)); draft Finance Bill 2013 There have been many alterations and proposed alterations • ordinary shares exempt class – rights exist which, if attached to the share, would prevent the distribution to the debt cap rules since they were first introduced from being exempt (CTA 2009 s 931K(3)); and following HMRC consultation with business and the profession. An outline of the main changes enacted with • portfolio holdings exempt class – the distribution would Finance Act 2012 and proposed changes in Finance Bill not fall within the exempt class for portfolio holdings if 2013 follows. all ‘relevant persons’ were taken into account. Relevant persons means the company receiving the distribution Finance Act 2012 and persons connected with it). • Dormant companies – the definition was amended (CTA 2009 s 931L.) to include overseas companies. Amendment is made to ensure that dormant companies with transfer pricing adjustments in computing taxable profits 3.5.7 Election for a distribution not to be exempt are not precluded from being treated as dormant for An election is available for companies to elect for a distribution debt cap purposes (TIOPA 2010 ss 262(4) and 353). which would otherwise be exempt to be treated as taxable. • Appointment of authorised company – this The election must be made within two years from the end of amendment removed the requirement for dormant the accounting period in which the distribution is received. companies to sign elections for allocation of disallowances and exemptions between group (CTA 2009 s 931R(3).) companies (TIOPA 2010 ss 276(2A), 288(2A)).

25 Tolley’s Tax Digest | Issue 125 | March 2013 Topical Corporation Tax Issues for Large Companies

• Allocation of disallowances and exemptions – which would be within the definition of collective this change ensures that groups cannot disallow investment schemes under UK law, from being financing expense or exempt financing income treated as the ultimate parent of a worldwide group. amounts which arose before a company was a This gives useful clarity in particular for groups member of the worldwide group (TIOPA 2010 ss owned by private equity funds (TIOPA 2010 s 292(5A), 296(2A)). 339(2),(3)).

• Anti avoidance – schemes preventing the debt • Group beginning or ceasing to be a worldwide group cap from applying to large groups – a new anti- during a period of account – the rules were amended avoidance provision was introduced in order to to ensure that the debt cap rules do not apply to groups counter schemes aiming to ensure that the debt that begin or cease to be worldwide groups during cap did not apply to groups because they did not a period of account. The rules now only apply for a have any ‘relevant group companies’. For instance, period if the definition of ‘worldwide group’ is satisfied previously such schemes may have operated by throughout the period (TIOPA 2010 s 348(6),(7)). using companies limited by guarantee, ie without • Business combinations and demergers – new rules share capital, to break the group for debt cap were introduced to deal with changes to groups as a purposes (TIOPA 2010 s 305A). result of business combinations and demergers. The • Calculation of financing income amount or financing new rules give clarity for groups in how to carry out expense amount – non co-terminus accounting computations where during a period of account, as a periods – this amendment clarifies that financing result of a business combination or demerger, there is a expense and financing income amounts should be new ultimate parent company of a worldwide group. adjusted on a ‘just and reasonable’ basis for periods The effect of the rules is that two computations will be when a company is not a member of the worldwide prepared, from the beginning of the period of account group. Previously the amount was determined on of the transaction until the date of the transaction, and a time apportionment basis (TIOPA 2010 ss 313(6)- another for the new debt cap group for the remainder (6A), 314(6)-(6A)). of the period of account (TIOPA 2010 s 348A).

• Group treasury companies – this removed the • Change in accounting standards – powers were requirement that group treasury company elections given to the Treasury to amend the debt cap rules had to be signed by all group treasury companies. in order to take into account changes in accounting The election can now be made on a company by standards (TIOPA 2010 s 353AA). company basis (TIOPA 2010 s 316).

