The UK has undertaken a series of changes in its tax policy in recent years with the aim of improving the attractiveness of the UK as a place to do business. These changes are continuing with a key goal of making the UK tax system the most competitive in the G20. This is becoming a reality as a result of a number of measures that have recently been introduced.
The change in tax policy was brought about by the threat that existing UK businesses were considering moving their headquarters outside the UK (referred to as ‘inversions’) and that international businesses were choosing other locations for investment. As a result the UK government has three clear goals in making the changes it has made:
1. To keep existing business activities in the UK (both UK groups and international groups with existing UK businesses);
2. To stimulate new business activity by existing UK businesses; and
3. To attract new business activity to the UK. One of the countries which the UK government is specifically targeting for new investment in the UK is India. Historically, Indian groups have made significant investments into the UK and the UK government is keen for this to continue.
In this article, we will look at the key changes that have been implemented in the UK under the tax reforms and how the UK is positioned today as a holding company and regional hub location.
Perceived “barriers” to the UK’s competitiveness The UK tax regime has traditionally had some key attributes that groups look for in headquarter or holding company jurisdictions. For example, the UK does not, under its domestic tax law, levy withholding tax on dividend distributions paid to overseas investors in UK companies. It also exempts capital gains derived from share disposals from tax.
However, several areas of UK tax law continued to make the UK appear uncompetitive especially when viewed against territories such as Singapore, Ireland and the Netherlands. These included the UK’s comparatively high corporation tax rate, the system of taxing dividends received by UK companies, the taxation of overseas branch profits and the CFC rules.
Foreign profits reform
Reduction in corporation tax rate
The “Corporate Tax Roadmap” released by the HM Treasury in November 2010 set out the plans for the reduction in the corporation tax rate. The rate at that time was set to steadily decline to 22% by 2014. The government has since announced a further reduction to 20% from April 2015. This would make the UK’s main corporation tax rate the lowest in the G20 alongside Russia, Turkey and Saudi Arabia.
Introduction of the UK’s foreign dividend exemption
Prior to the introduction of this new regime, the UK taxed the receipt of foreign dividends with credits potentially available for overseas and withholding tax suffered under the UK’s “double taxation relief” regime. This regime grew increasingly complex – creating an administrative and commercial burden on UK plc, which required reserves and cash to fund shareholder distributions. In many cases, the regime resulted in UK companies having to “top up” corporation tax payable even after taking credits, particularly when the headline UK corporation rate was as high as 30%.
Following representations from business and a consultation period, the UK’s dividend exemption was introduced with effect from 1 July 2009. The system introduced a number of “exempt classes” into which the vast majority of distributions should now fall. The main areas where dividends may still be taxable are if the distribution is itself deductible for overseas tax purposes, or where a distribution is funded from a previous structure designed to erode the UK corporation tax base.
Introduction of the “branch profits exemption”
Another area where the UK was seen as lagging behind other more competitive territories was the taxation of overseas branches of UK companies. As with distributions from overseas companies, the UK taxed the overseas branch profits of UK companies, with a credit for local tax suffered. Again this was a complex regime which often meant that additional UK corporation tax was payable, and impacted a purely commercial decision as to whether it was more efficient to enter a new territory via a branch or an overseas incorporated company.
To remove this barrier the UK authorities introduced an extremely flexible “branch profits exemption” with effect from 2011. Broadly, the regime allows a UK company to elect for its overseas branches to be exempt from UK tax. Electing companies will be exempt from UK tax on branch profits, but will not receive loss relief in respect of branch losses. There are certain conditions which need to be met in order to qualify for the election. For example, the branches must be ‘good’ branches as determined by applying the principles under the CFC rules. Also, if the UK company had taken the benefit of the losses of the branch, these losses must first be offset with taxable profits before the company can elect into the branch exemption rules. The branch profits are calculated using tax treaty principles. With this “optin” system, groups have the choice of applying the regime on a UK company-by-company basis through an election system. This is particularly useful as it allows groups to maintain the “old” position where it makes sense to do so – for example where a UK company has branches, or a majority of branches, with losses or “high tax” profits.
