Controlled Foreign Companies: The CFC Charge Gateway Chapter 4 - Profits attributable to UK activities: The Steps
The following steps are to be followed to determine the Chapter 4 profits.
The steps must be taken in accordance with the principles set out in the Organisation for Economic Co-operation and Development’s (OECD) 2010 Report on the Attribution of Profits to Permanent Establishments (“the Report”). Terms used in the steps are defined at TIOPA10/S371DA (see INTM200200), including that those terms used in the Report have the same meaning as in the context of the Report.
Step 1 - Identify relevant assets and risks
This is to identify “the relevant assets and risks” of the CFC. These are the assets the CFC has or has had and the risks it bears or has borne, in so far as they give rise to the CFC’s assumed total profits for the accounting period.
This will follow the same principles as the identification of assets and risks in a functional analysis for transfer pricing purposes (see INTM484040).
To the extent that parts of a company’s business hold a number of assets sharing the same characteristics and risk allocations (e.g. a portfolio of financial assets) it would be expected that these assets and risks would be dealt with together in the same way as they would be for transfer pricing analysis.
Step 2 - Exclude negligible items
This excludes an asset or risk from the relevant assets and risks if the CFC’s assumed total profits are only negligibly higher than they would have been if the CFC had not held the asset or borne the risk at all. This exclusion applies only as far as all the assets or risks excluded, when taken together, increase the CFC’s profits by only a negligible amount.
Negligible takes its ordinary meaning of an amount so insignificant as to be not worth considering. This should be taken in the context of the particular CFC whose profits are being considered.
Step 3 - Identify relevant SPFs
Having identified the relevant assets and risks in the first two steps, this step identifies SPFs within the CFC group which are relevant to the economic ownership of those assets or the assumption and management of those risks.
This requires an assumption that treats the CFC group as if it were a single company. The identification of SPFs should therefore be at the same level of detail and following the same principles as would be required to attribute assets and risks to the permanent establishments of a single company using the OECD authorised approach in the Report.
Where there is no reason to suppose that the attribution of particular assets or risks following the authorised OECD approach in the Report would be any different to what is reflected in the company’s accounting records there should be no need for further analysis in respect of those assets and risks.
Step 4 - Determine SPFs carried out in the UK
Determine the extent to which the SPFs identified in step 3 are SPFs carried out in the UK (UK SPFs) and to what extent they are non-UK SPFs. Where none of the SPFs are UK SPFs, no part of the relevant profits will fall within Chapter 4 and no CFC charge will attach to those profits. Accordingly the subsequent steps will not need to be taken.
It is important to note here that although SPFs are typically functions requiring active decision-making the focus is not on where a particular person is at the moment a decision is “taken”. The analysis needs to consider the procedures of the business, where people habitually perform the relevant functions and in what capacity and circumstances. As Paragraph 87 of Part I of the Report clarifies, “the focus … is on the active decision-making and management rather than on simply saying yes or no to a proposal”.
Step 5 - Attribute assets and risks to the UK
This step assumes that the SPFs identified at Step 4 as UK SPFs are performed by people in a UK permanent establishment (“PE”) of the CFC. It then determines the extent to which the assets and risks identified at step 1 would be attributed to that PE under the authorised OECD approach in the Report.
It is notionally assumed for this step that any non-UK SPFs are carried out by the CFC itself. This makes the attribution of assets and risks more straightforward than it might otherwise be i.e. it allows for a focus just on functions assumed to be performed in the territory of residence of the CFC and those performed in a single PE of the CFC in the UK.
As outlined at INTM200300 it is important to remember that we are concerned here with the attribution of assets and risks that would form part of the determination of the profits to be attributed to a PE under the terms of the business profits article (Article 7) of the 2010 OECD Model Tax Convention on Income and on Capital (MTC).
The functional and factual analysis may justify the attribution of an asset or risk entirely to one or the other location throughout the accounting period. Alternatively it may result in a share of an asset being attributed to both locations throughout the period, although such a treatment is unlikely to apply to a risk outside specific situations in the financial sector. Where there have been changes in where functions have been carried out during the period it may be that the asset or risk is attributed to one location for part of the period and to the other for the rest of the period.
In some cases there may be little activity in an accounting period in relation to assets or risks to inform the question of where they should be attributed. In that case the assumption would be that the assets and risks would continue to be attributed to the same location as they were in the previous period, as would be the case under Article 7 of the MTC.