• Calculation of tested expense amount and tested The majority of changes took effect for periods of account income amount – this amended the wording relating starting on or after the date of Royal Assent, which was 17 to the amounts which can be disregarded for the July 2012. purpose of the tested expense and tested income amount. Previously, amounts arising as a result of Draft clauses for Finance Bill 2013 a transaction that took place at a time a company The draft Finance Bill 2013 contains measures amending the was not a relevant group company or a UK group ability of group treasury companies to opt out of the regime. company were disregarded, but the amendment The reason for the amendment is to prevent companies ensures that the amount disregarded in both cases which were not properly performing group treasury is the amount which accrued before the company functions from making elections to opt out of the debt cap became a relevant group company or UK group rules. The draft amended rules ensure that companies may company (TIOPA 2010 ss 329(3),(6), 330 (3),(6)). only fully opt out of the debt cap regime if substantially all of • Disapplication of de minimis amount – this their activities are treasury activities, and all or substantially amendment introduced a new election enabling all of their assets and liabilities relate to such activities. If the net financing income and expense amounts to be ‘substantially all’ requirement is not met then companies included in the debt cap calculation, even if they are will only be able to exclude the portion of financing income less than the de minimis limit of £500,000. Previously, and expenses to the extent relating to treasury activities. such amounts were excluded if they were less than £500,000, which led to overall disallowances and The proposed amendments have effect for accounting anomalies within groups which would not have periods starting on or after 11 December 2012. otherwise existed. The election must be made within twelve months of the end of the first period of 4.1.2 Debt cap regime – a recap account for which it is to apply. It can be made on a period by period basis or will remain in place until Overview withdrawn (TIOPA 2010 s 331ZA). The debt cap regime may apply to groups which in an • Ultimate parent – this amended the definition of accounting period are ‘large’, there is a ‘worldwide group’ ‘ultimate parent’ to prevent foreign partnerships and the group is not a ‘qualifying financial services group’.

26 Topical Corporation Tax Issues for Large Companies Tolley’s Tax Digest | Issue 125 | March 2013

Once it has been established that a group fulfils these period from qualifying activities. Qualifying activities criteria, a ‘gateway test’, which compares the level of UK means lending activities and activities that are ancillary to net debt to the gross worldwide debt, is applied in relation lending activities, insurance and insurance related activities to each accounting period to determine whether or not and relevant dealing in financial instruments. detailed debt cap calculations are required. The debt cap does not apply if the gateway test is ‘failed’. (TIOPA 2010 ss 266-267.)

Where the gateway test is met, groups must then apply The gateway test the detailed computational rules to determine the amount of disallowed finance expense. Broadly, the calculation If the above criteria apply, then the gateway test is applied compares the ‘Tested Expense Amount’ (‘TEA’) to the to determine whether the group must carry out the detailed ‘Available Amount’ (‘AA’). The Total Disallowed Amount debt cap calculations for the accounting period. (‘TDA’) for the accounting period is the amount by which the TEA exceeds the AA. If the AA exceeds the TEA then Under the gateway test, the debt cap rules apply if, for an there is no disallowed amount. accounting period, the UK net debt of the group exceeds 75% of the worldwide gross debt of the group. There is flexibility for groups to choose how to allocate disallowances between relevant group companies. (TIOPA 2010 s 261.)

There are a number of targeted anti-avoidance rules aimed ‘UK net debt’ means the ‘net debt amount’ of each company at specific schemes involving the debt cap rules. There is a that was a relevant group company (or group securitisation purpose test applicable to all of these rules such that they company) at any time in the accounting period. The ‘net should only apply where the main purpose or one of the debt amount’ generally means the average of: main purposes of entry into the scheme is to avoid the application of the debt cap rules. • the net debt of the company as at that company’s start date (the first day of the accounting period, or if These rules are considered in more detail below. later the date the company became a relevant group company); and

Scope • the net debt of the company as at that company’s The rules apply to a period of account of a ‘worldwide end date (the last day of the accounting period, or group’. This is defined as a group which is large and if earlier the last date the company was a relevant contains one or more relevant group companies (TIOPA group company). 2010 s 337). (TIOPA 2010 s 262.) The definition of ‘large’ is a group of which none of the members are defined as ‘micro’ or ‘small’ in accordance A company’s ‘net debt’ as at any date means: with EC Recommendation 2003/361/EC (6 May 2003). • the sum of the company’s relevant liabilities (defined A ‘relevant group company’ is broadly a company which is in TIOPA 2010 s 263(3)) as at that date; less either UK tax resident or has a UK permanent establishment; • the sum of its relevant assets (defined in TIOPA 2010 and is either the ‘ultimate parent’ of the worldwide group s 263(4)) as at that date. or a relevant subsidiary of the ultimate parent. A ‘relevant subsidiary’ is either: The amount may be a negative amount.