Fundamental relaxation of the UK CFC rules
Compared to the above changes, which could be termed “easy wins”, the relaxation of the UK CFC rules has been the most discussed and involved process. The previous incarnation of these rules was one of the primary drivers behind some of the corporate “inversions” mentioned earlier (where existing UK businesses were moving their headquarters outside the UK), and in some cases prevented overseas groups from viewing the UK as a viable holding or regional holding company jurisdiction. A particular complaint of UK groups was that the rules were applied in a disproportionate manner. In order to tax profits artificially diverted from the UK they also often caught profits generated overseas through genuine commercial operations, i.e., amounting to an effective system of “worldwide taxation” employed by the UK.
After significant consultation, the revised CFC rules are now on the statute book and have taken effect from 1 January 2013. The driving principle behind the new rules is one of “territoriality”. The revised CFC rules have been carefully crafted only to apply to target profits which are shown to have been “artificially diverted” from the UK. Profits which have been generated overseas through genuine economic activities and through activities which pose no risk to the UK corporation tax “base” should be left untaxed by the new UK CFC rules.
The rules remain relatively detailed, but include a wide-range of exemptions from the CFC rules, only one of which has to apply to prevent a CFC charge. As such, we anticipate that a majority of overseas subsidiaries of UK companies should be exempt under the new CFC rules. For overseas trading activities, only where it can be shown that profits have arisen, to a significant extent, due to UK activities (such as key decision makers or developers of intellectual property being in the UK) do we expect to see taxation of profits under the UK CFC provisions.
For interest income, the UK regime includes UK CFC taxation at one quarter of the UK headline corporation tax regime (which would be a rate of 5% by 2015), with the potential for 0% under certain specific conditions.
Whilst the UK has chosen to retain CFC rules and is therefore at a disadvantage compared to other territories which does not have such rules, the practical impact of the UK CFC rules for groups which choose to locate their headquarters or holding or regional holding companies in the UK is likely to be limited to that of compliance going forward.
‘Above the line’ research and development (“R&D”) tax incentive
The UK has had an R&D tax incentive for large companies for over 10 years but following a series of consultations it was decided by the government that a fundamental change is required in order to make the incentive more attractive to innovative businesses. Under the old rules, a ‘super deduction’ was available, i.e. a deduction in addition to that for the qualifying R&D expenditure was available. For example 130% of qualifying expenditure was deductible in certain cases.
Under the new rules, the benefit by way of credit will be ‘above the line’. This will allow the benefit of the R&D relief to be accounted for as a reduction of R&D expenditure within the Profit & Loss account. The associated tax credit is offset against corporation taxes payable.
The change to an above the line credit is being made in order for the benefit of the incentive to be more directly linked to the amount of R&D expenditure and also to show an improved pre -tax profit as a result. By applying the credit against the R&D expense, thus reducing the cost of the R&D in the accounts of the company and reflecting the impact within the pre-tax profit, it is thought that the incentive will have more of an effect in encouraging R&D activity in the UK.
The new credit will be a taxable credit of 10% of qualifying expenditure. The credit will be fully payable to companies which have no corporation tax liability, subject to a cap equivalent to the Pay As You Earn/National Insurance Contributions (PAYE/NIC – employment and social security) liabilities of the company. The new credit will be available for qualifying expenditure incurred on or after April 1, 2013 and will initially be available as an alternative to the current super deduction, before completely replacing the super deduction from April 1, 2016.
This is of great benefit to loss making groups in that they will be able to obtain payment for the credit, subject to the PAYE/NIC cap.
Patent Box
As part of the UK Government’s aim to encourage innovation in the UK and ensure the commercialisation of UK inventions in the UK, a new 10% tax rate has been introduced from 2013 and will apply to Patent Box profits. This is a significant saving as compared to the main headline tax rate of 20% (by 2015).
