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HMRC internal manual

International Manual

Controlled Foreign Companies: exemptions - Exempt Activities Test ('EAT'): Wholesale, distributive, financial or service business

ICTA88/SCH25/PARA6(2)(b) and PARA11

Where a controlled foreign company is mainly engaged in wholesale, distributive, financial or service business, it cannot meet the requirements of the exempt activities test if 50% or more of its gross trading receipts are derived from certain affiliates or unconnected UK persons (see INTM254850). Each of the following activities constitutes wholesale, distributive, financial or service business. The list is exhaustive.

  1. Dealing in any description of goods wholesale rather than retail.
  2. The business of shipping or air transport.
  3. Banking, deposit-taking, money lending or debt factoring, or any business similar to these businesses.
  4. The administration of trusts.
  5. Dealing in securities in the capacity of a broker, as defined in ICTA88/SCH25/PARA9(2) (see INTM254870).
  6. Dealing in commodity or financial futures.
  7. Effecting or carrying out contracts of insurance, as defined in Article 3(1) of the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001.
  8. The provision of services not falling within any of the above.

The definitions of wholesale, distributive, financial and service business and of investment business (see INTM254870) are not mutually exclusive and it is possible, although unlikely in practice, for a company’s main business to be both financial and investment business. In such a case it is unnecessary to apply the 50% gross trading receipts test as the company will inevitably fail the exempt activities test by virtue of ICTA88/SCH25/PARA6(2)(a)(i).

Where the gross trading receipts of a company include the sale proceeds of any property or rights, the cost to the company of the property or rights is to be deducted in computing its gross trading receipts for the purposes of ICTA88/SCH25/PARA6(2)(b). The effect of this for a company dealing in goods or other property is that its gross trading receipts are taken to be its gross trading profit after deduction of the cost of the goods.

The definitions in ICTA88/SCH25/PARA11 (1) are, in the main, self explanatory. The word ‘services’, for example in the last of the above definitions - ‘the provision of services’ - takes its ordinary English meaning (albeit in the context of ICTA88/SCH25/PARA11 (1)). It covers a very wide ambit of activities, including, for example:

  • a business providing group management services (such as administration, treasury or property management services);
  • a business providing international services to third parties but through another group company based, for example, in the territory of the third party; and
  • a business developing software on behalf/for the use of other group companies.

If a company is unsure about whether a controlled foreign company is involved in the provision of services, it can ask CSTD Business, Assets & International Base Protection Policy team for guidance or a clearance. Where a company is mainly engaged in either (i) banking, deposit-taking, money lending, debt factoring or any similar business, or (ii) insurance business, (that is, (c) and (g) above respectively), there are modifications to the application of the 50% rule for transactions with associates etc. in ICTA88/SCH25/PARA6(2)(b).

Directly and indirectly

In most cases, it should be clear whether a transaction has been made directly with an affiliate or with an unconnected UK company, permanent establishment or ‘habitually resident’ individual (see below for the meaning of ‘habitually resident’).

This principle is harder to apply when the transaction is indirect. There will be many occasions when a UK person does business with an intermediary third party which is unconnected to the controlled foreign company but which also does business with that controlled foreign company. If that intermediary is in the UK, then any receipts of the controlled foreign company will fall within the list, as they come directly from a UK person. If the intermediary is not in the UK, the transaction may still fall within the definition of receipts indirectly derived from UK persons.

The test to be applied here is no different in principle from the test applying under the existing legislation to payments indirectly derived from connected or associated companies. However, we recognise that, in practice, controlled foreign companies may not always have access to information on indirect transactions with third parties. We will therefore accept that it may be reasonable to rely on assumptions as to the source of funds received ‘indirectly’ in the light of this guidance. In the vast majority of cases, identifying whether or not payments are derived directly or indirectly from UK persons will be so straightforward that the result of the 50% test will be very clear. In such cases, precise identification of ‘indirect’ customers will not be needed. However, in marginal cases, those companies that operate at or close to the 50% limit will need to pay closer attention to demonstrating entitlement to the exempt activities test.

Examples of direct transactions

If the third party deals directly with the retail customers of its UK associates, then it would be reasonable to expect the controlled foreign company to be able to identify those UK customers. However, if there is no similar connection between the UK person and the controlled foreign company’s group, then the controlled foreign company may make such assumptions as are reasonable in identifying indirect UK transactions. The examples below illustrate this distinction:

Example 1

If the intermediary identified in Paragraph 16 normally deals with individuals in its own territory, then it would be reasonable to assume that all transactions between the controlled foreign company and the third party are not indirectly with UK individuals. It would not be necessary to identify all customers of the third party in the absence of a relationship between those customers and the controlled foreign company’s group.

Example 2

If the said intermediary deals with customers introduced by an associate of the controlled foreign company, then it would be reasonable for the controlled foreign company to identify those persons more precisely.

Examples of indirect transactions

It will not always be the case that the payment between the UK person and the intermediary will be entirely independent of any subsequent transactions between that party and the controlled foreign company. A receipt does not necessarily lose its integrity or identity merely because it passes through a different form or legal entity. There is a strong presumption that any payment to a controlled foreign company by an intermediary third party, which is in some form conditional, dependent or related to a receipt by that intermediary from a UK source, will fall within the term ‘indirectly derived’. However, conditional or dependent in this context should not be read as including a remote cause. The capital funding of a non-UK trust or non-resident company may derive from UK individuals. But this linkage alone would not be sufficient to deem all subsequent expenditure by those persons as indirectly derived from the UK. As a general rule, a payment will be indirectly derived from the UK if the subsequent transaction with the controlled foreign company transfers a significant part of the economic risk/return to the controlled foreign company.

Example 3

A controlled foreign company has receipts from the provision of services to an intermediary which has 51% UK shareholders (unconnected to the controlled foreign company) but trades outside the UK. The UK residence of the shareholders will not be sufficient to make that service income indirectly derived from a UK person in the hands of the controlled foreign company (provided no special requirements attach to those UK shareholders’ capital investment e.g. to link that investment with the subsequent service provision).

Example 4

A UK person takes out a service warranty with a non-UK third party. That company passes a substantial part of its liability from that and other transactions with UK persons to a captive insurance company. The receipts of the captive arise as a direct consequence of the transaction with the UK person and will therefore be indirectly derived from UK persons.

Permanent Establishments - ICTA88/SCH25/PARA6 (2c)

The list of non-qualifying transactions includes non-resident UK companies that have a permanent establishment in the UK. However, only transactions directly or indirectly with that UK permanent establishment will come within the extended list. All other transactions with the non-resident company will fall outside the scope of the extended list, provided that company does not itself carry out transactions with UK persons.

Note that for accounting periods commencing on or after 1 January 2003, as a result of the changes made by FA03/S152, this reference is to the ‘permanent establishment’ of such a company. However, for accounting periods commencing on or after 27 November 2002 but before 1 January 2003 the reference is to ‘branch or agency’.

Habitually resident - ICTA88/SCH25/PARA 6(2A)(f)

For the purpose of establishing whether business has been derived from a UK individual, the new legislation introduces the concept of ‘habitual residence’. Other tests, such as residence, ordinary residence and domicile, require detailed examination of facts and circumstances beyond what is necessary for this purpose. ‘Habitually resident’ is a significantly simpler concept, essentially focussed on the question ‘does this person normally live in the UK’?

The term ‘habitual residence’ is used in insurance legislation to identify classes of business. The term is derived from Article 2(d) of the second EU non-life insurance directive.