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Demystifying the CFC minefield?

With draft legislation set to be published this autumn regarding changes to the Controlled Foreign Company (CFC) rules ahead of full reform in 2012, Watson Buckle partner John Kinsella offers his thoughts on CFCs and the implications for businesses – and concludes that expert advice will be more important than ever.

Given the current economic climate and high budget deficit, the government is keen to stop businesses artificially diverting profits from the UK to countries with a more favourable tax regime.

At the same time, it also wants the CFC measures to be seen as an incentive to  ensure that the companies already based here choose to stay and to attract new inward investment to the UK.

In achieving this difficult balancing act, there will be a number of exemptions which, while similar to the current regulations, differ in the detail. Getting to grips with the nuances will mean that businesses will need expert advice.

As the Chancellor’s last Budget promised, there will be a partial exemption for finance companies (FCPE), although this will only apply to offshore firms. This means that they will benefit from an effective UK tax rate of one quarter of the main rate on profits derived from overseas group financing arrangements, resulting in a rate of 5.75 percent by 2014.

Such companies may also look to the proposed general purpose exemption (GPE) to exempt the remaining quarter of their profits, although the FCPE should prove more effective for them.

However, the GPE is likely to be widely used by CFCs, due to the complexity of the ther tests proposed – including those relating to intellectual property, investment activities and finance income for CFCs that take part in genuine commercial activities and wish to apply the territorial business exemption (TBE).

Another exemption, which applies to firms with profits below £200,000, will reduce the burden for SMEs – although they will still need to work out whether they are affected by the rules or not.

Further complexity arises from the fact that the term “artificially diverted” is not clearly defined within the proposal documents – although, at least, it will not be assumed that a CFCs profits would have arisen in the UK if it did not exist.

Overall, these measures mean that the compliance burden is likely to be as profound when the new rules come into force as it is now. This will make it difficult for companies with overseas connections to figure out whether the regulations apply to them and, if so, what the relevant tax charge will be.

Furthermore, while parts of these proposals, such as the FCPE, are likely to be seen favourably by companies, their existing offshore financing arrangements are likely to be complicated, especially those that have been structured in line with the current CFC regulations.

In fact, all groups will need to analyse their CFC activities to ensure they are operating as effectively as possible. Additionally, inbound investors will need to take these complexities into account when choosing to operate in the UK. It is, therefore, imperative that these companies seek expert advice as soon as possible from firms, like UK MGI members, with expertise in this area.

For help and advice on this and other complex areas of UK Tax please get in touch with John Kinsella at Watson Buckle. 01274 516711 or JohnK@watsonbuckle.co.uk