The relief applies to worldwide profits from pat-ented inventions protected by the UK Intellectual Property Office of the European Patent Office as well as patents granted by other recognised patent offices. It is not only royalties and income from the sale of IP that qualifies for this regime – all profits (less a routine profit and marketing charge) from sales of products which incorporate a patented invention qualify. This is a very broad definition and is intended to ensure that the tax rate of 10% applies to all profits arising from patents and not just the profits attributable to the patent itself.
A company qualifies if it has the ownership (or an exclusive licence) of patents and the company (or the wider group) has performed qualifying development and has the responsibility for and is actively involved in the ongoing decision making concerning the further development and exploitation of the IP. This allows a business to benefit from the regime even where they did not develop the IP originally. This supports the objectives of the Patent Box to encourage continuing development and commercial exploitation of patents by UK businesses.
The new Patent Box provides an attractive opportunity for businesses to reduce the costs associated with the commercial exploitation of patented IP. The regime is flexible and generous and should prompt global businesses to favourably consider using the UK as a place to invest in innovation.
Substantial Shareholdings Exemption (SSE)
The Substantial Shareholdings Exemption (SSE) regime was introduced in 2002. The SSE broadly exempts from UK corporation tax any capital gain on disposals by trading companies or groups, of substantial shareholdings in other trading companies or groups. Generally speaking, ‘trading’ refers to operating companies/groups with an active trade/business. The important point here is that the business should be an operating business with income from its operations (as against a business with minimal operations receiving mainly passive income). However, the legislation has also set out detailed technical conditions for the exemption to apply, and anti-avoidance provisions, all of which must be met. Care in particular cases is therefore needed in order to determine the availability of this relief.
Broadly, there are three sets of conditions which must be satisfied in order to obtain the exemption:
1. The substantial shareholding requirement – The investing company (the company making the disposal) must own at least 10% of the ordinary share capital of the investee (company whose shares are being disposed) for a continuous period of 12 months preceding the disposal
2. Conditions relating to the ‘investing’ company/ group, i.e., the company/group making the disposal – The investing company must be a ‘sole trading company’ or a member of a ‘qualifying group’. This condition must be met from the start of the latest 12 months period for which the substantial shareholding requirement (above) is satisfied, until the time of the disposal. It must also be met immediately after the disposal takes place. A ‘sole trading company’ is a company which is not a member of a group, which is carrying on trading activities and whose activities do not to a substantial extent include activities other than trading activities. A ‘qualifying group’ is a group, the activities of whose members, taken together, do not to a substantial extent include activities other than trading activities. Intra-group activities, such as intercompany loans, rental streams or royalty charges are ignored for this purpose. As stated earlier, ‘trading’ here refers to operating companies/groups with an active trade/business, i.e. the business should be an operating business with income from its operations. Whether a company or group is carrying on trading activities requires a consideration of the activities, income, assets, liabilities and people functions of the relevant company/group.
3. Conditions relating to the ‘investee’ company/ sub-group, i.e., the company/sub-group being disposed of – The investee must have been a ‘qualifying company’ from the start of the latest 12 month period for which the substantial shareholding requirement (above) is satisfied, until the time of the disposal. This condition must also be met immediately after the disposal. A ‘qualifying company’ means a trading company or the holding company of a trading group or a trading sub-group. Broadly, this means that the activities of the company being sold and its 51% subsidiaries (if any) will be considered. To qualify for the exemption, at least one of these companies must be carrying on trading activities. Also, the activities of all the group/subgroup companies, taken together, must not include to a substantial extent activities other than trading activities. As stated earlier, ‘trading’ here refers to operating companies/groups with an active trade/business, i.e. the business should be an operating business with income from its operations. Whether a company or group is carrying on trading activities requires a consideration of the activities, income, assets, liabilities and people functions of the relevant company/group.
