Controlled Foreign Companies: Entity Exemptions: Chapter 14 - The Tax Exemption: The Basic Rule
Whether the tax exemption applies depends on a three step rule.
The tax exemption will apply if the CFC’s territory of residence can be determined under the general rule at TIOPA10/S371TB (see INTM242300) and if the local tax amount in step 2 is 75% or more of the corresponding UK tax in step 3. (subject to anti-avoidance provisions in TIOPA10/S371NC).
The steps taken to establish whether the exemption can apply are detailed at TIOPA10/S371NB.
Step 1 - Determine the CFC’s territory of residence
The territory of residence of the CFC will need to be determined in order to apply the tax exemption. The territory of residence rules are set out in Chapter 20 (see INTM242000).
The operation of the residence rules in TIOPA10/S371TB (see INTM242200) will sometimes result in a company having no territory of residence under the general rule at TIOPA10/S371TB. This general rule provides that a CFC is taken to be resident in the territory under the law of which it is liable to tax by reason of domicile, residence or place of management. If a CFC is not liable to tax in the circumstances outlined in TIOPA10/S371TB, its territory of residence will normally be the territory in which it was incorporated or formed under TIOPA10/S371TA(1)(b) and (2) (see INTM242200). Where this is the case, the CFC cannot benefit from the tax exemption. This will normally apply to CFCs that are incorporated in a tax shelter where there is no liability to tax or where the CFC is incorporated in a territory that taxes on a “source” basis.
If the CFC’s territory of residence cannot be determined by application of TIOPA10/S371TB then the tax exemption cannot apply and there is no need to consider Steps 2 and 3.
Step 2 - Determine the “local tax amount”
The local tax amount taken into account for the purposes of the tax exemption is the tax paid under the law of the CFC’s territory of residence on its profits, exclusive of any capital gains or losses (i.e. the CFC’s “local chargeable profits”) (see INTM226150). However this amount is subject to any reductions (i.e. adjustments) required by TIOPA10/371NC,
It is not necessary to determine the local tax amount if the local tax amount of a CFC is determined under a ‘designer rate regime’ (see INTM226200). If this is the case, then the tax exemption cannot apply.
There may be situations where the CFC’s local chargeable profits are aggregated with some other amount in order to compute the tax paid in its territory of residence and the tax is paid either by the CFC or some other person (as the case might be if the CFC were part of a foreign fiscal consolidation). In these situations the tax payable on this aggregated amount is to be apportioned on a just and reasonable basis between the CFC’s local chargeable profits and the other amounts in order to establish the local tax amount.
CFCs A, B and C are all resident in the Netherlands and decide to form a fiscal unity. Under the arrangements B’s and C’s local chargeable profits are accounted for on a consolidated basis by A with tax payable by A on the local chargeable consolidated profits of A, B and C. This will have the effect that, if during an accounting period A made a profit of 100, B made a loss of 200 and C made a profit of 400, for Dutch tax purposes, A would be charged to tax on a consolidated sum of 300. If Dutch tax were charged at a rate of 25% the total tax paid by A is 75. Accordingly, in order to determine the local tax amount for CFCs A, B and C, the Dutch tax of 75 will need to be apportioned amongst the three CFCs on a just and reasonable basis.
It will normally be appropriate to pro rata the tax amongst the profit making companies in calculating the local tax amount for A, B and C as each CFC is considered on an entity basis. This means that, in this instance, CFC A will have a local tax amount of 15 ( 1/5 of the tax paid on its proportion of local chargeable profits of 500 before netting off B’s losses), B will have a local tax amount of nil (as on an entity basis it had no local chargeable profits) and CFC C will have a local tax amount of 60 (4/5 of the tax paid on its proportion of local chargeable profits of 500 before netting off B’s losses).
Advice should be sought from the Base Protection Policy Team at CSTD, Business Assets & International where an alternative method of allocating the local tax is suggested or needs to be considered. An appropriate method would not be to choose which profits the losses are allocated against.
Step 3 - Determine the “corresponding UK tax”
TIOPA10/S371NE defines ‘corresponding UK tax’ as the amount of corporation tax which would be chargeable in respect of the CFC’s assumed taxable total profits for the accounting period computed on the basis of:
- the corporation tax assumptions in Chapter 19 (including the assumption that the company is resident in the United Kingdom) (see INTM239000), and
- the assumptions and adjustments required by TIOPA10/S371NE(2) (see INTM226250).
If step 1 shows that the CFC can determine a territory of residence under the general rule of residence and the local tax amount calculated in step 2 is 75% or more of the corresponding UK tax as calculated in step 3 then the tax exemption applies to the CFC and there will be no need to apportion profits to the chargeable company or companies. (subject to the designer rate provisions not applying to the CFC (see INTM226200)).
It will often be clear from the accounts of a CFC that the CFC’s local tax amount is 75% or more of the corresponding UK tax and it may not therefore be necessary to compute the corresponding UK tax liability to confirm the position. However, where accounts show a significant tax charge it should not be assumed automatically that the CFC’s local tax amount is more than 75% of the corresponding UK tax. For example, the charge shown in the tax account may include a provision for a deferred tax liability, it may be an estimate which proves to be much larger than the final liability, or it may include amounts which are not taxes on profits similar in nature to income or corporation tax. If in doubt, ask for further information in order to confirm the actual figure of tax paid.