The United Kingdom has for a number of years been an attractive holding company jurisdiction for multinational groups, combining a relatively low headline corporation tax rate with a predominantly territorial tax regime, no withholding tax on dividends and an extensive tax treaty network.
The United Kingdom has also been a proactive supporter of the Organisation for Economic Co-operation and Development (OECD) base erosion and profit shifting (BEPS) initiative, tackling profit shifting and tax avoidance, at times going further than the BEPS-recommended actions to protect its tax base.
II Local Developments
i Entity forms
Most UK business of any significant size is carried on in a company, which might either be UK resident or the branch of a non-UK company. Partnerships (which are transparent for UK tax purposes) tend to be limited to the professions and to private equity-style investment structures. English law does allow a limited liability partnership, which is more corporate in form but is treated as transparent for tax purposes, and this has proved a popular structure for professional services firms. There is no equivalent of the US 'check the box' rules in the United Kingdom.
ii Corporation tax
UK tax-resident companies are subject to corporation tax on their worldwide profits. A company incorporated in the United Kingdom will generally be resident in the UK unless it is treated as resident in another jurisdiction under the tie-break provision in a relevant tax treaty with the UK. The practical application of this provision has changed as the United Kingdom has moved away from agreeing the place of effective management tie-break in its treaties, instead moving towards a mutual agreement procedure. Non-UK incorporated companies are treated as UK tax-resident if their central management and control is in the United Kingdom.
Non-UK resident companies pay corporation tax on profits arising from a trade carried on through a UK permanent establishment. Therefore, if a branch's activities fall short of a trade (if it is carrying on an investment business, for example) it is not subject to corporation tax, although it may be subject to income tax on certain income arising in the United Kingdom.
Since 2016, a non-resident company without a UK permanent establishment will be subject to corporation tax if its trade consists of 'dealing in or developing' UK land. In addition, as from April 2019, a non-resident company may be subject to corporation tax on certain disposals of direct or indirect interests in UK land.
The current rate of corporation tax is 19 per cent, set to reduce to 17 per cent for the year commencing 1 April 2020. Since 2016, banks have incurred an 8 per cent surcharge on top of the headline rate of corporation tax. By comparison, the rates of income tax (paid by individuals and trusts) are considerably higher (up to 45 per cent) and individuals pay capital gains tax (CGT) at rates of up to 28 per cent.
Corporation tax is to a large extent an accounts-based system, with taxable profits being derived from the accounts, although there are some adjustments. For example, accounts depreciation of plant or machinery is not tax deductible, but instead capital allowances are given, at various rates depending on the type of asset and the level of expenditure incurred.
Dividend income (whether paid by a UK or a non-UK company) is generally exempt from corporation tax, subject to some complex anti-avoidance rules. In addition, the exemption for dividends paid to a 'small' company does not apply unless the paying company is resident in the United Kingdom or a treaty jurisdiction.
Another significant exemption from corporation tax is the substantial shareholding exemption (SSE), which exempts gains (and disallows losses) arising from the disposal of shares in substantial shareholdings (broadly 10 per cent or more) in UK and non-UK trading companies or groups, where the seller has held a substantial shareholding for a continuous 12-month period in the six years before the date of disposal.
The combination of the dividend exemption and the SSE, when joined to the lack of withholding tax on dividends paid by a UK company and the UK's extensive tax treaty network, has made the UK a popular jurisdiction for locating group holding companies.
Broadly speaking, the UK has adopted a territorial tax system, taxing only UK source income. This means that most dividends received by a UK company from non-UK subsidiaries (and indeed from other non-UK companies) will benefit from the dividend exemption for corporation tax. Although broad in its scope, the dividend exemption is not entirely straightforward in its application, and there are various exclusions, such as where the dividend is deductible in another jurisdiction.
As a general rule, and subject to tax treaty provisions and double tax relief, the UK taxes the profits earned in overseas branches of UK resident companies. A UK company may, however, elect for the profits (including capital gains) of its overseas branches to be exempt from UK taxation. If such an election is made, the UK company cannot then use the losses of the overseas branch. An election is irrevocable and covers all overseas branches of the company making the election.
