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HMRC internal manual

International Manual

Controlled Foreign Companies: Entity Exemptions: Chapter 13 - The Low Profit Margin Exemption: The Basic Rule

TIOPA10/S371MB provides an exemption for the CFC’s accounting period if the CFC’s accounting profits before interest deductions are no more than 10 per cent of the CFC’s relevant operating expenditure.

For the purposes of this exemption only, accounting profits are further adjusted to be determined before any deduction for interest. Interest income is therefore included in the measure of accounting profits but interest expense is not.

The meaning of interest is not defined in the Taxes Acts. If a question arises as to whether an amount constitutes interest, further guidance can be found at SAIM2030 onwards.

Accounting profits

Accounting profits are defined at INTM248200. Broadly, they are the amount of pre-tax profits of the CFC determined in accordance with generally accepted accounting practice.

Accounting profits are then adjusted to include or exclude certain items regardless of what the CFC’s accounts show. One of these adjustments applies the transfer pricing rules at Part 4 of TIOPA10 to the measure of accounting profits if the difference made by the application of the rules is more than £50,000.

An example of this is shown in example 1 of INTM225650.

Some of the further adjustments to accounting profits exclude the following:

  • amounts that would be exempt distributions (under Part 9A CTA09) in the hands of the CFC if it were a UK tax resident company,
  • property business profits or losses and
  • capital profits or losses.

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Relevant operating expenditure

Relevant operating expenditure is operating expenditure included in the accounts for the relevant accounting period of the CFC excluding:

  • costs of goods purchased by the CFC unless those goods are actually used by the CFC in its territory of residence (such as use for manufacturing or physical delivery and sale in the CFC’s territory of residence), and
  • any expenditure giving rise directly or indirectly to income of a person related to the CFC.

A person related to the CFC is defined at INTM248350 and includes both UK resident and non-UK resident persons.

Operating expenditure is not otherwise defined and should therefore take its ordinary meaning of day-to-day expenses incurred in providing goods or services. Examples include distribution costs, employees’ salaries or administrative expenses.

Depreciation may also be included in operating expenditure if it would be so treated in determining the CFC’s accounting profits prepared in accordance with a generally acceptable accounting practice.

Excluding from operating expenditure the cost of goods purchased but not actually used by the CFC in its territory of residence ensures that the CFC is not used for sheltering profits in a low taxed jurisdiction in which little or no actual activity takes place (this is often referred to as invoice routing).

Excluding from operating expenditure any expenditure giving rise directly or indirectly to income of a related person ensures that operating expenditure is not inflated by intra-group charges.