Controlled Foreign Companies: The CFC Charge Gateway Chapter 4 - Profits attributable to UK activities: Case study
This page provides a case study to demonstrate the application of the CFC legislation to a group which undergoes a restructuring to minimise its effective tax rate. Whilst in this example the group has a UK resident parent, the rules will apply equally if the ultimate shareholder is a UK resident company or non-UK resident company.
The original structure
A UK group has substantial production, distribution, marketing and sales operations in the UK. The group’s products contain patented inventions and registered designs and are marketed and sold using registered trademarks. 40% of sales take place in the UK. All the group’s intellectual property rights (“IPR”) (including patents, design rights and trademarks) are registered in the UK, and owned by a UK subsidiary of the group.
UK Profits and tax before CFC is set up
Prior to the transfer of IPR, the majority of the group’s profits arise in the UK, with smaller amounts accruing to the local distribution companies reflecting their limited functionality and inherently lower level of risk. The group’s total sales are £1,000m per annum, generating total pre-tax profits of £130m: total pre-tax profits in the UK of £100m and total pre-tax profits in overseas distributors of £30m p.a.
Using a mixture of assignment and exclusive licence agreements the group transfers beneficial ownership of its worldwide IPR to a CFC, in exchange for a one-off payment. Under the agreements the CFC is responsible for maintaining and defending the group’s IPR and is also entitled to develop and register new IPR.
The CFC enters into limited risk distribution agreements with the group’s local distribution companies, so that product is sold by the CFC to the local distribution companies at a variable discount to the end-sales price fixed so that those companies are guaranteed to earn a small margin on their costs.
The CFC contracts with UK group companies to manufacture products on a contract basis and to perform marketing, legal and other services on a fee-for-service basis. The CFC pays the UK companies on a cost plus basis, i.e. the fees it pays are set equal to the actual costs incurred by the UK companies plus a small mark-up.
All intra-group transfer prices are set in accordance with the OECD’s Transfer Pricing Guidelines by reference to uncontrolled comparables.
As a result of these contracts the CFC enjoys the risks and rewards of owning the group’s IPR. Any profits resulting from the fact that the group companies are under common control (e.g. market power, efficiencies due to co-ordination of group functions) will also accrue to the CFC.
The CFC has business premises in its territory of residence, and a team of administrative staff who deal with intra-group supply scheduling and invoicing generated from buying the goods from the UK and selling to UK and overseas distribution companies. The CFC does not take delivery of products. These are delivered by the UK manufacturer to the various local distribution companies for selling on to the ultimate customer.
Although the CFC owns the group’s IPR, it does not have any staff who have any expertise in intellectual property management. It purchases the necessary services from UK affiliates.
Similarly, although the contractual arrangements are such that it is the CFC which exploits the group’s IPR by arranging for the production, distribution, marketing and sale of the group’s products, all the necessary work is carried out in the UK and in the group’s other markets by other group companies. The CFC is neither involved in that work, nor does it have the necessary staff or expertise to oversee that work.
UK Profits and tax after CFC is set up
After the transfer of the IPR, group sales are unchanged at £1,000m p.a., but the total pre-tax profits of the UK companies are now only £10m p.a. The group’s total pre-tax profits are increased to £132m, as the project to introduce the CFC as a virtual hub achieved sufficient efficiencies in production scheduling to reduce total costs by £2m, even after the additional costs of running the CFC’s operations. Of the remaining £122m p.a. pre-tax profits, only £10m accrues to the overseas distribution companies and the balance of £112m accrues to the CFC. Assuming no tax is paid by the CFC, a 20% UK tax rate, and an average rate of 30% in the group’s other markets, if it were not for the UK’s CFC rules the total tax saving would be £24m, of which £18m would be UK tax.
Application of Chapter 4
There is a clear diversion of profits from the UK as a result of these arrangements. Although the CFC owns valuable assets and bears contractual risk, it does not have the staff to manage those assets or risks. Essentially, the group’s UK management have arranged for the CFC to own the group’s IPR, and, under current transfer pricing rules it receives 85% of the profits of the group as a result.
The CFC rewards the UK companies which actually manage the assets and risks held by the CFC, but that reward is on a cost plus basis because the risk has been contractually “stripped out” from the activities of production, distribution, marketing and sales, and placed in the CFC.
The intra-group transfer of the IPR is economically neutral for the group as a whole. However, although the UK companies are carrying on the same activities as before, they are now far less profitable.
The decrease in UK profits and therefore UK tax and the increase in CFC profits is driven entirely by the transfer of the IPR, and by the intra-group contractual arrangements. This movement of profits out of the UK is not as a result of a shift of substantial commercial activity - it is in fact a diversion of profits out of the UK.
