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HMRC internal manual

International Manual

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HM Revenue & Customs
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Controlled Foreign Companies: exemptions - Acceptable Distribution Policy ('ADP'): Non-resident shareholders: two classes of shares

The ADP exemption was abolished in FA09 for accounting periods of CFCs beginning on or after 1 July 2009. This guidance only applies to APs ending on or before 30 June 2009

ICTA88/SCH25/PARA2(5) and 2A(5)(a) to (c)

The second exception to the general rule that net chargeable profits are not reduced to take account of non-residents with shareholdings in a controlled foreign company applies where throughout the accounting period concerned there are two classes of issued shares which are-

  1. non-voting fixed rate preference shares, and
  2. shares with voting rights exercisable in all circumstances at general meetings of the company.

There are two legs to the definition of ‘non-voting fixed rate preference shares’. The first is that the shares must be fixed rate preference shares as defined in ICTA88/SCH18/PARA1(3). Broadly, such shares -

  1. must be issued for new consideration, for example they must not be acquired as part of a bonus issue, and
  2. must not carry rights to acquire additional shares or securities, and
  3. must not carry rights to convert into other shares or securities of any other description except
* fixed-rate preference shares, (within this definition), or 
* securities, provided they

* do not carry an interest entitlement based on the company’s results or assets, or which exceeds a reasonable commercial return, and
* do not carry an entitlement to more than would reasonably be available on repayment compared to securities listed in the Official List of the Stock Exchange, based on the consideration lent, or

* shares or securities in the company’s quoted parent company, and
  1. must carry rights only to fixed dividends at no more than a reasonable commercial rate, and
  2. on redemption must carry no rights to an amount exceeding the new consideration given for the shares other than rights comparable with those carried by fixed dividend shares issued on the Stock Exchange.

The second leg of the definition of non-voting fixed-rate preference shares requires that such shares should either carry no voting rights at general meetings or else only carry rights which are contingent on the non-payment of a dividend and which have not become exercisable up to the date of payment of a dividend for the accounting period to which the acceptable distribution policy test is being applied.

Where the second exception applies the required dividend is established by reference to the ‘appropriate portion’ of the net chargeable profits as defined in ICTA88/SCH25/PARA2(6). This is in terms of the following formula:

(P x Q)/R + [(X - P) x Y]/Z

where -

P is the total of the dividends paid on the non-voting shares which meet the conditions in ICTA88/SCH25/PARA2(1)(a) (dividends paid for the accounting period not paid out of specified profits) and ICTA88/SCH25/PARA2(1)(b) (time limit for payment of dividends);

Q is the number of non-voting shares by virtue of which United Kingdom residents have interests in the company at the end of the accounting period;

R is the total number of issued non-voting shares at the end of the accounting period;

X is the net chargeable profits;

Y is the number of voting shares by virtue of which United Kingdom residents have interests in the company at the end of the accounting period; and

Z is the total number of the issued voting shares.

Example

A controlled foreign company has two classes of share capital. Class A consists of non-voting fixed-rate preference shares and Class B of ordinary shares with full voting rights. The Class A shares carry the right to a 10% fixed dividend and are held 40% by United Kingdom residents and 60% by non-residents. The Class B shares are held 80% by United Kingdom residents and 20% by non-residents. The net chargeable profits for the accounting period are £99,000 and dividends for that period are paid £10,000 to holders of Class A shares and £80,000 to holders of Class B shares. The appropriate portion of net chargeable profits is calculated as follows -

First component:

(P x Q)/R

(Class A dividend x Class A shares held by United Kingdom residents)/Total Class A shares issued

(10,000 x 40)100 = 4,000

Second component:

[(X - P) x Y]/Z

[(Net Chargeable Profits less Class A dividend) x Class B shares held by United Kingdom Residents] /Total Class B Shares issued

[(99,000 - 10,000) x 80]/100 = 71,200

The appropriate portion of the net chargeable profits is therefore £75,200 (£4,000 plus £71,200). The dividends paid to United Kingdom resident shareholders are £4,000 in respect of the Class A shares (40% of £10,000) and £64,000 in respect of the Class B shares (80% of £80,000). Since at least 90% of the appropriate portion of the net chargeable profits has been paid to United Kingdom residents as dividend (i.e. £68,000 out of £75,200) the company satisfied the acceptable distribution policy test. Without the rules in ICTA88/SCH25/PARA2(5) to (7) the company would have failed the acceptable distribution policy test because the dividends paid to United Kingdom residents represents only 68% of total net chargeable profits.