• a 75% subsidiary of the ultimate parent; or (TIOPA 2010 s 263.) • the ultimate parent is beneficially entitled to either 75% of the company’s profits available for distribution The net debt amount will be nil if a UK group company to equity holders or to 75% of assets available for has either a net debt amount of less than £3 million, or it is distribution to equity holders on a winding up. a dormant company throughout the period (TIOPA 2010 s 262(3),(4)). (TIOPA 2010 s 345.) ‘Worldwide gross debt’ means the average of: There is an exclusion from the debt cap for qualifying financial services groups (TIOPA 2010 s 261(2)). For this • the sum of the relevant liabilities of the group as purpose, ‘qualifying financial services groups’ are groups at the last day of the day before the first day of the which derive all or substantially all of their UK trading period; and income or worldwide trading income for an accounting

27 Tolley’s Tax Digest | Issue 125 | March 2013 Topical Corporation Tax Issues for Large Companies

• the sum of the relevant liabilities of the group as at • a negative net financing deduction; or the last day of the period. • the amount is ‘small’,

‘Relevant liabilities’ are the amounts of borrowings, then the amount is taken to be nil. finance lease liabilities and any other financial liabilities producing a return financially equivalent to interest which are disclosed in the consolidated financial statements. This (TIOPA 2010 s 329.) would effectively be the amount of the group’s external debt. ‘Small’ means the de minimis amount of £500,000 (TIOPA 2010 s 331). As discussed above, Finance Act 2012 introduced (TIOPA 2010 s 264.) a new election for groups to disapply the operation of the de minimis amount, in TIOPA 2010 s 331ZA. This election also has effect in relation to the ‘Tested Income Amount’ See Example 11 below. (considered below).

4.1.3 The detailed debt cap calculation The Available Amount (‘AA’) Groups which pass through the gateway test must then The AA is the sum of the amounts disclosed in the financial prepare the detailed debt cap calculations to determine statements of the worldwide group for the period of whether any disallowance of finance expense is required. account of: As explained in the overview, the calculation compares the ‘Tested Expense Amount’ (‘TEA’) to the ‘Available Amount’ (‘AA’). The Total Disallowed Amount (TDA) for • interest payable on borrowing; the accounting period is the amount by which the TEA • amortisation of discounts and premiums relating to, exceeds the AA. If the AA exceeds the TEA then there is no and expenses ancillary to, borrowing; disallowed amount. • financing expense implicit in payments under finance leases; Tested expense amount (‘TEA’) • financing expense relating to debt factoring; or The TEA is the sum of the net financing deductions of each relevant group company in the worldwide group for the • any other matters which may be specified in period of account. The ‘net financing deduction’ means: regulations.

• the sum of the company’s financing expense amounts (TIOPA 2010 s 332.) for the period (defined in TIOPA 2010 s 313); less

• the sum of the company’s financing income amounts With reference to the final category in this list, changes have for the period (defined in TIOPA 2010 s 314). been made to this list by means of statutory instrument – see the Tax Treatment of Financing Costs and Income (Available Amounts) Regulations 2010 (SI 2010/2929). If a company’s net financing deduction for the period is either:

Example 11 – gateway test The Hades group has £5 million of UK net debt and £5.5m of gross worldwide debt for the year ended 31 December 2012. The previous year it had the same level of gross worldwide debt but only £3m of UK net debt. The gateway test is applied as follows:

Gross UK net % of UK net debt to Gateway test worldwide debt gross worldwide debt debt

£ £ %

Year ended 31 December 2011 5,500,000 3,000,000 55% Failed – no need to apply debt cap rules for the period

Year ended 31 December 2012 5,500,000 5,000,000 91% Met – debt cap rules apply for the period

28 Topical Corporation Tax Issues for Large Companies Tolley’s Tax Digest | Issue 125 | March 2013

There are a number of specific exceptions from finance 2010 s 276 (disallowances) / TIOPA 2010 s 288 (exemption expense or finance income amounts, including for group of financing income). In particular, if a reporting body is treasury companies (TIOPA 2010 s 316), REITs (TIOPA 2010 appointed to act on behalf of the relevant group companies, s 317), short term debt (TIOPA 2010 s 319), stranded non- then the application, signed by all relevant companies, must trading loan relationship deficits (TIOPA 2010 s 322) and be submitted to HMRC at least three months beforehand management expenses (TIOPA 2010 s 324). (SI 2009/3173).

