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HMRC internal manual

International Manual

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HM Revenue & Customs
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Controlled Foreign Companies: exemptions - Exempt Activities Test ('EAT'): Banking, deposit-taking, money-lending and debt-factoring

ICTA88/SCH25/PARA11(3)-(5)

The application of the exempt activities test to a controlled foreign company engaged in banking, deposit-taking, money-lending or debt-factoring or a similar business - INTM254890 sub-head c) - is modified in three respects -

  1. certain interest receipts are treated as not deriving from associates; and
  2. there is a special test concerning the company’s capital structure;
  3. there is a special test concerning limiting the company’s receipts from any UK persons.

The first modification is intended to ensure that a controlled foreign company engaged in such businesses does not fail the exempt activities test because it lends its deposits to United Kingdom associates at interest. The second modification is designed to ensure that the controlled foreign company is carrying on a substantial part of its business with unconnected third parties. The third modification ensures that UK business receipts (other than interest) is not diverted to overseas banking subsidiaries.

Receipts from United Kingdom Residents - ICTA88/SCH25/PARA11(3)

The modification referred to at (a) above is that payments of interest received by the company from companies resident in the United Kingdom are not to be regarded as derived directly or indirectly from connected or associated persons. The effect is that interest payments from United Kingdom resident associates (for example, on deposits taken by the company in its territory or residence and lent on to its United Kingdom parent) will not themselves cause the company to fail the exempt activities test.

Example

A controlled foreign company carrying on a banking business has the following trading receipts

  £
   
Interest on loans to third parties 200,000
Interest on loans to United Kingdom resident associated companies 500,000
Interest on loans to other associates 250,000
Interest on investments 50,000
  1,000,000

 

But for the special rule in ICTA88/SCH25/PARA11(3), more than 50% of the company’s gross trading receipts would be derived from associates (that is, £750,000). However, under ICTA88/SCH25/PARA11(3) only the interest on the loans to non-resident associates of £250,000 is treated as derived from associates and 70% of its receipts (£200,000 + £500,000 = £700,000) are regarded as derived from non-associates.

Capital Structure Test - ICTA88/SCH25/PARA11(3)-(5)

The effect of the capital structure test referred to at (b) above is that a company engaged in banking, deposit-taking, money-lending or debt factoring or a similar business is conclusively presumed not to satisfy ICTA88/SCH25/PARA6(2)(b) (trading receipts derived from associates) if at any time during the accounting period under consideration the amount given by the formula (I-F) is 15% or more of the amount given by the formula (C-F), where

I is the aggregate value of the capital interests in the company held directly or indirectly by -

  • the persons who have control of the company, and
  • any person connected or associated with those persons

C is the amount of the company’s outstanding capital; and

F is the value of the company’s fixed assets.

Definitions

A ‘capital interest’ means -

  • an interest in the issued share capital or reserves of the company, or
  • an interest in a loan to or deposit with the company, or
  • the liability of a guarantor under a guarantee given to or for the benefit of the company.

The value of a capital interest is to be taken as the value shown in the company’s accounts, except in the case of a liability of a guarantor under a guarantee where the value to be taken is the market value of the benefit which the controlled foreign company derives from the provision of the guarantee.

‘Outstanding capital’ means the total value of all the capital interests in the company, less the value, as shown in the company’s accounts, of any advances made by the company to persons resident outside the United Kingdom who either -

i) have control of the company, or

ii) are connected or associated with the persons who have control of the company.

Where the controlled foreign company holds any securities (including stocks and shares) in a company within (i) or (ii) above other than as ‘trade investments’, those securities are treated as advances to be deducted in computing the ‘outstanding capital’.

‘Fixed assets’ means the plant, premises and ‘trade investments’ employed in the company’s business and their value is to be taken as that shown in the company’s accounts.

‘Trade investments’ means securities any profit on the sale of which would not be brought into account as a trading receipt in computing the chargeable profits of the accounting period in which the profit arose.

Capital structure test - example

The purpose of the capital structure test is to deny the benefit of the exempt activities test to companies which are mainly engaged in a business at ICTA88/SCH25/PARA11(1)(c) but which exceed the limit placed on the reliance of funds obtained from associates or from retained earnings. Such companies resemble moneybox or investment companies. Funds which are tied up in plant, premises and shares in other companies held as part of the underlying structure of the group are left out of account in the capital structure test.

Example

The accounts of a controlled foreign company which carries on an exclusively banking business show the following.

Assets   £
     
Fixed assets   200
Shares in subsidiary   500
Advances to third parties   9,300
Deposits with non-resident associates   2,000
Loan to United Kingdom parent   6,000
Investments (shares and fixed term securities)   500
    18,500
Liabilities £ £
Deposits by third parties 12,000  
Loans from associates 3,000 15,000
    3,500
Represented by   £
Share capital (held by parent) 1,000  
Long term loan from parent 1,000  
General reserve 500  
Retained profits 1,000 3,500

The total of the ‘capital interests’ in the company held by connected or associated persons is £6,500 computed as follows.

  £
   
Share capital 1,000
Long term loan 1,000
General reserve 500
Retained profits 1,000
Loans from associates 3,000
Capital interests (I) 6,500

The total of the company’s ‘outstanding capital’ is £16,500 computed as follows.

  £
   
Capital interests held by associates 6,500
Other capital interests (that is, third party deposits) 12,000
  18,500
Less advances (that is, deposits) to associates 2,000
Outstanding capital (C) 16,500

The total of the company’s ‘fixed assets’ is £700 computed as follows.

  £
   
Fixed assets in accounts 200
Shares in subsidiary 500
Fixed assets (F) 700

The amount given by the formula (I-F) is £6,500 - £700 = £5,800.

The amount given by the formula (C-F) is £16,500 - £700 = £15,800.

15% of the amount given by (C-F) is £2,370. The amount of £5,800 given by the formula (I-F) exceeds this amount of £2,370 and the company is conclusively presumed not to be engaged in exempt activities.

Practical considerations

The capital structure test must in strictness be satisfied throughout the accounting period under consideration. Where however a controlled foreign company engaged in banking, etc. is carrying on business almost exclusively with non-associates (that is, genuinely taking most of its deposits from, and lending to, members of the public) the examination may be confined to the company’s capital structure to the position at balance sheet dates and in the middle point of the accounting period.

UK Business Test

This test applies to a controlled foreign company’s accounting periods that start on or after 27 November 2002 and looks at the proportion of non-interest receipts by the controlled foreign company. Banking controlled foreign companies will fail the exempt activities test if more than 10% of their gross trading receipts are not interest and are derived directly or indirectly from:

  • UK resident companies;
  • the UK permanent establishments of non-UK resident companies (see INTM254890);
  • individuals who are habitually UK resident (see INTM254890).

Note that all the categories above include both connected and non-connected persons.

Gross trading receipts includes all income of the controlled foreign company regardless of whether this income is subsequently exempted under the banking UK source interest provisions of ICTA88/SCH25/PARA 11(3)(a).