In its June 2010 Budget the Government announced several proposals as part of a five-year plan to reform corporation tax, including a proposal to exempt foreign branch profits from corporation tax. This followed the previous government’s announcement in the 2009 Pre-Budget Report that it recognised foreign branch taxation as a ‘matter of growing importance’ and intended to engage with businesses to explore potential future rule changes. A discussion document setting out the proposal for such an exemption and key issues arising from it was published on 27 July 2010, alongside the reform of the Controlled Foreign Company (CFC) rules.
The key issues set out in the discussion document were addressed in several meetings by a working group, which was established to consider the options and questions set out therein during the consultation period, and at an open event held on 7 September 2010. The consultation period ran until 15 October, with draft legislation to be published in autumn 2010 (as of 1 November 2010 HM Revenue & Customs (HMRC) had not announced a date for such publication). The government will then hold a further consultation, with legislation to be included in the Finance Bill 2011.
Reasons for reform
A UK resident company currently pays tax on all of its income, wherever arising, subject to applicable exemptions and reliefs. As such, a UK resident company carrying on a trade outside of the UK via a permanent establishment is subject to corporation tax at 28% on any profits of the permanent establishment, subject to a credit in most cases for any tax suffered in the foreign jurisdiction. Losses arising to the permanent establishment may be relieved against profits arising in the UK.
Conversely, a UK resident company carrying on a trade overseas through a subsidiary can, in most cases, receive profits from the subsidiary tax free under the dividend exemption rules, which were introduced with effect from 1 July 2009. Those rules were created following FII Group Litigation v Commissioners of Inland Revenue , in which the Advocate General before the European Court of Justice opined that the UK tax legislation in force, prior to July 2009, was contrary to EU principles. Although exemption for branch profits was contemplated as part of the July 2009 reform, the previous government decided to limit the exemption to foreign dividends, making overseas permanent establishments less tax efficient for many UK corporates.
In addition to achieving consistency between the taxation of overseas subsidiaries and branches, the government is seeking to enhance the UK’s attractiveness as a place to do business. With other EC countries, such as France, Germany and the Netherlands, already exempting or applying a low tax rate to profits of overseas branches, change is required to remain competitive.
The discussion document sets out two methods (option A and B) for identifying branch profits for the purposes of determining the profits that will be subject to exemption.
Option A identifies foreign branch profits as being those calculated under the UK’s double tax treaties. In other words, the profits are those determined by the business profits article of the relevant treaty.
Option B identifies foreign branch profits as those calculated under existing rules applicable to UK branches of foreign companies, for corporation tax purposes.
If option A is introduced, the level of profits, and thereby exemption, would depend on the terms of the individual treaty, giving rise to different results between jurisdictions and uncertainty as a consequence of discrepancies between individual treaty’s mutual agreement procedure. If option B was introduced, although making the calculation simpler, the amount of profit exempt from UK tax may differ from the amount that is taxed in the jurisdiction in which the branch is resident, leading to a mismatch.
In addition to determining the amount of income to be treated as exempt, the discussion document also considers exemption for chargeable gains on disposals of branch assets. The document raises concerns over issues such as how gains arising from assets used partly by a branch, and partly by other branches or the UK company’s headquarters, would be allocated and how to mitigate avoidance. HMRC addressed that and associated issues in more detail at the open event held on 7 September 2010. Where assets are transferred by the company to its non-resident branch, the government proposes a ‘hold-over’ regime whereby any gain resulting from the transfer of assets from the head office to its branch would be determined at the date of the transfer and then held over until the date of disposal of the asset by the branch, as a means of counteracting tax avoidance by companies hiving down assets to an overseas branch and escaping a chargeable gain on a subsequent disposal. The government has indicated that a transitional rule may also be introduced to tax-accrued, but unrealised, gains on assets currently within the scope of the legislation.
HMRC wishes to avoid the artificial diversion of UK profits to exempt branches to escape corporation tax. The discussion document suggests that anti-avoidance legislation is developed in conjunction with that applicable to the CFC regime. In that respect, the discussion document proposes three possible approaches applying CFC principles. However, at the open event, HMRC identified difficulties in applying tests relevant for CFC purposes.