The financing income exemption In the absence of valid statements of allocated disallowances and / or exempt financing income, HMRC will allocate the If for an accounting period the TEA exceeds the AA, so that amounts between the relevant group companies in accordance there is a TDA, then the group may be able to specify that with the formulae in TIOPA 2010 s 284 (allocated disallowances) an amount of its ‘financing income amount’ (defined in and TIOPA 2010 s 296 (exempt financing income). TIOPA 2010 s 314) is exempt from tax. 4.2 Changes to the ‘deemed release’ rules The financing income amount which may be exempted for a period of account must not exceed the lower of: Finance Act 2012 made changes to the ‘deemed release’ rules in CTA 2009 ss 361 and 362 and introduced a new • the TDA; and widely drawn anti avoidance rule, CTA 2009 s 363A.

• the ‘tested income amount’. By way of background, where a liability under a connected company debtor relationship is formally released in (TIOPA 2010 s 292(6).) accordance with CTA 2009 s 358, credits arising are not brought into account, unless either CTA 2009 ss 361 or 362 The ‘tested income amount’ is: applies.

• the sum of the net financing incomes of each UK CTA 2009 s 361 brings credits into account for a ‘deemed group company for the period of account (defined in release’ where a company connected with the debtor to a TIOPA 2010 s 314); less loan relationship acquires the debt, and the acquisition cost is less than the carrying value. This is unless the release is • the sum of the company’s financing expense amounts a release of ‘relevant rights’, under the exceptions in CTA (defined in TIOPA 2010 s 313). 2009 ss 361A-361C:

(TIOPA 2010 s 330.) • the acquisition is in the course of a corporate rescue (‘corporate rescue exception’); The new election out of the de minimis rule in TIOPA 2010 s 331ZA discussed above applies to the tested income • equivalent consideration is given in the form of debt amount as well as to the tested expense amount. (‘debt for debt exception’); • equivalent consideration is given in the form of Statement of allocated exemptions ordinary share capital of the new creditor or a connected company (‘equity for debt exception’). Groups have flexibility in allocating TDA and exempt financing income between the relevant group companies, provided that: CTA 2009 s 362 brings credits into account as a ‘deemed release’ where an existing debtor and creditor to a loan relationship become connected, and the loan relationship • the ‘reporting body’ submits a ‘allocated would have been impaired in the accounts of the creditor disallowances’ / ‘statement of allocated exemptions’ had an accounting period ended immediately before the for the period of account to HMRC; companies became connected. For companies becoming • the statement is received by HMRC within 12 months connected prior to 27 February 2012, the amount of of the end of the period of account; and the deemed release was the amount of the impairment adjustment which would have been made by the creditor • the statement meets a number of requirements company had a period of account ended immediately specified in TIOPA 2010 s 280 (disallowances) / before the companies became connected. TIOPA 2010 s 292 (exempt financing income).

For companies becoming connected from 27 February 2012 (TIOPA 2010 s 279 disallowance of deductions.) to 1 April 2012, the amount of the deemed release credit was the lower of: (TIOPA 2010 s 290 exempt financing income.)

• the above amount ie the amount of the deemed release The appointment of a ‘reporting body’ is outlined in TIOPA was the amount of the impairment adjustment which

29 Tolley’s Tax Digest | Issue 125 | March 2013 Topical Corporation Tax Issues for Large Companies

would have been made by the creditor company had 4.3 Income tax withheld at source on interest a period of account ended immediately before the payments companies became connected; and Following Budget 2012, HMRC opened a consultation into • the difference between the pre-connection carrying possible changes to income tax rules on interest payments values in the accounts for the creditor and the debtor, ie (‘possible changes to income tax rules on interest’). The key the creditor’s asset value and the debtor’s liability value. proposals in the consultation document included the following:

For companies becoming connected from 1 April 2012, the • removal of the exemption from the requirement comparison is between: to withhold income tax on payments in respect of ‘quoted eurobonds’ in respect of certain payments;

• the pre-connection carrying value in the debtor’s • removal of the distinction between ‘yearly interest’ accounts if a period of account had ended and non yearly interest (ITA 2007 Pt 15); immediately prior to the companies became connected; and • clarification in statute of the meaning of ‘UK source’ in relation to interest; –– the cost of the creditor’s asset representing the loan relationship, on an amortised cost basis • proposals for changes to the ‘funding bond’ rules of accounting, on the last day of the period (interest paid in kind / ‘PIK’), to require the payment of account ending immediately before the one of tax withheld at source in cash and requirements in which the companies became connected; or relating to valuation; and

