Controlled Foreign Companies: Computation of Chargeable Profits and Creditable Tax: Transactions with associates
Where transactions with controlled or controlling companies or companies under common control are not at open market value and the overseas company’s profits are less than they would be if the transaction were at arm’s length then an uplift in the chargeable profits is required to bring the profits to the level that they would have been if the transaction had been at arm’s length.
Because the computation of chargeable profits results in a notional amount for the purposes of the CFC legislation only, there are additional provisions to ensure that the application of TIOPA10/Part 4 (previously ICTA88/SCH28AA) to CFC mirrors that which would have applied to a UK company. For accounting periods beginning before 1 April 2004, Schedule 28AA was disapplied to transactions between UK companies. The broad effect of this exclusion was mirrored by paragraph 20 of Schedule 24 and is detailed in the first section below.
Following the changes to transfer pricing in sections 30-37 of Finance Act 2004, UK-UK transactions were no longer taken out of Schedule 28AA and paragraph 20 was repealed.. For accounting periods ending on or before 21 March 2010, a compensating adjustment is provided when the disadvantaged person was within the charge to Corporation tax. An equivalent effect s provided where the profits of a CFC are wholly subject to UK taxation, by virtue of ICTA88/SCH28AA\PARA6B. Details are also given below.
Application before 1 April 2004
There are two circumstances when the controlled foreign company is the advantaged person (as defined by TIOPA10/Part 4) but where adjustments to the profits are not required. The first is where the disadvantaged person in the transaction is a United Kingdom resident company and the second is where the disadvantaged person is another controlled foreign company which is subject to an apportionment or pursues an acceptable distribution policy.
Where United Kingdom resident company is disadvantaged
Before 1 April 2004, where transactions between an overseas company and a United Kingdom resident company within the charge to tax are not at arm’s length and the overseas company is the advantaged person - that is to say that its profits are less than they would have been if the transaction had been at arm’s length - then no adjustment is made to the chargeable profits of the overseas company. This is because, under the assumption that the overseas company is UK resident and therefore within the charge to tax when its profits are computed, the transaction is between two companies within the charge to corporation tax. (It should be noted that this does not prevent an increase to the profits of a UK resident company where it is the advantaged company in relation to transactions with a controlled foreign company since a controlled foreign company is only deemed to be UK resident and therefore within the charge to tax for the limited purpose of computing its own chargeable profits. Double taxation of the uplift is prevented by a corresponding reduction in the profits of the controlled foreign company - see below.)
Controlled foreign company subject to direction apportionment or acceptable distribution policy is disadvantaged - ICTA88/SCH24/PARA20(2)
Where transaction between an overseas company and a second overseas company take place other than at arm’s length and the first company is the advantaged company no adjustment to the profits of the first overseas company falls to be made before 1 April 2004, if the second overseas company is a controlled foreign company which is either subject to an apportionment under ICTA88/S747(3) or pursues an acceptable distribution policy.
In addition ICTA88/S209(2)(da), which treated interest as a distribution when it was paid other than at arm’s length, was disapplied in the same circumstances that ICTA88/SCH28AA was disapplied, before 1 April 2004 i.e. as a result of the second overseas company being subject to an apportionment or pursuing an acceptable distribution policy.
A Ltd, a United Kingdom company, wholly owns B Ltd, resident outside the United Kingdom, which in turn wholly owns C Ltd, also resident outside the United Kingdom.
C Ltd has made an interest free loan to B Ltd at the beginning of year 1.
In computing the chargeable profits of C Ltd for year 1 the assumption of United Kingdom residence allows an imputation of interest on the loan to B Ltd under TIOPA10/Part 4 (ICTA88/SCH28AA).
In year 2 the chargeable profits of B Ltd are subject to an apportionment on A Ltd.
In computing the chargeable profits of C Ltd for year 2 no imputed interest is added to the chargeable profits.
In year 3 B Ltd pursues an acceptable distribution policy.
In computing the chargeable profits of C Ltd for year 3 no imputed interest is added to the chargeable profits.
The group structure is as above but C Ltd is thinly capitalised by B Ltd.
In year 1 ICTA88/S209(2)(da) applies to restrict the interest charge in C Ltd.
In year 2 the chargeable profits of B Ltd are subject to an apportionment and in year 3 B Ltd pursues an ACCEPTABLE DISTRIBUTION POLICY.
In neither year does ICTA88/S209(2)(da) apply to restrict the interest allowed in computing C Ltd’s chargeable profits.
ICTA88/S209(2)(da) ICTA 1988 may apply to treat interest as a distribution and thus disallow it in the computation of chargeable profits. ICTA88/S209(2)9da) will not however apply where ICTA88/SCH24/PARA20(2) ICTA88/SCH24 disapplies TIOPA10/Part 4 (ICTA88/SCH28AA).
Where ICTA88/S209(2)(da) is not disapplied it will give the same result as TIOPA10 Part 4. Chargeable profits equalling the interest paid may be apportioned to any person entitled to participate in distributions of the company (ICTA/S749B(1)(b)) which in this case will be the person making the loan. Net chargeable profits will therefore be increased by the interest paid.
Relief to prevent a double charge under ICTA88/SCH28AA - ICTA88/SCH24/PARA20(1) Before 1 April 2004
Where an adjustment was made under ICTA88/SCH28AA to increase the profits of a UK resident company (the advantaged person) and the disadvantaged person to the transaction was the overseas company the profits of the overseas company could be computed, on the receipt of a claim, as though the arm’s length provision applied (ICTA88/SCH28AA/PARA6). That was notwithstanding that an adjustment would not have been due if both companies were within the charge to tax.
X Ltd is a United Kingdom resident company with a wholly owned non-resident subsidiary, Y Ltd.
X Ltd has made an interest free loan to Y Ltd of £100,000.
X Ltd’s profits are £350,000.
Under ICTA88/SCH28AA X Ltd’s profits are increased to £360,000 (interest imputed at 10%).
Y Ltd’s profits are £55,000.
Y Ltd makes a claim for ICTA88/SCH28AA/PARA6 relief.
Its profits are then reduced to £45,000 which would bring the chargeable profits below the de minimis level.
AP beginning on or after 1 April 2004
From 1 April 2004, transactions with connected persons will be subject to Schedule 28AA (now TIOPA10/Part IV) if the overseas company’s profits were less than they would have been if the transaction were at arm’s length. This will result in such an uplift in the chargeable profits as is required to bring the profits to the level that they would have been if the transaction had been at arm’s length.
Where there has been such an uplift, i.e. the CFC profits are computed as though it were an advantaged person and the whole of the profits of that CFC are subject to apportionment, then TIOPA10/S179 (previously ICTA88/SCH28AA\PARA6B(2)) allows the ‘advantaged CFC’ to be recognised as an advantaged person for the purposes of any other company making a claim to a compensating adjustment.
A compensating adjustment will not be available if the advantaged CFC is only partially subject to UK tax. If the advantaged CFC is not wholly owned by UK resident companies or is not subject to apportionment under ICTA88/S747 because it has followed an ADP or made another claim for exemption under section 748 then there will be no compensating adjustment available to the disadvantaged company.