UK Treasury Releases Draft Rules On Foreign Profit Tax

by Robert Lee, Tax-News.com, London

11 December 2008

Tax firm KPMG has given a cautious welcome to the Treasury's publication of draft legislation on the taxation of foreign profits, although it warns that the risk of further corporate migration remains unless the government clarifies the proposed reform to the controlled foreign companies (CFC) regime.

The draft legislation, released by the government on Tuesday, is the latest stage in an ongoing consultation process formally launched in June 2007.

The legislation contains an exemption for foreign dividends for large and medium size groups, and a restriction on the deductibility of interest expense claimed by UK members of a multinational group by reference to the group’s consolidated net external finance costs (the so called worldwide debt cap).

The legislation would also repeal the Treasury Consent Rules, which require the Treasury to give consent to certain transactions, and replace it with a quarterly reporting requirement for certain transactions. In addition, it extends an existing anti-avoidance rule which denies relief for interest expense on loans taken out for an allowable purpose which includes obtaining a tax advantage.

Meanwhile, changes to the existing CFC rules would tax the profits of foreign subsidiaries in the hands of the UK parent in certain cases.

Whilst the rules are still being scrutinized by tax experts, Chris Morgan, Head of International Corporate Tax at KPMG believes that the package of reforms "is one of the most significant changes we’ve seen in the corporate tax landscape."

"It marks a decisive shift towards a territorial tax system where the UK only taxes profits made in the UK. Such a change is essential if the UK is to have a modern, competitive tax regime," he observed.

“It is good news that, as trailed in the pre-budget report, a dividend exemption has finally been introduced. This will simplify companies’ ability to manage their funding and capital structure. It should also be good for the UK economy. A recent survey carried out for KPMG suggested that up to 70% of large businesses would repatriate funds if such an exemption were introduced: 56% of the respondents said that they would bring back cash to the UK if an exemption was introduced and a further 14% said they were already lending back to the UK. We would expect these loans may well be unwound when the exemption comes in, leading to further cash repatriations," Morgan explained.

However, KPMG is of the view that the worldwide debt cap will be "less welcome" to multinationals.

“Effectively it means that UK companies in a multinational group will not be able to deduct more interest expense in the UK than the total external expense borne by the worldwide group,” Morgan continued.

However, he added most UK multi-nationals accept that a rule of this nature is justified.

"The government has to consider fiscal risk to the Exchequer. Preventing a multinational group having more debt in the UK than it needs to service the worldwide group seems legitimate," he noted.

Nevertheless, Morgan cautions that "in-bound investors are very worried about the effect and we are concerned that there is no commercial motive test."

He continued: "There will be cases where there are perfectly legitimate commercial reasons for having more debt in the UK than in the worldwide group. For example, with the current difficulty of raising funds externally, a UK subsidiary of a foreign parent may well borrow from its parent rather than from a bank. If the worldwide group was itself cash rich, the UK subsidiary may find it is denied a deduction for the finance cost even though it has borrowed on commercial, arm’s length terms. The rule may therefore end up penalising in-bound investors.”

KPMG welcomes changes to "archaic" Treasury consent rules - a hangover from the days of foreign exchange control which was abolished in 1979. However, the firm expressed concern over the potential administrative burden of the replacement reporting regime.

Morgan commented: “It is good news that the archaic Treasury consent rules have been abolished. We are concerned though about the amount of detail which will have to be reported on a quarterly basis under the new rules. It remains to be seen how this works in practice.”

Morgan concluded: “Overall the package appears to be favourable. However the key element is still missing. This is reform of the controlled foreign companies rules under which profits from overseas subsidiaries of UK-resident parents may be taxed in the UK as they arise. The CFC rules are one of the main reasons for a number of companies having migrated from the UK this year.

“It is good news that in the pre-budget report it was announced that government will continue to examine options to reform these rules so that they should not tax profits that are genuinely earned in overseas subsidiaries. It is important that companies and advisors work with government to achieve this aim.

“However in the meantime it would be very welcome if there could be a clear indication from government that the current rules will be applied in a similar vein. Unless this happens the risk remains that companies thinking of leaving the UK will not wait for a further one or two years to see whether the rules can be adequately modernised."

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