The United Kingdom's controlled foreign companies (CFCs) regime, which taxes certain undistributed profits of non-UK subsidiaries of a UK company (at the corporate tax rate), at first sight seems inconsistent with a territorial tax system, but in fact the CFC regime is not intended to catch profits that arise naturally outside the UK. Although the rules are complex, the intention is that the rules are targeted only at profits that have been artificially diverted from the UK. See further discussion below on the finance company exemption to the CFC rules.
Real estate investment trusts
Since 2007, the United Kingdom's real estate investment trust (REIT) regime has enabled qualifying companies to elect to be treated as REITs. The conditions for qualification include UK residence, listing (on a main or secondary stock market), diversity of ownership and a requirement that three-quarters of the assets and profits of the company (or group) are attributable to its property rental business.
The aim of the regime is that there should be no difference from a tax perspective between a direct investment in real estate and an investment through a REIT. Accordingly, a REIT is exempt from tax on income and gains from its property rental business but distributions of such income or gains are treated as UK property income in the hands of shareholders and are liable to 20 per cent withholding tax (subject to exceptions).
Patent box regime
Until 30 June 2016, the United Kingdom had a patent box regime that allowed an arm's-length return on intellectual property held in the UK to qualify for a reduced tax rate of 10 per cent even if all the associated research and development (R&D) activity was done outside the UK. In light of BEPS Action 5, although IP that was already in the patent box on 30 June continues to benefit from the old rules for five years, IP not already in the patent box on that date qualifies only to the extent it is generated by R&D activities of the UK company itself, or by R&D outsourced to third parties. Acquired IP and IP generated by R&D outsourced to associates are no longer eligible for the patent box.
Where IP has been generated from a combination of 'good' and 'bad' expenditure, a fraction of the patent income qualifies for the patent box and, in calculating this, there is a 30 per cent uplift for 'good' expenditure, to soften the impact of these rule changes.
Following Brexit, a further relaxation of the new rules may be possible: departure from the EU might enable the United Kingdom to treat all R&D outsourcing within the UK as 'good' expenditure, without fear of violating EU Treaty freedoms and state aid rules.
If a UK company is financed by subscribing for shares, there are no tax consequences for the share subscription but no tax deduction for dividends paid on the shares. The United Kingdom does not impose any withholding tax on dividends paid by UK companies, other than dividends derived from the tax-exempt business of a UK REIT (see above).
In addition to having to satisfy certain company law requirements, a repurchase of shares (although not a redemption of redeemable shares) in a UK-incorporated company may be subject to stamp duty at the rate of 0.5 per cent. Stamp duty is also payable on a sale of such shares.
In principle, a UK-resident company benefits from relief from UK corporation tax for interest and other financing costs, but this is an area that is subject to continually increasing restrictions.
The United Kingdom has a thin capitalisation regime. If the lender is a related party or the borrowing is guaranteed by a related party, these rules will be applied to determine the amount that the borrower could have borrowed from an independent lender and this can result in part of the borrowing costs being non-deductible. The United Kingdom does not have any 'safe harbours' for this purpose.
In line with BEPS Action 4, with effect from 1 April 2017, the United Kingdom has introduced an EBITDA-based cap on net interest expense. The restrictions, which apply only where a group has over £2 million in UK net interest expense, include:
- a fixed ratio rule that limits corporation tax deductions for net interest expense to 30 per cent of a group's UK EBITDA and a group ratio rule based on the net interest to EBITDA ratio for the worldwide group; and
- a modified debt cap that provides that a group's net UK interest deductions cannot exceed the global net third-party interest expense of the group (operating with 'similar effect' to the worldwide debt cap that formed part of the previous interest restriction regime).
Interest treated as a distribution will not be deductible. This will include situations where the interest exceeds a reasonable commercial return, the rate depends upon the performance of the borrower or the loan is convertible into shares.
Interest relief may also be restricted where a main purpose of being party to the loan in the relevant accounting period is to obtain a tax advantage.
