European Commission investigates the UK’s exemption from CFC rules for certain financing income

Mon 06 Nov 2017

The European Commission (EC) has announced it will undertake a State aid investigation into the financing exemption for the UK’s controlled foreign company (CFC) regime. The exemption has been applied by a number of both ‘UK multinational’s and ‘foreign companies investing into the UK’ to finance their overseas expansion.

The EC press release comments that the State aid investigation will assess whether the regime gives some companies a better treatment than others. It also points out the EU anti tax avoidance directive (ATAD) requires all EU member states to introduce CFC rules by 1 January 2019 and that ATAD does not provide for a group financing exemption.

The UK CFC group financing exemption is generally available to all UK groups with an overseas finance company, unless the business of the group is a banking or insurance business and the loan would not be made in the ordinary course of that business. The exemption is available to CFCs established both inside and outside the EEA, however, arguably going further than the Court of Justice of the European Union (CJEU) decision on controlled foreign financing companies in the Cadbury Schweppes case.  Whether that is in accordance with EU freedoms may be open to question, but any infringement would still seem to be difficult to confirm where there is genuine economic activity and no wholly artificial arrangements.  Whether the UK tax position of a wholly UK group with a UK finance company lending within the UK, compared to the UK tax position of a UK group with a foreign financing CFC finance subsidiary lending to other foreign group members, is sufficiently different to justify State Aid may require some detailed analysis.

UK groups that have claimed the full or partial CFC financing exemption, might like to consider whether any provision should be made against that exemption or for the refund of the tax charge, were the EC to issue an adverse decision and require the UK Government to recover any illegal State aid or repay any tax it collected.

The CJEU decision in Cadbury Schweppes

In 2006 the CJEU held that the application of the UK CFC rules in 1996 to Cadbury Schweppe’s Irish financing subsidiary (case C-196/04) were incompatible with the principle of freedom of establishment.  This was so, even if there were other tax motives, where the entity had a fixed establishment in Ireland and was undertaking a genuine economic activity.  At the time, the CJEU considered the CFC rules could only be applied in this sort of instance where the profits were derived from wholly artificial arrangements intended to escape national tax rules. The freedom of establishment principle only applies to entities established in EEA member states, but the decision was a significant blow to the UK’s CFC regime that applied at that time.

The UK CFC financing exemption

Since that CJEU decision the UK CFC regime has undergone significant reform. From 1 January 2013 the UK CFC regime has required a CFC’s profits to pass through a gateway and not be subject to any exemptions before its profits can be allocated to UK shareholders and taxed in the UK.  One of the available exemptions is the finance exemption, offering either a full exemption or a 75% exemption from UK tax for certain non-trade loan relationship profits that would otherwise be caught by the legislation.  The exemption must be claimed.

Consistent with the UK’s largely territorial basis for taxing company profits, and the CJEU decision in Cadbury Schweppes, the financing exemption only applies if the CFC has a business establishment from which its activities are wholly or mainly carried on. HMRC’s guidance indicates the financing exemption has “been introduced to address the difficult issues which arise as a result of the fungibility of money within a multinational group. The rules represent to a large extent a proxy for establishing the exact source and history (tracing) of a group’s financing arrangements and the extent these are borne by the UK.”

In order to potentially be within the UK CFC regime for finance activities (and therefore potentially able to access the full or partial exemption), it is likely there may be some involvement of UK personnel or provision of capital investment from the UK.  The exemption can only apply to a qualifying loan relationship that is a money debt arising from the lending of money (a CTA2009 part 5 debt, and not a debt treated as falling in part 5 as a result of CTA 2009 part 6 or 7) and is a ‘qualifying loan relationship’.  A qualifying loan relationship is a creditor loan relationship where the ‘ultimate debtor’ is connected with the CFC and controlled by the same UK resident person or persons that control the CFC.  Certain loans are specifically excluded from being a ‘qualifying loan relationship’.

The 100% exemption can only apply where the creditor loan relationship is funded from qualifying resources which can be:

• Profits derived from lending to CFC group members in the territory of the ‘ultimate debtor’;
• Derived from shares held by the CFC  in other CFC group members (such as pre-acquisition profits distributed to the CFC); or
• Derived from shares issued by the CFC to the CFC group parent.

Where a qualifying loan cannot meet the 100% exemption, profits from the qualifying loan relationship are exempt to the extent of 75%. Any CFC charge under the main rules on profits from qualifying loan relationships that do not come within the 100% or 75% exemption is capped at the level of net UK interest expense within the UK group. This cap is calculated using worldwide debt cap principles for periods before 1 April 2017 or based on a percentage of the aggregate net tax interest expense under the new corporate interest restriction rules on or after 1 April 2017.

For a discussion of the international tax issues affecting group structures that involve UK and overseas entities, please get in touch with Vesko Petkov the Mazars International Tax team.