–– the amount of consideration given by the • rules relating to requirement to withhold tax at source creditor for the acquisition of the loan on interest included in compensation payments. relationship. Summary responses to the consultation were published by (CTA 2009 s 362(3) and (4).) HMRC on 2 October 2012. Following this, draft Finance Bill 2013 includes draft legislation relating to a number of these The amount specified in sub-s (4) was amended so as measures, whilst a number of the proposed measures have not to create anomalies where for instance a creditor not been implemented. had accounted for the asset at fair value, but had to use amortised cost basis from the period in which I became The measures which have been abandoned include the connected with the debtor. following:

In addition to these changes to CTA 2009 s 362, new CTA 2009 • the proposed restriction of the ‘Quoted Eurobond’ s 363A was introduced. This is a targeted anti-avoidance exemption; rule aiming to prevent schemes trying to fall outside CTA 2009 ss 361 and 362. The provisions catch any case where • the requirement for income tax to be paid in cash on arrangements are entered into, the main purpose, or one of the issue of funding bonds; and the main purposes of any party entering into is: • the removal of the concept of yearly interest, although HMRC will be updating its guidance • to avoid an amount being treated as released under regarding ‘short’ loans. CTA 2009 ss 361 or 362; or

• to reduce the amount which is treated as released Measures which are included in the draft clauses for under CTA 2009 ss 361 or 362. Finance Bill 2013 are as follows:

(CTA 2009 s 363A.) • requirements for the issuers of funding bonds to issue certificates stating the valuation of the funding bonds;

HMRC guidance confirms that it will not seek to apply • requirements for tax to be withheld at source on CTA 2009 s 363A in the course of ‘normal’ acquisition or interest included in compensation payments; other commercially driven debt restructuring (CFM35590). It also confirms it would not ordinarily consider CTA 2009 • requirements for withholding tax to be accounted for s 363A to over-ride a prior debt for equity swap, or group on non-cash interest such as vouchers; continuity rules, or to take priority over the application • introduction of disguised interest rules for income of the exceptions in CTA 2009 ss 361A-361C. Illustrative tax; and examples are given in CFM35595. • statutory clarification of the treatment of ‘specialty debt’, ie debt executed outside and held outside the UK.

30 Topical Corporation Tax Issues for Large Companies Tolley’s Tax Digest | Issue 125 | March 2013

5 UK Implementation of the US ‘Foreign • reporting requirements; and Account Tax Compliance Act’ (‘FATCA’) • penalties. The Foreign Accounts Tax Compliance Act (‘FATCA’), included within the ‘Hiring Incentives to Restore Employment Act’, was A broad summary of the proposed requirements according introduced in the US in 2010 with the aim of combating tax to the draft guidance and Regulations follows; however evasion by US taxpayers owning non-US financial accounts. needless to say there will be further amendments to the Under FATCA, non-US financial institutions will be required legislation, some of which may be significant. In particular, to provide information about affected US taxpayers to the US there remain several areas of uncertainty, in particular in Inland Revenue Service (‘IRS’). Failure to comply with FATCA relation to the registration process which will be required will result in a 30% withholding tax on US source income for and how reports under the Regulations must be made. the financial institution. 5.1 Overview of process In order to implement FATCA, UK law has to be amended HMRC’s guidance notes sets out the following questions because under current law the required information cannot in order for entities to consider their obligations under be passed onto HMRC or IRS. The UK and US signed an the legislation (‘Implementation of International Tax Inter-governmental Agreement (‘IGA’), on 12 September Compliance (United States of America) Regulations 2013 2012, ‘Agreement to Improve International Tax Compliance Guidance Notes, page 9): and to Implement FATCA’.

• Am I a Financial Institution? The IGA includes the following: • Do I hold Financial Accounts? • UK financial institutions will be deemed to have • Are there indicators that any of the account holders’ complied with FATCA and will not be subject to the are Specified US Persons? penal 30% withholding tax provided they comply with legislation which gives effect to the IGA, and • After applying the relevant due diligence do I have the UK authorities share the information provided any reportable accounts? by financial institutions with the US; A flowchart setting out a broad summary of the process is • legislation implementing the IGA will contain details included at Appendix 2. of what information has to be reported to HMRC, the due diligence which financial institutions have to carry out and reporting requirements. 5.2 Definition of financial institutions