The UK imposes withholding tax at the rate of 20 per cent on 'yearly interest', namely interest paid on loans capable of being outstanding for one year or more. This rate may be reduced by an applicable double tax treaty.
In addition, there are various domestic exceptions that may be available. There is no obligation to withhold if:
- the interest is paid by a bank in the ordinary course of its business;
- the person beneficially entitled to the interest is a UK-resident company, or is non-UK resident but carries on a trade in the United Kingdom through a permanent establishment and is subject to UK tax on the interest;
- the interest is paid on a quoted Eurobond, namely an interest-bearing security issued by a company listed on a recognised stock exchange;
- the interest is paid on debt traded on a multilateral trading facility operated by a recognised stock exchange in an EEA territory; or
- the interest is paid on qualifying private placements.
There is also no obligation to withhold tax on 'short interest' (broadly where the loan will be outstanding for less than one year) or on returns that constitute discount (rather than interest).
Stamp duty is not generally payable on the transfer or repayment of plain vanilla loan capital.
Financing non-UK subsidiaries of a UK group
Since the reform of the CFC rules in 2013, many UK-owned multinational groups have relied on the finance company partial exemption (FCPE) from the UK CFC rules to finance their non-UK subsidiaries. This had the effect of imposing (while the main rate of corporation tax is 19 per cent) tax at 4.75 per cent on profits earned by a CFC from providing funding to other non-UK members of the relevant group. In certain situations the tax may be eliminated entirely.
The outcome of the European Commission's investigation into whether the FCPE constitutes unlawful state aid is still awaited at the time of writing.
iii Tax groups
While the United Kingdom does not permit group companies to be taxed on the basis of consolidated accounts, the various grouping rules achieve a degree of effective consolidation. A group consists, in most cases, of a parent company and its direct or indirect subsidiaries, but the test is different for different purposes.
Group relief group
Losses (other than capital losses) may be surrendered from one UK resident group company to another UK resident group company. Losses can also be surrendered by or to a UK permanent establishment (PE) of a non-UK group company. A UK PE of an overseas company can only surrender those losses as group relief if they are not relievable (other than against profits within the charge to UK corporation tax) in the overseas country. Similarly, a UK company can surrender the losses of an overseas PE if those losses are not relievable (other than against profits within the charge to UK corporation tax) in the overseas country.
The UK legislation permits group relief to be given in the UK for otherwise unrelievable losses incurred by group members established elsewhere in the EU, even if they are not resident or trading in the United Kingdom. However, the applicable conditions are very restrictive, so in practice UK companies rarely benefit from this rule.
A group relief group requires 75 per cent common economic ownership.
Capital gains group
There is no consolidation of capital gains and losses, but it is possible to make an election for a gain (or loss) on a disposal made by one capital gains group member to be treated as a gain (or loss) on a disposal by another group member. Capital assets may be transferred between capital gains group members on a no gain, no loss basis. This has the effect of postponing liability until the asset is transferred outside the group or until the company holding the asset is transferred outside the group.
When a company leaves a capital gains group holding an asset that it acquired intra-group in the previous six years, a de-grouping charge may arise. This charge will deem the leaving company to have disposed of and immediately re-acquired those assets at market value immediately after their acquisition. However, in some cases, the de-grouping charge will be added to the consideration received for the sale of the shares in the transferee company and may then be exempt under the SSE (see above).
Although at first sight the grouping test for CGT appears to require 75 per cent common ownership, it may be possible to structure a CGT group with only 51 per cent economic ownership.
Stamp duties groups
Transfers between group companies are relieved from stamp duties where certain conditions are met. A stamp duty group requires 75 per cent common economic ownership.