Where these conditions are met, gains arising on the disposal of shares will be exempt from corporation tax on chargeable gains. Equally, capital losses arising on such disposals are not allowable. Where there is significant uncertainty on the applicability of the SSE to a proposed transaction, an application can be filed with the UK tax authorities, Her Majesty’s Revenue and Customs (HMRC) to obtain a clearance that the conditions of the SSE would be considered to be met.
General Anti-Abuse Rule (GAAR)
There has been substantial consultation by the UK government on the introduction of a GAAR.
The GAAR is not part of the package of measures (discussed above) which have a key goal of making the UK tax system the most competitive in the G20. While the introduction of a GAAR could be considered to introduce some uncertainty, the government has clearly stated that the aim of the GAAR is to target only artificial and abusive schemes.
In addition, the introduction of the UK GAAR will bring the UK in line with most other European (and other) countries, which already have GAARs.
The government has confirmed that the GAAR should only apply to arrangements which begin after the legislation becomes the law (expected to be by July 2013) and it will apply only to arrangements which pass two tests. Arrangements will pass the first test if one of their main purposes is to obtain a tax advantage, judged objectively. The second test is a reasonableness test which will only be met if the arrangements entered into cannot be regarded as a reasonable course of action, having regard to the consistency of the substantial results of the arrangements with the principles and policy underlying the relevant tax provisions. Tax advantages which are caught by the GAAR will be counteracted on a just and reasonableness basis.
As part of the GAAR being introduced, an advisory panel will be formed which will have two main roles. Firstly, to provide opinions on the potential application of the GAAR, after representations have been made to them, and secondly to approve the guidance which HMRC will prepare on the GAAR.
It is the stated aim that the GAAR should target and counteract only artificial and abusive schemes. On the basis that any tax planning undertaken by Indian businesses generally has commercial substance, the GAAR is not expected to have any significant impact on normal commercial transactions undertaken by Indian groups in the UK.
The UK is ‘open for business’
As mentioned above, the recently announced changes to the UK corporate tax system are part of a package of measures which have been introduced over the last few years. To summarise, the most significant of the changes include:
• A continued reduction in the UK’s main rate of corporation tax to 20% from 1 April 2015 (the rate is currently 23% and was 30% before April 2008).
• A Patent Box regime, from 1 April 2013, which will result in qualifying patent box profits being taxed at a significantly reduced rate of only 10%, the aim being to encourage the development and exploitation of patents and other similar intellectual property in the UK.
• An exemption system for most dividends received by UK companies and for gains made on the sale, by a UK company, of most shareholdings in trading companies.
• An elective exemption system for overseas activities of a UK company (overseas branches).
• A reformed controlled foreign companies (CFC) regime which is targeted at only taxing profits that have been artificially diverted from the UK.
• The introduction of the new ‘above the line’ R&D tax incentive.
These changes have resulted in the UK’s tax system becoming more territorial and making the UK a very attractive location for regional holding and “hub” companies, acquisition companies and publicly listed parent companies, particularly when combined with a number of long standing attractive features, including being the G20 country with the most double tax treaties and the absence of a withholding tax on dividends paid by a UK company.
The UK as a headquarter and holding company jurisdiction
Over the last three years, a number of groups, particularly US groups (for example – Ensco Inter-national and Rowan Companies), have relocated their headquarters to the UK, partly because they understood that there should no longer be adverse UK corporation tax implications from doing so. Other US and non- US groups have also been actively using the UK as a regional holding company jurisdiction, particularly since the structure of the new UK CFC rules has been settled. The interaction between HMRC and these groups has also been encouraging, with HMRC actively engaging in pre-transaction discussions with businesses and offering pre-transaction clearances.
For Indian groups investing overseas, particularly into Europe and the US, the UK is now competitive with other more traditional holding company jurisdictions such as Singapore, Netherlands and Luxembourg. In addition to offering similar benefits in terms of low or zero holding company corporation tax, many groups often have substantial existing operations in the UK. This, combined with the UK’s extensive double tax treaty network, offers plenty of potential for multinationals to use the UK as an efficient regional management and financing hub.