• the US will in turn provide the UK authorities with Financial Institutions include entities falling into at least information regarding US accounts of UK taxpayers; one of the following categories which are not exempt and (exemptions are summarised below):

• data will have to begin to be collected by financial • custodial institution; institutions in 2013, and will have to be received by HMRC from 2015. • depositary institution;

• investment entity; Subsequently on 18 December 2012, HM Treasury and HMRC released draft Regulations, ‘International Tax • specified insurance company. Compliance (United States of America) Regulations 2013’. The regulations enable the implementation of the IGA. More 5.3 Custodial Institution than 80 pages of draft guidance and a summary of responses A custodial institution is one which earns a substantial to consultation were published alongside the Regulations, portion of gross income from the holding of assets on behalf with further comments invited by 13 February 2013. of others and from related financial services. Examples given in HMRC’s guidance of custodial institutions Draft enabling legislation for the Regulations was published are brokers, custodial banks, trust companies, clearing in Finance Bill 2013 on 11 December 2012. organisations and nominees.

The key points clarified in the draft Regulations and 5.4 Depositary institution accompanying guidance include the following: A depository institution means a person carrying on certain regulated activity that is a regulated activity under the • definition of a UK reporting financial institution Financial Services and Markets Act 2000. The examples (‘UKFI’); given in HMRC’s guidance of entities which would be • definition and explanation of ‘financial accounts’; included within this definition are savings or commercial banks, credit unions, industrial and provident societies and • due diligence requirements;

31 Tolley’s Tax Digest | Issue 125 | March 2013 Topical Corporation Tax Issues for Large Companies

building societies. Entities which issue pre-payment cards of entity, such as partnerships and trusts etc, it will not such as pre-paid credit cards are also within the definition. necessarily be straightforward to determine whether the financial institution is UK resident. HMRC’s guidance 5.5 Investment entities gives further guidance and examples. An investment entity is an entity carrying on one or more 5.9 Financial accounts of the following activities for customers (HMRC Guidance notes, page 17): 5.9.1 Definition For the purposes of FATCA and the UK-US Agreement, • ‘Trading in money market instruments (cheques, ‘financial account’ includes: bills, certificates of deposit, derivatives etc.);

• foreign exchange; • accounts maintained by UK financial institutions or UK branches of non-UK financial institutions; • interest rate and index instruments; • capital or profit shares in partnerships which fall • transferable securities and commodity futures trading within the definition of investment entity. • Individual and collective portfolio management;

• Otherwise investing, administering or managing Certain equity and debt interests in the financial institution funds or money on behalf of other persons.‘ are excluded from the definition of financial accounts if they are regularly traded on a recognised securities market 5.6 Specified insurance company Financial accounts are reportable accounts if they are held A specified insurance company is an insurance company if by at least one ‘specified US person’ or by a non-US Entity products are written classified as cash value insurance or with one or more controlling persons that are specified annuity contracts, or if payments are made with respect to US persons. If no specified US persons hold reportable such contracts. The definition includes holding companies accounts then financial institutions must make a nil return. of companies meeting the definition. Companies which only provide general insurance or term life insurance are Financial accounts include depository accounts, custodial not included. accounts, cash value insurance and certain annuity contracts and equity or debt interests in Investment entities. There 5.7 Exemptions is further commentary regarding the types of accounts Exemptions may be available for certain entities: included within these headings in HMRC’s guidance.

• exempt beneficial owner – including specified 5.9.2 Exempt products UK Governmental organisations, central banks, There is an extensive list of types of financial products international organisations; which are exempt from being financial accounts, including • retirement funds; the following:

• deemed compliant financial institutions – including • Exempt pension schemes, including registered not-for-profit organisations such as registered pension savings schemes, pension annuities; charities and community amateur sports clubs, and financial institutions with a local client base (reduced • Individual Savings Accounts (ISAs) and Junior ISAs; reporting requirements if a number of conditions are • child trust funds; met); • Premium Bonds issued by UK National Savings and • regulations exemption – this allows for application Investments; of broader exemptions which may be available under the US regulations if the entity would otherwise be • Children’s Bonus Bonds issued by UK National at a disadvantage as a result of being within the UK Savings and Investments; regulations. • Fixed Interest Savings Certificates issued by UK National Savings and Investments; 5.8 Residence • Index Linked Savings Certificates issued UK The US-UK Agreement and the UK draft Regulations only National Savings and Investments; apply to United Kingdom financial institutions. Entities will therefore have to consider their residence as well as • Tax Exempt Savings Plans issued by a friendly whether they fall within the definitions outlined above. The society; definition of UK residence for this purpose is the residence • HMRC-approved Save As You Earn Share Option of the entity for tax purposes. In respect of certain types Schemes.