VAT group membership is generally voluntary. Transactions between group members are usually disregarded for VAT purposes. Broadly, two or more corporate bodies are eligible to be treated as members of a VAT group if each is established or has a fixed establishment in the United Kingdom and they are under common control. The eligibility criteria for the United Kingdom's VAT grouping rules are, however, the subject of a current consultation that may result in allowing partnerships and individuals who have a business establishment in the UK and control a body corporate to join a VAT group.
iv Intra-group transactions
The United Kingdom has transfer-pricing rules that apply to both international and domestic transactions between associated companies. Two companies will be deemed associated if they satisfy the 'participation condition'. This condition stipulates that, at the time of the transaction, one of the parties directly or indirectly participates in the management, control or capital of the other or the same person directly or indirectly participates in the management, control or capital of both parties. Generally, if one person has rights that enable it to control another person, both will satisfy the participation condition.
Usually, transfer-pricing adjustments may only be made where there would otherwise be a UK tax advantage; however, UK companies potentially disadvantaged by the adjustment may make a compensating adjustment to their taxable profits. A compensating adjustment is not usually available to companies resident outside of the UK, subject to some exceptions; for instance, where the disadvantaged company is a CFC.
Corporation tax on capital gains
Where an asset is transferred between connected parties, any capital gain is generally computed on the basis of the market value of the asset transferred, rather than the actual consideration received. Similar rules apply when debt, derivatives and intangibles are transferred. Such assets may, however, generally be transferred between UK taxable members of the group on a no gain, no loss basis.
Diverted profits tax
With effect from 1 April 2015, the United Kingdom introduced an entirely new tax – the diverted profits tax (DPT) – which is intended to protect the UK tax base from artificial profit-shifting structures. It has two main targets: where there is a substantial UK operation but sales to UK customers are made by an affiliate outside the United Kingdom in such a way that the UK operation is not a PE of the non-UK affiliate; and where the UK operation makes deductible payments (e.g., royalties for intellectual property (IP)) to a non-UK affiliate, these are taxed at less than 80 per cent of the rate of UK corporation tax and the affiliate has insufficient 'economic substance'. As a deterrent, the rate applicable to the 'diverted' profits is 6 per cent higher than the rate at which corporation tax would otherwise have been payable on the diverted profits.
v Third-party transactions
Because of the SSE for CGT on the disposal of shares in trading companies, sellers of businesses typically prefer to sell shares in the target where the disposal would be expected to result in a gain.
Gains arising from the disposal of shares in a UK company by a non-UK resident are generally not subject to UK corporation tax, subject to certain anti-avoidance rules. There are anti-avoidance rules applying to the disposal of shares in a company that owns UK real estate. Where a non-resident acquires UK real estate through a UK company, such that the main purpose of the acquisition is to realise a gain, an income tax charge may arise in respect of gains made on the disposal of shares in the UK company holding the real estate. The Finance Act 2019 includes new provisions that bring gains made by non-UK residents on the direct or indirect disposal of interests in UK real estate into the charge to corporation tax (for non-resident companies) or CGT (for other non-resident persons). The new regime will, subject to limited exceptions, tax gains arising from disposals of shares in entities that derive at least 75 per cent of their value from UK land and where the person making the disposal holds a substantial indirect interest in the land (generally at least 25 per cent). The reforms will take effect from 6 April 2019.
Separately, special rules apply to disposals by non-residents of shares in companies that hold petroleum production licences for the exploration or exploitation of oil and gas in the United Kingdom or the UK's continental shelf.
It is possible, if certain conditions are met, to effect a disposal of a trade on a tax-exempt basis by hiving the trade into a new company and then selling the shares in the new company. If structured correctly, the SSE is available even though the shares in the new company may not have been in existence for 12 months, and exit charges on the intra-group transfer of the trade may also be avoided.
If SSE is not available, a seller of shares may still be able to roll over or defer payment of any tax liability if the consideration for the sale comprises shares or loan notes issued by the purchaser.
Where a UK company disposes of business assets, tax on any chargeable gains arising from the sale of land, buildings and fixed plants, and machinery can be deferred by claiming business asset rollover relief, provided the proceeds of the sale are reinvested in qualifying assets. The gain is effectively rolled over into the new asset and becomes payable when the replacement asset is sold (unless a further claim for rollover relief is made at that time) or, if the new asset is a depreciating asset, on the earlier of the disposal of that asset and 10 years following its acquisition. A similar rollover regime applies to the disposal of intangible assets.