Chapter 4 Profits and Exclusions
Chapter 4 brings the profits of a CFC into charge to the extent that those profits are generated by UK significant people functions (SPFs) (as explained below), unless
- An entity-level exemption applies or
- One of the Chapter 3 exemptions applies or
- One of the Chapter 4 exclusions applies to exclude a particular element of the CFC’s profits.
In this example, none of the entity level exemptions apply.
Exempt Period Exemption (see INTM224100): This exemption does not apply if the CFC was not in existence in the previous period. The CFC has been created in this period, so this exemption does not apply.
Excluded Territories Exemption (see INTM224700): This exemption does not apply if the CFC is involved in an arrangement with a main purpose of obtaining a tax advantage for any person. Obtaining such an advantage is clearly one of the main purposes of these particular arrangements.
Low Profits Exemption (see INTM225500): This exemption only applies if the total profits of the CFC are less than £500,000. The profits of the CFC exceed this limit, so this exemption does not apply.
Low Profit Margin Exemption (see INTM225700): This exemption only applies if the CFC’s profits do not exceed 10% of its expenditure. Given the high level of profits which arise in the CFC, this exemption will not apply.
Tax Exemption (see INTM226000): This exemption only applies if the tax paid by the CFC is at least 75% of the tax it would have paid in the UK. This exemption clearly does not apply.
Chapter 3 exclusions
If any one of Conditions A-D in TIOPA10/S371CA is met (see INTM197300), then there is no Chapter 4 charge.
Condition A is not met (see INTM197310): There is no doubt that the arrangements have all four of the characteristics necessary to preclude Condition A being met. The arrangements do have a main purpose of reducing UK tax, since the UK tax saving far outweighs any pre-tax efficiencies from the new arrangements. The CFC is more profitable than it would have been if the arrangements had not been put in place. There was an expectation of a reduction of tax in any territory. It is reasonable to suppose the arrangements would not have been made in the absence of that expectation, since it would have been easier to introduce the production scheduling efficiencies using existing staff in the UK.
Condition B is not met (see INTM197320): The CFC relies upon related parties in the UK to manage its assets and risks as it does not have the capacity to do so itself. As there are UK managed assets and risks, this Condition is not met.
Condition C is not met (see INTM197330): If the UK-managed assets and risks - which in this case amount to all of the assets and risks of the CFC - were to stop being UK managed, the CFC would not be commercially effective. Nor would it be possible for the CFC to replace the UK management of its assets and risks with third party management. There are two reasons for this. Firstly, it is not possible to outsource what are essentially entrepreneurial decisions about the development and exploitation of IPR. Secondly, the management of the CFC’s assets and risks is inextricably linked to the production, distribution and marketing activity carried out by the group in the UK. The CFC itself does not have the capacity to oversee and control all these activities if they were carried on by a third party.
Condition D is not met (see INTM197340): The CFC’s profits do not consist of either non-trading finance profits or property business profits.
Chapter 4 exclusions
The basic Chapter 4 rules (see INTM200500) operate by considering whether any of the significant people functions (SPFs) relevant to assets or risks owned or borne by a CFC are carried on in the UK, and by deeming that any such UK SPFs are carried on by a UK permanent establishment (UK PE) of the CFC. The SPFs for a particular asset or risk are usually the functions carrying out active decision-making relating to the acquisition, creation, assumption or management of the asset or risk. This is contrasted to merely approving or rejecting proposals, which are not SPFs.
The rules then attribute the assets and risks of the CFC to that deemed UK PE on the basis of the SPFs that have been identified as being carried on in the UK. The rules calculate the profits of the deemed UK PE as if it were a separate entity with the assets and risks that have been attributed to it. These profits are provisionally included within the CFC chargeable profits, subject to the Chapter 4 exclusions.
The first three of the Chapter 4 exclusions (TIOPA10/S371DC to S371DE) operate to exclude assets and risks from those attributed to the deemed UK PE if there is sufficient non-tax reason for holding the assets/risks outside the UK, so that the associated profits are therefore not regarded as diverted. The final Chapter 4 exclusion (the “trading profits exclusion” in TIOPA10/S371DF) operates as a simplified proxy for the full SPF analysis. It exempts the entity from Chapter 4 if it meets five separate low-risk characteristics which indicate that the profits identified by Chapter 4 would in any case be zero or minimal. In such cases, the trading profits exclusion reduces the compliance burden by obviating the need to identify SPFs and attribute assets and risks.
TIOPA10/S371DC Exclusion: UK activities a minority of total activities (see INTM200500)
This exclusion measures the proportion of activities which are UK activities. The exclusion works by determining whether the income attributed to the deemed UK PE in respect of each identified asset or risk (or bundle of assets and risks if it is impractical to separate them) is more than half of the total income attributable to that asset, risk or bundle.
