The UK within International Structures – Recent Developments
The idea of Chancellor George Osborne in a poncho may be a surprising image, but recent proposals for change in UK tax law in the international sphere have been a case of the good, the bad and the ugly.
CFC Reform – Finance Companies
The UK's controlled foreign company (CFC) rules apply to impose a charge to tax on UK parent, or intermediate parent, companies on the profits of subsidiaries in low taxed jurisdictions. The rules have been the subject of a long drawn-out consultation process, but the endgame now appears in sight and revised rules are due to be adopted in Finance Bill 2012.
The new rules bear many resemblances to the old, with certain improvements. However, there is one genuinely new and interesting development for multi-national groups; the introduction of a favourable regime for intra-group finance company income. Multinational groups should consider carefully whether to restructure to use UK entities as holding vehicles, or intermediate holding vehicles, for entities in other jurisdictions.
Under the proposed rules, the UK parent entity can set up a group financing subsidiary in either a low tax jurisdiction or one which provides a generous regime for financing activities. This finance company can then be used to leverage the remainder of the worldwide group. The finance company will need some "substance" and will need to show it is properly established and locally managed in its jurisdiction. This will generally entail having local directors who understand the business and having premises permanently available to the finance company.
Provided the finance company meets these establishment criteria, the UK parent entity will only be taxed under the CFC rules on an apportionment of 25% of the finance company's profits (with credit given for foreign tax paid on those profits). Since the UK's main corporation tax rate is reducing on an annual basis to 23% by 2014, this will give rise to an effective rate of tax on financing income for the group of only 5.75%. This is likely to present considerable arbitrage possibilities for the group as a whole. The position may even improve further as the Government is also considering a full exemption from the CFC rules for financing income of companies within groups which earn the majority of their commercial profits overseas.
Double Tax Treaty Reform?
Many international investors investing into the UK will structure their investment through other jurisdictions. For funds investors, this will often mean the use of a Luxembourg holding company. Where funds have a substantial level of US investors, this makes sense as the Luxembourg company can be funded with hybrid instruments, usually structured as Convertible Preferred Equity Certificates (CPECS). CPECs are treated as debt under Luxembourg rules, so do not trigger withholding tax on distributions. However, they do not give rise to "dry income" issues for US investors (where accrued income is taxable even though it has not been paid out).
The Luxembourg company will then typically advance the funds through a mixture of debt and equity to the UK. Under the terms of the UK/Luxembourg double tax treaty, the UK borrower entity can make interest payments to the Luxembourg company without having to account for UK withholding tax (charged at 20%), provided that the arrangement is structured so that the Luxembourg company is the beneficial owner of the interest. Luxembourg companies are thus also a popular vehicle for mezzanine debt funds. Such structures have been used countless times.
However, on 1 August this year, HM Revenue and Customs introduced a giant fly to the ointment with an announcement that they would be legislating to introduce a unilateral anti-avoidance override to the UK's double tax treaty arrangements. Such a provision would have allowed the UK to deny entities the ability to rely on a double tax treaty where the main purpose, or one of the main purposes, to the arrangements was the avoidance of UK tax. The type of lending structure outlined above would, on the face of the draft legislation, have been caught, as would many other structures within multinational groups.
However, following howls of protest from many quarters, the Government reversed its previous announcement on 9 September and stated that it would not now be introducing the proposed changes. However, it reserved the right to challenge specific arrangements which it considered abusive. It also stated that it would only bring in future changes following proper consultation.
As a result, the problem looks to have passed for the time being. However, it is clear that the UK may look to bring in more targeted rules in future and cross-border holding and lending structures should in particular be kept under review.
Another more positive recent development has been the continuing discussions surrounding a UK "Patent Box" regime, which will give a 10% tax rate for qualifying activities.
The Patent Box will apply to income from patents granted by the UK's Intellectual Property Office (IPO) and the European Patent Office (EPO). The box will include worldwide income earned by a UK company from inventions covered by a qualifying patent. The requirement for a UK or European Patent is a quality control measure, to ensure that the patent has been independently validated as innovative and useful. In some circumstances, it may therefore be necessary to seek additional registration for patents held elsewhere.
Income from patent licensing and royalties will qualify for the proposed 10% rate. In addition, where an invention is incorporated into patented products, a proportion of sales income can also qualify as will income from the sale of patents.
Draft legislation will be published in October 2011, leading to final legislation in Spring 2012 and commencement of the regime on 1 April 2013. The introduction is also likely to be subject to transitional rules and will be phased in for existing patents over a 5 year period.
The Patent Box will not be available in all circumstances and the company claiming a Patent Box tax deduction must remain actively involved in the ongoing decision making connected with the exploitation of the patent. Further the IP holding company or another group company must have performed significant activity to develop the patented invention or its application.
The overall aim of the provisions is to encourage multinational groups to undertake research and development and hold patents in the UK. Whilst there may be better regimes elsewhere, it is likely to make elaborate and expensive planning for patent holding activities less attractive.
Tom Cartwright is a director in the McGrigors Tax Team. Tom's practice focuses on all areas of corporate tax, including the tax aspects of corporate acquisitions and reconstructions, involving the financing and structuring of UK and cross-border buy-outs, mergers and acquisitions. He has considerable expertise in tax structuring for debt restructuring and corporate recovery for distressed businesses.
McGrigors Tax is an award winning tax practice with an unrivalled depth of experience in all areas of tax – both direct and indirect. The team includes tax lawyers, senior ex-HMRC officers, and advisers with a Big Four accounting firm background and is ranked as Band 1 in both major legal Directories.
Tom can be contacted on +44 (0) 20 7054 2630 or at Tom.Cartwright@mcgrigors.com.