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HMRC internal manual

International Manual

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

As with the transaction leg, there is just one question to be answered with regard to the motive element:

Was the main reason, or one of the main reasons, for the existence of the controlled foreign company to achieve that reduction in United Kingdom tax by that diversion of profits?

Whilst the diversion of profits leg looks to the main reason for the existence of the controlled foreign company and the transaction leg looks to the main purpose of the transaction, leading Counsel has confirmed that nothing hangs on the difference between the two words.

The reasons for a company’s existence and which of those reasons constitute main reason’s, are questions of fact. In practice, if the existence of a controlled foreign company achieves more than a negligible saving of tax, it would normally be reasonable to infer that the tax saving was one of the reasons for bringing the company into, or keeping it in, existence. If the tax saving is substantial, it would be reasonable to infer that it was a main reason for the company’s existence.

The diversion of profits leg of the motive test looks to the reasons for a controlled foreign company’s existence in the particular accounting period under consideration. However, the events of earlier accounting periods will often show clearly why a company was brought into existence. The fact that it was set up to divert profits and that its functions have remained unchanged since then will have a considerable bearing on the reasons for keeping it in existence during the accounting period in question. Equally, if its functions have changed substantially since it was first set up such that it no longer exists to divert profits, the fact that it was initially set up to divert profits will not necessarily mean that it will fail the motive test.

As with the transaction leg, an important point with regard to the motive element is that the test is not concerned with the sole or t h e main reason for the existence of the controlled foreign company. It similarly recognises that many (probably all) companies exist for a variety of reasons and, indeed, that there may be more than one main reason. So, while there may be sound commercial reasons underlying the establishment of a controlled foreign company, that does not necessarily mean that the test is thereby satisfied.

Even if there is a genuine commercial reason underlying the establishment of a controlled foreign company, the controlled foreign company will still fail the motive element of the diversion of profits leg if achieving a reduction in United Kingdom tax by a diversion of profits from the UK (as defined in ICTA88/SCH25/PARA19) is also one of the main reasons for its existence. Regardless of the commercial considerations, only if achieving the reduction in UK tax by a diversion of profits from the UK is n o t one of the main reasons for the existence of the controlled foreign company will the motive part of the leg be satisfied.

The diversion of profits leg of the motive test can therefore, in essence, be narrowed down to two basic questions:

  • could the business of the controlled foreign company have been carried out in the United Kingdom?
  • is one of the main reasons it was not carried out in the UK because the tax that would have been payable in the United Kingdom would have been greater than the tax paid by the controlled foreign company in the territory in which it is resident?

If the answer to either of these questions is no, the motive test will be passed. If, however, the answer to both of them is yes, the motive test will be failed.