Controlled foreign companies: changes to prevent profit shifting
Fri 07 Mar 2014
Two changes will be introduced to the CFC rules in the Finance Bill 2014, in order to prevent profit shifting under the finance company exemption provisions.
If a UK company currently has in place a loan made to a non-UK group company, the temptation would be to transfer that loan to a new low-taxed offshore subsidiary in exchange for the issue of shares in that subsidiary. The effect of this would be to transfer the profits on the intra-group lending into the low-taxed jurisdiction. If the CFC finance company exemption applied, the UK company would no longer have a tax cost related to that financing. Hence, the overall tax cost to the group would be reduced.
Accordingly, the first amendment to the CFC rules is designed to stop groups from transferring to a non-UK company the UK profits arising from existing intra-group lending. This is achieved by preventing the transferred loans from being ‘qualifying loan relationships’ for the finance company exemptions where three conditions are met:
- There must be a loan made by a connected UK resident company to a connected non-UK resident company;
- An ‘arrangement’ is made directly or indirectly in connection with this loan; and
- The main purpose, or one of the main purposes, of the arrangement is to achieve a reduction in UK credits (i.e. income) or an increase in UK debits (i.e. expenses) of the UK connected company compared to what they would otherwise have been.
The test will be applied on a loan by loan basis.
The change will impact companies which transfer UK receivables into an offshore finance company with effect from 5 December 2013. Companies which transferred UK receivables into an offshore finance company prior to 5 December 2013 will not be impacted by the rule change.
The second change strengthens an existing anti-avoidance provision to prevent an offshore CFC benefiting from the partial or full finance company exemption, where UK debt replaces third party debt of a non-UK group company via the CFC, as part of an arrangement to gain a tax advantage for any person.
Companies who have entered into such an arrangement will be affected from 5 December 2013, even if the arrangement was entered into prior to that date. If this is part way through an accounting period, the period is split and profits apportioned between the two periods.
The finance company exemptions were intended to apply to new overseas financing, rather than to allow existing UK taxable income to be reduced. The changes follow greater than expected use of the finance company exemptions in respect of existing UK debt.
It is surprising that the existing rules did not already prevent UK companies obtaining a tax advantage by transferring existing UK debt to an offshore CFC.
The second change is less surprising as it more clearly strengthens the existing rule and will further restrict the perceived anti-avoidance that the measure is aimed at.
For example, a non-UK group company A has existing third party debt of 49. Company A’s UK parent, company B, borrows 100 from an unconnected third party. Company B injects equity of 100 into an offshore group finance company, Company C. Company C lends 100 to Company A (the “relevant loan”). Company A uses part of the loan of 100 to repay its third party debt of 49. Under existing rules, it could be argued that the relevant loan has not been used “wholly or mainly” to repay third party debt, as only 49 out of the loan of 100 has been used to repay third party debt. Hence, Company B would obtain tax relief on its loan of 100, whilst interest receivable by Company C on the loan to Company A would be a qualifying loan relationship and exempt from a CFC charge. Overall, the group has obtained UK tax relief by substituting the existing non-UK third party debt with new UK third party debt.
Under the revised rules, where the relevant loan is “used to any extent (other than a negligible one)” to repay third party debt, the related interest receivable in the offshore group finance company will not be a qualifying loan relationship and will therefore not be exempt from a CFC charge. In the above example, the interest receivable by Company C on its loan of 100 to Company A will not be a qualifying loan relationship, and would therefore be denied the benefit of the CFC finance company exemption
In recently published supplementary guidance, HMRC has emphasised that nothing within the CFC rules restricts the application of other anti-avoidance legislation, including the unallowable purpose rule. In the above example, HMRC could seek to deny tax relief to Company B for the interest it pays on its borrowings of 100.