32 Topical Corporation Tax Issues for Large Companies Tolley’s Tax Digest | Issue 125 | March 2013

• HMRC-approved Share Incentive Plans; and Additional specified information is required in respect of accounts which are custodial accounts, depositary accounts • HMRC-approved Company Share Option Plans. or other types of accounts. 5.10 Due diligence requirements 5.12 Penalties The due diligence process for Financial Institutions to Under the UK draft Regulations, penalties will be due as identify the status of account holders is based on self- follows: certification by the account holders.

• failure to comply with any obligations under A financial institution cannot rely on self-certification if there the Regulations (excluding obligations to report is any reason to consider it may be incorrect or unreliable. payments to NPFIs) – £300;

Financial Institutions must confirm the reasonableness • reporting inaccurate information – up to £3,000; and of self-certification based on information to which it has • failure to report or inaccurately reporting payments access, including information obtained for the purpose to non-participating financial institutions – £300 per of Anti-Money Laundering procedures and ‘Know Your failure. Customer’ procedures. Third parties’ KYC or anti-AML requirements may be relied upon and financial institutions Penalties will be capped at £3,000 per calendar year. may request that they obtain self-certification. The financial institution must confirm the reasonableness of self- certification obtained this way, which may be by asking for certification by the third party. 6 EU Financial Transactions Tax – update EU Ministers have approved an EU-wide Financial There is specific guidance given by HMRC regarding self- Transactions Tax. 16 EU member states, including the UK, certification procedures for new individual and entity will not introduce the tax, but notable states amongst the 11 accounts and pre-existing individual and entity accounts states which have agreed to introduce the tax include France and numerous examples are included within the guidance. and Germany. The tax was approver under ‘enhanced cooperation’, having failed to reach unanimous support from Where an account holder has been identified as a specified all 27 EU member states. EU law enacted under enhanced US person, a US Federal Tax Identification Number (‘TIN’) cooperation only applies to a subset of member states. must be obtained in most instances. More detail on the TIN requirement is included in HMRC’s guidance. By the time of publication of this edition of Tax Digest, a draft plan for the Financial Transactions Tax is expected Financial institutions can elect not to review accounts where to have been published. Following a Draft Directive, the account balances are below specified thresholds. There originally released on 28 September 2011, The Financial are different thresholds depending on the type of account. Times has reported that it has seen a revised copy of the draft plan, and in his article ‘Wider euro “Tobin tax” will 5.11 Reporting requirements net 35bn Euros’, (Financial Times, 29 January 2013), Alex Barker outlines some of the proposed features according to Having carried out the required due diligence procedures, this latest draft. These include the following: financial institutions must report certain information regarding its reportable accounts to HMRC. The reporting • anti-avoidance measures will be included to requirements are phased in over a three year period starting discourage businesses from using ‘safe havens’. from 2013. The following information must be supplied in These may include measures to apply the tax to relation to each specified US person and each controlling transactions based on where the financial product person of an entity account who is a specified US person: was issued, even if they are traded by parties in Asia, US or UK; • name; • 0.1% levy on stock and bond trades, and 0.01% levy • address; on derivatives, to be imposed on financial institutions • US TIN where applicable; either with headquarters in the ‘tax area’ or who are trading on behalf of clients based in the tax area; • the account number or equivalent; • the tax is proposed to be implemented by January • the name and identifying number of the reporting 2014, but may take longer to implement; financial institution; and • exemptions to the tax include on overnight • the account balance or value as of the end of the repurchase agreements, issuance of shares and units calendar year or other appropriate period. Where in retail funds, exchanges of stock in mergers and an account is closed during the year the balance spot currency transactions; and immediately prior to closing must be reported.

33 Tolley’s Tax Digest | Issue 125 | March 2013 Topical Corporation Tax Issues for Large Companies

• Eurozone states or central banks will not be liable for the tax when intervening in secondary sovereign bond markets.

The latest list of EU member states to offer support to the tax is:

• Belgium;

• Germany;

• Estonia;

• Greece;

• Spain;

• France;

• Italy;

• Austria;

• Portugal;

• Slovenia; and

• Slovakia.