However, this prompts the question of how far back it is necessary to look in order to carry out the attribution required at step 5, particularly for the first accounting period for which a CFC may have chargeable profits and in relation to assets acquired or risks assumed in earlier periods. The application of the principles of attribution from the Report is unlikely to have been previously considered in relation to such assets or risks. There is of course no simple answer to this question, although the relevant principles might be seen through the analogy of a situation where a tax treaty in the terms of the MTC came into force in relation to a PE that had previously been taxed on some different basis, or not at all.
In practice where there is little activity in the accounting period to inform the analysis, there is likely to be transfer pricing documentation or other evidence in relation to the relevant functions that have been performed by the CFC and in the UK.
Step 6 - Exclude assets and risks where attribution is not mainly to the UK
This step excludes from the relevant assets and risks of the CFC, any assets and risks to the extent that the attribution of ownership determined at step 5 would result in the CFC losing no more than half of the income related to the asset or risk, taking into account any additional expenses that the CFC would have to pay based on that attribution of ownership.
This is done by comparing two amounts, “A” and “B”. Amount A reflects the step 5 attribution under which the CFC’s ownership of the asset or extent to which it bears the risk is modified. Amount B reflects the situation where the asset had not been held, or the risk had not been borne, by the CFC at all.
So an asset or risk, from the relevant assets and risks identified at step 2 and attributed to any extent to the UK at Step 5, is excluded at Step 6 where amount A is not more than 50% of amount B.
Amount A is specified as the total of:
- The gross amounts of the CFC’s income that would not have become receivable during the accounting period if the CFC had not held the asset or borne the risk - but only to the extent that such income would be attributed to the notional UK permanent establishment of the CFC assumed at step 5, and
- the additional expenses that the CFC would have incurred if it had not held the asset or borne the risk, to the extent that it would be attributed to the UK permanent establishment of the CFC assumed at step 5.
Taking the example of an Intellectual Property (IP) asset, the receipt in question is likely to be a royalty (or part royalty) that the CFC would not have received if it did not hold the relevant IP (or did not hold the whole of it).
There may be an additional expense in such a case if the CFC had to pay a royalty for the use of IP that it did not hold itself (or did not hold the whole of it) - for example if it sold branded goods without holding the brand IP.
Amount B is the total of:
- The gross amounts of the CFC’s income that would not have become receivable during the accounting period if the CFC had not held the asset or borne the risk to any extent at all; and
- the additional expenses that the CFC would have incurred if it had not held the asset or borne the risk to any extent at all.
In most cases amounts A and B would probably represent either just gross amounts that would not have been receivable by the CFC or just additional expenses that the CFC would have incurred, and not both. For example if the CFC simply held IP from which it derived royalties, the effect of a step 5 attribution for UK SPFs would probably just be on the receipts. If, on the other hand, a CFC used a patent it held as part of its main activity without receiving royalties, the effect of a step 5 attribution for UK SPFs would probably just reflect payments it would have to make to use the patent.
However it is possible that a CFC might exploit IP both by receiving royalties for the right to use it as well as by using the same IP in a business activity of its own. In that sort of situation amounts A and B might be made up of both income and payments.
So in general terms assets or risks to be excluded at step 6 will be those for which the relevant SPFs are mainly performed outside the UK. This is established by a comparison of gross amounts so that a detailed calculation of profits in relation to the asset or risk being considered is not necessary.
Finally, for the purposes of the exclusion at Step 6 a bundle of assets or of risks is treated as if it were a single asset or risk if it is not reasonably practicable to separate those assets or risks for the purposes of determining amounts A and B.
Step 7- Determine the provisional Chapter 4 profits
This step involves re-determining the CFC’s assumed total profits as if the CFC did not hold the assets and did not bear the risks included in the relevant assets and risks (not including those assets or risks, if any, excluded at step 6), to the extent that they would be attributed to the UK permanent establishment of the CFC mentioned at step 5.
The provisional Chapter 4 profits are defined as the amount of the CFC’s assumed total profits left out of the re-determined profits. In other words they are the difference between the actual assumed total profits of the CFC and what those profits would be without the assets and risks attributable to the UK SPFs.
Step 8 - Determine the Chapter 4 profits after further exclusions have been applied
This final step determines the profits that fall within Chapter 4 allowing for exclusions from the provisional Chapter 4 profits of any amounts that are within the conditions of the exclusions in TIOPA10/S371DD (Exclusions - Economic value - see INTM200600), S371DE (Exclusions - Independent companies’ arrangements - see INTM200700) and S371DF(Exclusions - Trading profits - see INTM200800).