The United Kingdom's membership of the EU, and therefore the application of the various European 'freedoms', has meant that the UK has generally evolved to treat many cross-border transactions in the same way as wholly domestic transactions. For example:
- most tax grouping rules look to the worldwide ownership to establish group membership, although transactions may only be treated as intra-group if both parties are within the charge to UK tax;
- the dividend exemption applies to dividends received from UK and from non-UK companies; and
- the SSE applies to shares in UK and non-UK companies.
Interest paid to another UK company is not subject to withholding tax, whereas a borrower paying interest to a non-UK company would need to rely on one of the other exemptions from withholding tax listed above or by claiming relief under an applicable tax treaty.
If a company moves its tax residence so that it ceases to be tax-resident in the UK, there is a deemed disposal of all of its assets for tax purposes. The company also must make certain arrangements with HMRC for the payment of taxes before it can migrate.
vi Stamp taxes
There are currently three different stamp taxes in the United Kingdom.
Stamp duty is a tax on certain documents and is usually borne by the purchaser. The main category of charge takes the form of an ad valorem duty, at 0.5 per cent of the consideration, on a transfer on sale of stock or certain securities (or of an interest in a partnership that holds such stock or securities). In practice, stamp duty is generally only payable if the stock or securities are issued by a UK-incorporated company.
Stamp duty reserve tax
Stamp duty reserve tax (SDRT) is charged on an agreement to transfer chargeable securities for money or money's worth (whether or not the agreement is in writing). Subject to some exceptions, 'chargeable securities' are (principally) stocks or shares issued by a company incorporated in the United Kingdom, and units under a UK unit trust scheme. SDRT is imposed at the rate of 0.5 per cent of the amount or value of consideration. Although there is a significant overlap between stamp duty and SDRT, it is usually possible to avoid there being a double charge.
Depositary receipts and clearance
Because shares and securities in depositary receipt form or in a clearance system may be traded free of stamp taxes, the relevant legislation imposes an entry charge at the rate of 1.5 per cent if UK shares are issued or transferred to a depositary receipt issuer or into a clearance service. The decision in HSBC found that in many instances this charge is contrary to EU law and so the 1.5 per cent charge is now often avoided. In the 2017 Autumn Budget, the UK government confirmed that this would remain the case after the United Kingdom leaves the EU.
Stamp duty land tax
Stamp duty land tax (SDLT) is a tax on transactions involving immovable property and is payable by the purchaser. The top rate of SDLT on commercial property is 5 per cent; for residential property, the rate can reach 15 per cent. There is also an SDLT charge on the net present value of rent payable under a new lease.
The United Kingdom has had VAT since becoming a member of the European Economic Community in 1973 and the UK VAT legislation gives effect to the relevant EU Directives. There are three rates of VAT:
- the standard rate of VAT is 20 per cent and applies to any supply of goods or services that is not exempt, zero-rated or subject to the reduced rate of VAT;
- the reduced rate of VAT is 5 per cent (e.g., for domestic fuel); and
- the zero rate of VAT, which covers, for example, books, children's wear and most foodstuffs.
In addition, certain supplies, such as banking and insurance, are exempt from VAT. This means that businesses in these sectors are usually unable to recover much of the VAT that they incur on supplies made to them.
While the fundamental VAT rules within the United Kingdom may not change much upon its exit from the EU (not least because VAT has generated over 20 per cent of all UK tax receipts over the last seven years), transactions in both goods and services between the United Kingdom and the other 27 EU countries are likely to be affected significantly.
III INTERNATIONAL DEVELOPMENTS AND LOCAL RESPONSES
i OECD-G20 BEPS initiative
The United Kingdom has been proactive in its engagement with the BEPS initiative, although it also pre-empted the BEPS project and introduced DPT, with effect from 1 April 2015. In relation to BEPS:
- The UK was the first country to commit formally to implementing the country-by-country template and regulations have been in effect since March 2016.
