The UK controlled foreign company (CFC) rules are designed to impose UK corporation tax on profits earned by overseas companies controlled by UK persons where those profits have been artificially moved offshore. The rules were updated from 2013 to include an exemption (of between 75% to 100% of relevant financing income) for income arising in the CFC which was generated from financing activities with, of course, anti-avoidance measures applying in some circumstances. This exemption potentially allows a UK tax saving of up to 19% (current corporation tax rate) of interest income earned, and up to 23% for the period affected by the European Commission state aid investigation (2013 to 2019)
For example, in the following structure, the overseas trader obtained an interest deduction for the interest expense but the CFC Finance Company has no (or little) tax on the interest receipt. The UK holding company was not subject to a CFC charge on the interest income of the CFC Finance Company if it was fully exempt or taxed on 25% at the main corporation tax rate (23% - 19% in the years affected) if partially exempt - although the overall outcome may have been subject to withholding tax overseas.
The UK Government made changes to the exemption from 1 January 2019 by disapplying the full or partial CFC exemption for non-trade finance profits generated by UK significant people functions (SPFs) – read more.
Illegal state aid?
The low effective tax rate available because of the exemption attracted the attention of the European Commission and, in 2017, it began an investigation into whether or not this constituted illegal state aid.
On 2 April 2019, the Commission announced that some parts of the exemption under UK law were deemed to be justified on administrative grounds – so that companies did not have to carry out “complex and disproportionately burdensome intra-group tracing exercises”. However, it states that such administrative burdens did not justify the exemption where the offshore financing activity was managed mostly by UK-based group personnel. It has directed the UK Government to claw back the tax relief given under the exemption since 2013.
Therefore, whether or not groups that have used offshore group finance companies since 2013 will be subject to a clawback of the tax saved by claiming the exemption will depend on an analysis of the significant people functions carried out in relation to the lending of the finance company, and whether one or more of these functions was carried on in the UK. This will mean that each case will need to be considered on the specific facts.
Tax relief clawed back
At the time that the draft legislation for Finance Act 2019 was published, HMRC estimated that the tax impact of the change to the exemption rules would be ‘negligible’ each year. However, with six years potentially affected in a retrospective manner by virtue of the state aid decision and adding compound interest to the tax clawed back, affected groups are likely to see the cost they now face as substantial. Under EU rules, the Government is supposed to take action to recover this illegal state aid within four months, although that may be difficult for HMRC to achieve in practice.
Firstly, the precise arrangements of each potentially affected group need to be considered on the specific facts. There may be alternative filing positions for some clients who may have relied on the partial exemption as the ‘simplest’ approach rather than the only available approach. Secondly, we understand that a further complexity will arise from the fact that HMRC would seek to test the position for each tax year for which relief was claimed. Therefore, even though loans may have lasted throughout several years in the period, a group must consider the significant people functions carried out in relation to the lending for each of the six tax years for which a clawback may apply.
Given that the UK has already changed the rules for the exemption and they are already in line with the European Commission’s judgement on state aid and the fact that it is perhaps a sensitive time to pursue such a dispute with the EU, it seems unlikely that the Government will appeal the ruling to the Court of Justice of the European Union. HM Treasury is also likely to welcome the additional revenue – although details of how HMRC will implement the claw back of relief are not yet available.
It is possible that some affected companies will appeal the ruling to the General Court of the EU but this is unlikely to prevent HMRC for implementing clawback procedures in the interim.
Groups that have operated offshore group finance arrangements that previously benefited from the exemption should quantify their potential financial exposure. They should then examine the audit trail for lending decision making by the offshore finance company for each of the relevant tax years to establish/confirm where the significant people functions were carried out. In doing so, they should consider if there may be alternative filing positions available for open tax years that do not rely on claiming the relevant exemption. HMRC is likely to want robust evidence of the offshore company’s procedures and activities to prove that claims for the exemption between 2013 and 2019 did not constitute state aid.
For help and advice on this or any other CFC issue, please contact Nick Udal or Ross Robertson.
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