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HMRC internal manual

International Manual

Controlled Foreign Companies: exemptions - Exempt Activities Test ('EAT'): Effectively managed in territory of residence

ICTA88/SCH25/PARA6(1)(b) and PARA8(1)(a) and (b)

A controlled foreign company cannot be engaged in exempt activities unless its business affairs are effectively managed in its territory of residence throughout the accounting period under consideration. This wording differs from ICTA88/S749(3)(a) which refers to the ‘company’s place of effective management’ (INTM254400). Although the considerations may be similar, the exempt activities test fixes on the management of the business.

The requirement is expanded by the conditions in ICTA88/SCH25/PARA8(1), (5) and (6). The legislation differentiates between companies resident in European Economic Area (EEA) territories and those that are not in relation to accounting periods beginning on or after 6 December 2006 (FA07/S48/SCH15/PARA7).

Companies not resident in an EEA territory

ICTA88/SCH25/PARA8(1) provides that a controlled foreign company [not resident in an EEA territory] is not to be regarded as effectively managed in its territory of residence unless

Employees

The requirement in (i) above will be met where the staff employed by the company in its territory of residence are sufficient in numbers, qualifications and experience to supervise, control and carry out the bulk of the company’s profit-making activities. It is not required that all the company’s employees should be located in the territory of residence; for example, some staff may operate a permanent establishment of the company’s business in another territory, even though the main business is in the territory of residence. It should be noted that directors are office holders and will only qualify as employees if they hold a contract of employment.

The persons who may be treated as employees for the purpose of (i) above are

  1. the company’s own employees
  2. persons who are wholly or mainly engaged in the company’s business and who are remunerated by a person connected with (the definition in ITA07/S993 applies), and resident in the same territory as, the company, and
  3. in the case of a holding company only, persons engaged in the business of the company whose remuneration is paid as described in (b) above. Given the nature of the work required in a holding company, such persons do not have to be wholly or mainly engaged in the company’s business.

Staff seconded to the company by associates who are resident in the same territory may thus in certain circumstances be regarded as employed by the company for the purpose of ICTA88/SCH25/PARA8(1)(a). Staff seconded from associates in another territory or the staff of an independent agency cannot be regarded as so employed.

A number of insurance companies have employed the staff of insurance management agencies directly. Only where the local laws of employment apply between the company and staff and the salaries are met directly by the company will this arrangement be acceptable.

Services

There are a number of modifications to the general requirement that a controlled foreign company should not perform services in the UK for person’s resident outside its territory of residence if it is to be regarded as effectively managed in its territory of residence. No account is to be taken of services performed in the UK where:-

  • services are provided through a UK permanent establishment or agency of the controlled foreign company so that the resulting profits or gains are within the charge to UK tax;
  • services are provided on arm’s length terms through some other person (either a UK resident or a non-resident with a UK permanent establishment) whose profits from the provision of the services are within the charge to UK tax; or
  • the services are no more than incidental to services provided outside the UK.

Example

A United Kingdom group is commissioned to design a major installation for an overseas government but the formal contract is placed with a group subsidiary resident in Bermuda. All the work under the contract is carried out on a subcontract basis by a company in the UK.

The services provided by the Bermudan company are clearly within ICTA88/SCH25/PARA8(1)(b) and the company cannot be regarded as effectively managed in Bermuda unless the services fall within ICTA88/SCH25/PARA8(4). In this particular case:

  • the services would come within ICTA88/SCH25/PARA8(4) only if the Bermudan company paid an arm’s length price for its use of UK personnel, that is, one which fairly reflected the division of effort in the performance of the contract; and
  • even if the services do come within ICTA88/SCH25/PARA8(4), the company’s business affairs will only be effectively managed in Bermuda for the purposes of ICTA88/SCH25/PARA6 (1)(b) if the condition in ICTA88/SCH25/PARA8(1)(a) is also met - that is, that the number of persons employed by the company in Bermuda is adequate to deal with the volume of its business.

Companies resident in an EEA territory

For companies resident in EEA territories in relation to accounting periods beginning on or after 6 December 2006 ICTA88/SCH25/PARA8(5) provides that PARA 6(1)(b) shall not be regarded as fulfilled unless there are sufficient individuals working for the company in the territory who have the competence and authority to undertake all, or substantially all of the company’s business.

ICTA88/SCH25/PARA8(6) provides that individuals are not to be regarded as working for the company in any territory unless

  1. They are employed by the company in the territory, or
  2. They are otherwise directed by the company to perform duties on its behalf in the territory