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HMRC internal manual

International Manual

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Controlled Foreign Companies: exemptions - the motive test: The diversion of profits leg of the motive test

ICTA88/S748(3)(b) and ICTA88/SCH25/PARA19

The diversion of profits leg of the motive test deals with controlled foreign companies which are used to reduce United Kingdom tax but which may not undertake transactions which achieve a reduction in UK tax as defined by ICTA88/SCH25/PARA17. For example, the only transaction which a moneybox company might undertake in an accounting period is to deposit its funds at interest in a bank account. The only transactions it might be involved with might be:

  • the subscription of shares in it by the UK parent; and
  • the deposit of the funds from the subscription at interest in an offshore bank account.

The results of the first transaction will not be directly reflected in the controlled foreign company’s profits (simply in its balance sheet) whereas the second transaction is with a non-UK person, making it unlikely that it would achieve a reduction in UK tax. Indeed, in subsequent accounting periods, there may not even be any transactions at all. Clearly, however, such a company can be used to reduce UK tax. So, the second part of the motive test focuses on the reasons why a controlled foreign company was brought into, and continues in, existence.

Through ICTA88/S748(3)(b), the diversion of profits leg looks to see whether the main reason (or one of the main reasons) for the company’s existence in an accounting period was, within the meaning of the legislation, ‘to achieve a reduction in United Kingdom tax by a diversion of profits from the United Kingdom’. It is, in practice, a rather more difficult leg to apply than the transaction leg (not least because the statutory definition of a ‘diversion of profits from the United Kingdom’ goes rather wider than many people’s interpretation of the ordinary meaning of the words) but there are a number of similarities.

As with the transaction leg, there are two separate aspects to the diversion of profits leg, the second of which is relevant only if the first aspect is in point:

  • a statutory definition- in ICTA88/SCH25/PARA19 of what is meant by a controlled foreign company’s existence in an accounting period achieving a reduction in United Kingdom tax through the diversion of profits from the United Kingdom; and,
  • a motive element in section ICTA88/S748(3)(b) to determine whether the main reason, or one of the main reasons, for the company’s existence in the accounting period was to achieve that reduction.