Full reform of the controlled foreign companies legislation

On 30 June 2011, the government published the long-awaited consultation document on reform of the controlled foreign companies (CFC) legislation. The consultation follows the announcement at Budget 2011 that the government would consult on full reform this year with new legislation to be included in the Finance Bill 2012.

The regime has been repeatedly criticised as being an impediment to the competitiveness of the UK’s tax system. Indeed, the government’s stated aim for reform is creating a more competitive regime, while providing adequate protection of the UK’s corporation tax base.

Another impetus for reform has been whether the legislation is compatible with EU law, which was considered by the European Court of Justice (ECJ) in Cadbury Schweppes plc v CIR [2006] . Following the ECJ’s ruling, the UK introduced some legislative amendments in Finance Act 2007. Despite these changes, in May 2011, the European Commission formally requested that the UK amend its CFC legislation, on the basis that it does not comply with EU law.


The purpose of the CFC regime is essentially anti-avoidance, broadly, preventing UK companies rolling up income in low-tax territories to avoid UK tax.

Currently a company is a CFC if it is:

  • resident outside the UK for tax purposes;
  • controlled by person(s) resident in the UK; and
  • subject to a lower level of taxation in the territory in which it is resident (broadly, less than 75% of the UK corporation tax rate).

Where a company is deemed to be a CFC, its chargeable profits for the relevant accounting period are calculated as if it were UK resident and apportioned amongst all persons who had an interest in it at any time in that period. Where the amount apportioned to a UK-resident company (and its associated and connected persons) is 25% or more of the profits of the CFC, that company is chargeable on a sum equal to the UK corporation tax that would be due on the profits apportioned to it.

There are a number of exemptions to the current regime including an exempt activities test, motive test, a de minimus profits exemption and a list of countries excluded from the regime.


The consultation document explains that the new regime will be targeted at situations that pose the highest risk of artificial diversion of UK profits and will ensure that genuine foreign profits are exempt from UK tax. The new regime will apply equally to entities resident in EU and non-EU jurisdictions. The consultation document specifies that the government considers that the proposed reforms are consistent with EU law, although it remains questionable whether the European Commission will agree with this assertion.


The new regime will operate in a similar way to the current regime. CFCs will be identified and then a number of exemptions will exist to exclude CFCs that do not give rise to an artificial diversion of UK profits. The government considers that the majority of overseas operations will be outside the scope of the regime.

Three stages to the regime are currently envisaged:

  • Step 1: identifying CFCs;
  • Step 2: exempting CFCs that pose a low risk to the UK tax base; and
  • Step 3: calculating a CFC charge.


The government is not proposing to amend the definition of a CFC substantially and intends to maintain the existing lower level of tax threshold. Given that the main rate of UK corporation tax will be reduced to 23% by 2014, the government contends that a lower level of tax threshold of 75% is appropriate, since the regime will not apply if the applicable foreign tax rate is more than 17.25%.


A number of exemptions will be introduced to recognise that the majority of CFCs undertake genuine commercial activities that do not artificially divert profits from the UK. A CFC can meet whichever exemption is most appropriate and there is no requirement to apply the exemptions in a specific order.

The proposed exemptions are outlined below.

Low profits exemption

Akin to the existing de minimus exemption, this will be designed to remove CFCs that make low levels of profits and therefore, represent a low risk to the UK tax base.

Excluded countries exemption

This exemption will exclude CFCs that meet certain conditions and are located in jurisdictions with tax regimes that have broadly similar rates and bases to the UK. The government is reviewing three broad categories of territories to which the exemption may apply.

Temporary period exemption

This will allow an exemption from the regime for a period of up to three years, where an overseas subsidiary comes within the scope of the rules following a reorganisation or change to UK ownership. The scope of this exemption will be similar to the exemption introduced by Finance Bill 2011 as part of the interim CFC reforms.

Territorial business exemptions

These exemptions will endeavour to exclude CFCs that undertake genuine commercial activities and do not constitute a significant risk of artificial diversion of UK profits. The government is proposing to introduce three territorial business exemptions, which contain a series of mechanical tests based on the CFC’s characteristics:

  • Exemption 1: based on satisfaction of a profits rate safe harbour, currently envisaged as 10% of operating expenses;
  • Exemption 2: an exemption for CFCs carrying on manufacturing trades; and
  • Exemption 3: a more general exemption for CFCs carrying on commercial activities, where there is a low risk of artificial diversion of profits.
Sector-specific rules

The government recognises that specific exemptions are required for the insurance and banking sectors and therefore intends to introduce specific rules to exempt their genuine overseas operations.

Finance company rules

This includes a partial finance company exemption that will apply to overseas financing. The government considers that, by 2014, generally, this should result in an effective UK corporation tax rate of 5.75% on profits from overseas intra-group finance income. The consultation document questions whether it could be appropriate to offer full exemption for overseas finance income in certain circumstances.

General purpose exemption

Essentially, this exemption will fulfil the same role as the current motive test, considering the facts and circumstances to assess whether the CFC’s profits have been artificially diverted from the UK. The consultation document suggests that where the diversion of UK profits is tax driven, it will be deemed to be artificial. However, the government states that unlike the current motive test, there will be no default assumption that profits would have arisen in the UK. Businesses will be able to apply for a non-statutory clearance from HMRC that a CFC satisfies the exemption.


Where a CFC charge arises it will be proportional to the UK profits that have been artificially diverted. Genuine foreign profits will be outside the scope of the regime. The workings of the new rules and the self-assessment requirements will largely remain unchanged.

The government may have established the framework for full CFC reform, however the precise detail and mechanics of the rules remains uncertain and will be determined over the coming months.