Given the arrangements entered into by the CFC in the example, and the fact that most if not all of the SPFs for any given asset or risk (or for a bundle of assets or risks considered together) take place in the UK, this exclusion will not apply to any of the CFC’s assets or risks.
TIOPA10/S371DD Exclusion: Economic value (see INTM200600)
This exclusion applies to asset or risks (which again may be bundled if impractical to consider individually) if the non-tax component is a substantial proportion of the total economic value added by not holding the asset or risk in the UK. Although not defined in the legislation, we would ordinarily expect 20% of the economic value to be a substantial proportion of the total. In making this comparison, any non-UK tax savings are ignored completely, i.e. they are disregarded when calculating the total economic value added. In the example, applying this rule to the arrangement as a whole, the total increase in annual post-tax profit is £26m, of which £6m is the non-UK tax saving (30% of the £20m reduction of profit in the distributors). Therefore the total net economic value is deemed to be £20m. Of this £18m is the UK tax saving and £2m is due to non-tax changes. £2m is not a substantial part of £20m so the exclusion does not apply. In fact the rule should be applied to each asset or risk (or bundle) held by the CFC separately. As none of the non-tax value depends on holding the assets and risks in the CFC, the non-tax value considered by this exclusion will be zero in each case and this exclusion will therefore not reduce the profits included by Chapter 4.
TIOPA10/S371DE Exclusion: Independent companies’ arrangements (see INTM200700)
This exclusion allows amounts to be excluded from provisional Chapter 4 profits if it is reasonable to suppose that, were the UK SPFs not carried out by connected companies in the UK, the CFC would enter into arrangements with third parties which :
- were structured in the same way; and
- would have the same commercial effect for the CFC.
Again, assets and risks can be bundled.
In this example, the CFC would not and could not enter into similar arrangements with third parties. The CFC is entirely reliant on the expertise and substance of the UK connected companies to generate its profits, and it does not have sufficient substance or knowledge to oversee or manage those UK connected companies. It would not be in a position to manage contractual arrangement with third parties. Further a company without any particular expertise or assets to use in conjunction with these IPR would not acquire them as it would not be in a position to generate an adequate risk-adjusted return on the capital invested.
TIOPA10/S371DF Exclusion: Trading profits (see INTM200800)
This exclusion imposes a number of mechanical conditions which are designed to make it easy for a CFC with limited connection with the UK and substance in its home territory to self-assess under Chapter 4
This exclusion contains five separate conditions, all of which have to be met.
Business premises condition (see INTM200810) - a test of substance in the territory: The CFC in the example would meet this condition as it has premises in its territory where its work is mainly carried on.
Income Condition (see INTM200820): not more than 20% of the CFC’s trading income can be derived from UK resident persons, or UK permanent establishments.
As 40% of the sales of the CFC arise in the UK, this condition is not met.
At this point, it is not strictly necessary to consider the other conditions of the exemption, as the exemption clearly cannot be met. For completeness, the other conditions are considered below.
Management Expenditure Condition (see INTM200830): not more than 20% of the management expenditure of the CFC (as defined) can be incurred with related parties in the UK, or on CFC staff working in the UK.
This condition is intended to be a proxy for the full SPF approach in Chapter 4. The relevant management expenditure refers to individuals who manage or control assets or risks in the UK. In this case, as the majority of the CFCs assets and risks are in fact managed by connected parties in the UK, it is likely that this will be reflected in the management expenditure incurred. This condition will not be met.
IP Condition (see INTM200840): if significant IP has been transferred from the UK to the CFC within the previous 6 years, this condition is not met.
As the IP held by the CFC has been transferred to it by a UK connected party within the last six years, this condition is not met.
Export of Goods condition (see INTM200850): if more than 20% of the CFC’s trading income arises from goods exported from the UK, this condition is not met. As 60% of the CFC’s trading income arises from goods exported from the UK and none of these goods are exported to the CFC’s territory this condition is not met.
Chapter 4 CFC charge
As the CFC does not satisfy any exemption or exclusion, profits, as determined by TIOPA10/S371DB (see INTM200500) will pass through the CFC charge gateway at Chapter 4, and be apportioned to UK interest holders, who will be subject to a CFC charge on those profits.
Given that all of the SPFs are carried out in the UK, a detailed computation under TIOPA10S371DB would result in all of the assets and risks of the CFC being attributed to a deemed UK PE, which in turn would mean that all of the CFC’s profits of £112m would be included in the Chapter 4 profits. Those Chapter 4 profits would give rise to a CFC charge (see INTM194100).