Although abstaining or opposing member states will not introduce the tax, they will be impacted. For instance a non-EU financial institution would be liable for the tax under the proposals when it is a party to a financial transaction with an EU party. Affected businesses will need to give consideration to the impact of the tax on their product strategies and administrative processes to ensure compliance.

34 Topical Corporation Tax Issues for Large Companies Tolley’s Tax Digest | Issue 125 | March 2013

Appendix 1: 'Above the line' credit for research and development – summary of calculation steps

Computation step Draft CTA 2009 reference

Qualifying expenditure ss 104C-104I (SMEs) ss 104J-104L (large companies) (Existing CTA 2009 Pt 13)

Amount of R&D expenditure credit (9.1% / ring fence trade rate) s 104M

Step 1: Set off against corporation tax liability for the period s 104N(2) Step 1

Step 2: Cap amount remaining after Step 1 at PAYE / NIC for R&D staff for the period s 104N(2) Step 2 s 104N(3)

Step 3: Set off amount remaining against any unpaid corporation tax liability s 104N(2) Step 3 for other periods

Step 4: May surrender amount remaining to group member s 104N(2) Step 4 s 104O

Step 5: Deduct notional corporation tax at main rate on amount remaining as if it were s 104N(2) Step 5 profits of the period s 104P

Step 6: Deduct any other amounts owed to HMRC s 104N(2) Step 6

Step 7: Result is amount repayable to the company by HMRC, subject to: s 104N(2) Step 7 – going concern; s 104Q – HMRC open enquiries; and – unpaid PAYE / NICs

35 Tolley’s Tax Digest | Issue 125 | March 2013 Topical Corporation Tax Issues for Large Companies

Appendix 2: Foreign Account Tax Compliance Act (FATCA) and UK Regulations to implement US-UK Treaty dated 12 September 2012 – overview of process steps

Definition of 'Reporting Financial Institution' ä

Exemptions available? ä

Classification of type of financial institution:

– Custodial institution – Depositary institution – Investment entity – Specified insurance company ä

Definition of 'reportable' / financial accounts ä

Due diligence: Identify which account holders are specified US persons ä

Report 'reportable financial accounts'

36 Topical Corporation Tax Issues for Large Companies Tolley’s Tax Digest | Issue 125 | March 2013

Notes

37 Tolley’s Tax Digest | Issue 125 | March 2013 Topical Corporation Tax Issues for Large Companies

Notes

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TTD Issue 101 – Tax on Termination Payments (March 2011) TTD Issue 102 – Entrepreneurs’ Relief (April 2011) TTD Issue 103 – Purchase Of Own Shares (May 2011) TTD Issue 104 – Tax and the Family Home (June 2011) TTD Issue 105 – Pension Schemes: Tax Planning (July 2011) TTD Issue 106 – A Practitioner’s Guide to the Finance Act 2011 (August 2011) TTD Issue 107 – Tax on Company Reorganisations (September 2011) TTD Issue 108 – VAT Update and Current Issues (October 2011) TTD Issue 109 – Inheritance Tax – International Aspects (November 2011) TTD Issue 110 – Taxation in Corporate Insolvency (December 2011) TTD Issue 111 – Research and Development Tax Relief (January 2012) TTD Issue 112 – Pension Schemes: Auto-enrolment rules (February 2012) TTD Issue 113 – High Net Worth Individuals (March 2012) TTD Issue 114 – Disguised Remuneration (April 2012) TTD Issue 115 – Employee Share Schemes (May 2012) TTD Issue 116 – Seed Enterprise Investment Scheme (June 2012) TTD Issue 117 – The Substantial Shareholding Exemption (July 2012) TTD Issue 118 – A Practitioner's Guide to the Finance Act 2012 (August 2012) TTD Issue 119 – Value Added Tax – An Update (September 2012) TTD Issue 120 – Recent Developments on Residence and Domicile Matters (October 2012) TTD Issue 121 – The New Controlled Foreign Companies Regime (November 2012) TTD Issue 122 – Topical Tax Planning Issues for Owner-managed Businesses (December 2012) TTD Issue 123 – Employer-provided Benefits (January 2013) TTD Issue 124 – Income Tax: Transactions in Securities (February 2013) TTD Issue 125 – Topical Corporation Tax Issues for Large Companies (March 2013)

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