The discussion document considers whether the exemption should be extended to branches in low or no tax jurisdictions. Currently, the dividend exemption is limited to medium and large companies, and small companies within the treaty network. It is suggested that the same test could apply to the branch exemption regime. In the working group meeting held on 9 September, HMRC expressed concern that extending the branch exemption beyond those jurisdictions covered by the treaty network would, in effect, extend the exemption beyond what is necessary to move from a credit to exemption basis.
If an exemption from corporation tax became legislation, relief for losses arising in an overseas branch would be disallowed. This will affect loss-making branches, particularly those operating in certain sectors. To mitigate the effect on UK resident companies of no longer being able to utilise such losses, the discussion document contemplates the introduction of several solutions, including an election not to apply the exemption regime. Alternatively, loss relief may be allowed, but will be subject to a clawback mechanism. It is intended that the next meeting of the working group will concentrate on that issue.
In determining the amount of interest expense that a financial services branch may deduct from its branch profits, the discussion document has two alternatives:
- to apply the capital allocation approach, whereby that proportion of the company’s interest cost applicable to the branch is equal to the proportion that the branch’s risk-weighted capital bears to the institution’s total risk-weighted capital; or
- to apply thin capitalisation rules so that the capital attributed to the branch is the same amount as that which would be attributed under transfer-pricing principles.
Clearly, the exemption of branch profits is a radical change and will result in several detailed considerations for particular industries and companies. The discussion document considers particular rules for, inter alia, air transport and shipping, the taxation of small companies, and transitional rules in relation to brought-forward losses.
Minutes of the Working Group
The first meeting of the working group, held on 3 August 2010, included representatives from HMRC, HM Treasury, BP, HSBC and Sony. The minutes of the meeting were published on 2 September 2010. No clear consensus between options A and B emerged. An alternative to options A and B was mooted, whereby the legislation would focus on what would be taxable in the UK, rather than what would be exempt, using the Organisation for Economic Co-operation and Development (OECD) principles to define the profit attributable to the UK.
At the open event, HMRC noted that, in addition to the proposals in the discussion document and the working group minutes, it is looking into how the exemption regime will apply to the insurance businesses, manufactured overseas dividends, deductions for share options and capital allowances.
During the ensuing question and answer session, HMRC confirmed that the exemption would apply to both trading and non-trading branches, and that it expects that the introduction of the exemption will result in a reduced tax take for the Exchequer.
The working group met again on 9 September 2010. At that meeting, some members expressed concern with the third alternative (ie the alternative discussed at the previous meeting, applying OECD principles), since its effect on substantial UK business was perceived to be greater than options A and B. In addition, the new Article 7 of the OECD Model Double Taxation Convention, on which it would be based, has not yet been introduced into the current treaty network, giving rise to similar double taxation concerns as those raised in relation to option B. However, the matter remains open.
The introduction of an exemption for overseas branch profits will be welcomed by UK resident companies operating profitable overseas branches. Under the current regime, while double tax relief (DTR) may be available in relation to any tax suffered overseas, to claim relief the UK resident company has to establish the level of profit attributable to the branch (which may be calculated differently in each jurisdiction) and make the claim. The introduction of an exemption from tax in the UK should not only decrease the tax cost for such companies, but also the compliance burden and complexity arising from claiming DTR.
However, the introduction of an exemption also gives rise to difficulty in relieving overseas losses against UK profits (depending on the ultimate resolution of that issue). UK resident companies operating through loss-making overseas branches may suffer an increased tax bill as a consequence of no longer being able to utilise such overseas losses. This is likely to affect certain industries more than others; in particular, the oil and gas industry typically incurs up-front losses on significant start-up costs on exploration, and, in some cases, a project may not become profitable. In some jurisdictions there may be regulatory or contractual reasons why it is preferable for, by way of example, financial services and insurance industry participants to operate through a branch on the one hand or a subsidiary on the other. Local law may restrict choice preventing a company from optimising its tax position.
While the proposals remain at a consultative stage, the publication of draft legislation in autumn 2010 should, it is to be hoped, add clarity to the options set out in the discussion document and, if appropriate, a further article considering progress will be published in early 2011. In the round, the proposals should be welcomed as a step towards greater consistency and simplicity for foreign taxation, and, if the government’s calculations are correct, a reduced tax burden for UK resident companies.
By Clare Carpenter, professional support lawyer, Watson, Farley & Williams LLP.