- The UK has modified its patent box regime in response to Action 5 (Countering Harmful Tax Practices).
- The UK introduced an anti-hybrids regime with effect from 1 January 2017, which to some extent has a broader reach than the BEPS recommendations.
- Legislation to implement Action 4 (Deductibility of Interest) took effect from 1 April 2017.
- The UK has ratified the Multilateral Convention and notified most of its treaties to the OECD.
The United Kingdom has also proposed an extension of royalty-withholding tax, so that it now can in certain circumstances have extraterritorial scope: IP royalties paid out of, for example, the non-UK hub for European sales activities may be treated for the purposes of UK withholding tax as having been paid out of the UK, to the extent it is 'just and reasonable' to do so. A further extension of the UK's royalty tax regime was announced in October 2018, under which any company in a low- or no-tax jurisdiction is itself liable to pay UK income tax at 20 per cent on royalty payments to the extent the royalties are attributable to (eventual) sales to UK customers. This charge applies even if the royalty income is subject to a CFC or GILTI charge further up the recipient's corporate structure, and is backed up by secondary liability provisions, under which the UK tax can be collected from affiliates if the royalty recipient fails to pay.
ii ATAD I and ATAD II
The EU Anti-Tax Avoidance Directive (ATAD) requires EU Member States to adopt specific anti-avoidance provisions to present a united European front against tax avoidance. The United Kingdom has made some amendments to its existing hybrid and CFC rules to ensure they are ATAD compliant.
iii EU proposals on taxation of the digital economy
The United Kingdom has announced that, in the absence of reform of the international rules for profit allocation for tax purposes, it will impose a digital services tax to take effect from April 2020. This would be imposed at the rate of 2 per cent of UK revenues from certain search engines, social media platforms and online marketplaces. The detailed rules are still to be finalised.
iv DAC 6
DAC 6, as EU Council Directive 2011/16/EU is commonly called, imposes disclosure requirements for cross-border arrangements involving at least one EU Member State. DAC 6 requires intermediaries to report to the tax authorities arrangements with aspects characteristic of aggressive tax planning. Intermediaries include those who assist, organise, advise, manage or design a relevant arrangement. The drafting of DAC 6 is sufficiently broad to include arrangements that may not be motivated by tax planning. For this reason, it may raise uncertainties as to whether transactions need to be disclosed. Companies will need to notify from 31 August 2020, but notifications may need to be made in respect of arrangements from 25 June 2018.
v Tax treaties
The United Kingdom has one of the most extensive treaty networks in the world, with over 130 comprehensive income tax treaties currently in force. One of the consequences of an exit from the European Union (assuming the United Kingdom loses the benefit of the Parent-Subsidiary and Interest and Royalties Directives and repeals the UK legislation implementing them) will be greater reliance on the UK's treaty network to provide exemption from withholding taxes. The practical applications of the typical limitations in benefits present in many US treaties may also be affected by the UK leaving the EU.
UK tax treaties generally follow the OECD Model Convention, with some inevitable variation from one treaty to the next. In general, UK tax treaties tend to reduce or eliminate withholding taxes. In the past, the corporate residence tie-break in UK treaties tended to be a place of effective management test, but newer treaties have adopted a mutual agreement tie-break, and the United Kingdom has also opted for this in the multilateral instrument on BEPS.
At the time of writing, Brexit and a change of government remain the biggest uncertainties for the United Kingdom. It seems unlikely, however, that this will cause a fundamental shift in the tax regime for corporates. In particular, the United Kingdom's desire to remain 'open for business' post-Brexit will, if anything, increase, and so it is unlikely that we will see significant changes to this policy of an attractive territorial tax regime balanced with a robust defence of the UK's tax base.
Another significant uncertainty is the EU state aid challenge to the UK's CFC regime for finance companies. This is a very real concern for many UK-based multinationals, and they will be awaiting the EU's decision and any subsequent steps from the UK with great interest.
1 Sara Luder and Dominic Robertson are partners at Slaughter and May.