Once again, top lecturer Neil Da Costa has a simple solution for a complex issue.
In this series, I explain topics students struggle with using simple examples. This month, I will be showing you how to deal with Controlled Foreign Companies (CFCs) using exotic islands and electric eels.
CFCs – a definition
Many UK companies have set up overseas resident subsidiaries in tax havens to reduce their UK tax liability. Companies that are resident overseas are not subject to any UK corporation tax. In addition, overseas dividends are not subject to UK corporation tax.
A CFC is therefore a non-UK resident company that is controlled (51% OSC) by UK resident companies that have artificially diverted profits away from the UK.
The UK company is subject to a CFC tax charge equal to all the CFC profits it is entitled to taxed at the UK tax rate of 19%.
Double Tax Relief (DTR) can be claimed based on the lower of UK and overseas tax and can always be claimed even in the absence of a double tax treaty.
Simple example: CFC tax charge
Big Ltd (UK) sets up a 100% owned CFC in Paradise, where the rate of tax is just 2%. The CFC has no commercial objective apart from reducing the UK corporation tax liability. The CFC has profits of £1m. There is no double tax treaty between Paradise and UK.
Compute the CFC tax charge for Big Ltd (UK) assuming that no exemptions apply.
The CFC tax charge is based on the share of the CFC profits that Big Ltd (UK) is entitled to taxed at 19% (100% x £1m x 19% = £190,000).
Double Tax Relief will be available based on the lower of UK tax (£190,000) and the overseas tax (£1m x 2% = £20,000) so DTR is £20,000.
The CFC tax charge is £190,000 – £20,000 = £170,000 which will be added to the corporation tax liability of Big Ltd (UK).
The anti-avoidance rule effectively removes any tax benefit to Big Ltd (UK) of setting up a CFC in a tax haven.
If any one of five exemptions apply, there is no CFC tax charge. The five exemptions can be remembered by the mnemonic ‘Electric Eels Love Low Tax’ (imagine someone swimming in the Cayman Islands being electrocuted).
Exempt Period: The first 12 months of the overseas company coming under control of the UK companies. It is not available to newly incorporated companies.
Excluded Territories: The overseas country is in a country that is not a tax haven and is included in a list of excluded territories.
Low Profits: The CFC has trading profits of not more than £500,000 or investment income of not more than £50,000.
Low Profit Margin: The CFC has a profit margin of less than 10% based on operating expenditure.
Tax Exemption: The rate of tax in the overseas country is at least 75% of the UK tax rate. (19% x 75% = 14.25%)
Simple example: CFC Exemptions
Big Ltd (UK) has got the following five overseas subsidiaries. Explain which CFC exemptions apply.
Big Ltd buys 100% OSC of a company A Ltd that has been trading for many years. A Ltd is a CFC and its profits are £1m for the first year owned by Big Ltd.
Claim the exempt period exemption for the first 12 months from the date that Big Ltd buys the company.
Big Ltd owns 100% OSC of a company B Ltd. B Ltd is a CFC and its profits have been £5m a year. B Ltd is resident in Happyland.
Happyland is on the list of excluded territories.
Claim the excluded territory exemption for all years avoiding a CFC tax charge for Big Ltd.
Big Ltd owns 100% OSC of a company C Ltd. C Ltd is a CFC and has trading profits of £400,000 and investment income of £45,000.
Claim the low profit exemption as the CFC has trading profits of not more than £500,000 and investment income of not more than £50,000 in the 12-month period.
Big Ltd owns 100% OSC of a company D Ltd. D Ltd is a CFC and has made profits of £1m on sales revenue of £12m.
Claim the low profit margin exemption as the profit margin is 1/12 – 1 = 1/11 = 9.09% which is less than 10%.
Big Ltd owns 100% OSC of a company E Ltd. E Ltd is a CFC and is resident in Beachland. Beachland has a corporation tax rate of 15%.
Claim the tax exemption as the rate of tax in Beachland is more than 14.25%.
By taking advantage of the CFC exemptions, UK companies can still get a tax benefit through setting up companies in tax havens.
• Neil Da Costa is a Senior Tax Lecturer with Kaplan. He believes in keeping things simple and making tax fun.