The Corporate Tax Planning Law Review: United Kingdom
The United Kingdom has for several 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 UK 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.
The UK left the EU on 31 January 2020 and is currently in a transition period that expires on 31 December 2020. The UK'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 tax base.
Similarly to many other countries, the UK government has announced fiscal measures to help businesses deal with the impact of covid-19. Measures include deferment of VAT, holidays from business rates (a form of property tax) and, in order to reduce redundancies, the option to claim 80 per cent of the wage costs of employees placed on leave (and associated employer social security contributions). At the time of writing, we await the detail of many of these measures.
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 transparent for tax purposes. It has proved a popular structure for professional services firms. There is no equivalent of the US 'check the box' rules.
ii Corporation tax
UK tax-resident companies are subject to corporation tax on their worldwide profits. A company incorporated in the UK 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. Non-UK incorporated companies are treated as UK tax-resident if their central management and control is in the UK.
Non-UK resident companies pay corporation tax on profits arising from a trade carried on through a UK permanent establishment (PE). 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 UK.
Since 2016, a non-resident company without a UK PE 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. Since 2016, banks have incurred an 8 per cent surcharge on top of the headline rate. 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 largely 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. 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.
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 dividend exemption and the SSE, alongside the lack of withholding tax on dividends and the UK's extensive tax treaty network, have made the UK a popular jurisdiction for group holding companies.
The UK has broadly 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 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.
Subject to tax treaties and double tax relief, the UK normally 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 this 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 electing company.
The UK's controlled foreign companies (CFC) regime, which taxes certain undistributed profits of non-UK subsidiaries of a UK company (at the corporation 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, their intention is to target 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 UK'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, stock market listing, 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 profits 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 UK 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) was done outside the UK. In light of BEPS Action 5, although IP that was already in the patent box on 30 June 2016 continues to benefit from the old rules for five years, other patent income 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.
After the end of the Brexit transition period, a further relaxation of the new rules may be possible: departure from the EU might enable the UK to treat all R&D outsourcing within the UK as 'good' expenditure, without fear of violating EU Treaty freedoms.
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 UK 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), or flow-through distributions of interest paid by a listed investment trust.
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.
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.
If the lender is a related party or the borrowing is guaranteed by a related party, arm's-length transfer pricing rules will be applied to determine the amount and rate at which the borrower could have borrowed from an independent lender. The UK does not have any 'safe harbours' for this purpose.
In line with BEPS Action 4, the UK 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 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 debt cap that provides that a group's net UK interest deductions cannot exceed the global net third-party interest expense of the group.
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 if 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. 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 UK through a PE and is subject to UK tax on the interest;
- the interest is paid on a quoted Eurobond (i.e., debt 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 has the effect of imposing 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. Prompted by a challenge from the EU under the state aid regime, from 1 January 2019 the UK amended the FCPE rules to exclude profits attributable to significant people functions within the UK. The European Commission's challenge of the pre-2019 FCPE regime is currently being appealed by the UK Government and affected groups.
iii Tax groups
While the UK 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 – discussed below) may be surrendered from one UK resident group company to another. Losses can also be surrendered by or to a UK PE of a non-UK group company. A UK PE of an overseas company can only surrender those losses if (broadly) they are not relievable (other than against dual inclusion profits) 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 dual inclusion profits) 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 in the EU27, even if they are not resident or trading in the UK. However, the applicable conditions are extremely 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 elect for a gain (or loss) on a disposal made by one capital gains group member to be deemed to be realised 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 UK 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 degrouping charge may arise. This charge will deem the leaving company to have disposed of and immediately reacquired those assets, at market value, immediately after their acquisition. However, in some cases, the degrouping 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).
A CGT group consists of a principal company and its 75 per cent subsidiaries and their 75 per cent subsidiaries (and so on) provided that the principal company has at least 51 per cent economic ownership of all the companies.
Stamp duties grouping rules
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 UK and they are under common control. Since 1 November 2019, VAT grouping is also possible between individuals and partnerships who have a business establishment in the UK and any UK body corporate they control.
iv Intra-group transactions
The UK's transfer pricing rules apply to both international and domestic transactions between associated companies. Two companies will be associated if they satisfy the 'participation condition'. This 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).
Usually, transfer pricing adjustments may only be made where they would increase UK taxable profits. However, where transfer pricing adjustments are made to a UK–UK transaction, the 'other side' of the transaction may make a compensating adjustment to reduce its taxable profits correspondingly.
Diverted profits tax
In 2015, the UK introduced the diverted profits tax (DPT) – which is intended to protect the UK tax base from artificial profit-shifting. It has two main targets: where there is a substantial UK operation but sales to UK customers are made by a non-UK affiliate in such a way that the UK operation is not a PE of that non-UK affiliate; and where the UK operation makes deductible payments (e.g., royalties for IP) to a non-UK affiliate and these are taxed at less than 80 per cent of the rate of UK corporation tax. As a deterrent, the DPT rate is 25 per cent, compared to the headline corporation tax rate of 19 per cent. In practice, most DPT cases are resolved through transfer pricing adjustments, rather than through a DPT charge.
v Third-party transactions
Because of the SSE on the disposal of shares in trading companies, sellers of businesses typically prefer to sell shares in the target rather than selling assets.
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. In particular, since 2019, gains made by non-UK residents on the direct or indirect disposal of interests in UK real estate are subject to tax. Subject to limited exceptions, gains arising from disposals of shares in entities that derive at least 75 per cent of their value from UK land, where the person making the disposal holds a substantial indirect interest in the land (generally at least 25 per cent), are taxed.
Separately, special rules apply to disposals by non-residents of shares in companies that hold petroleum production licences for the UK North Sea.
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 cancelled. Hive-downs of capital assets into a subsidiary followed by a sale of that subsidiary on a tax-exempt basis have been possible since 2011. Recently a similar tax treatment has been extended to hive-downs of IP. While the rules for IP work slightly differently (and can operate less generously) this change has been welcome, and there has been an increase in M&A transactions involving a preliminary hive-down of IP.
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 plant, and machinery can be deferred by claiming business asset rollover relief, provided the proceeds of the sale are reinvested in qualifying assets.
The UK's historic membership of the EU, and therefore the application of the European 'freedoms', has meant that the UK now treats many cross-border transactions in the same way as wholly domestic transactions. For example:
- most tax grouping rules look to 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;
- dividend exemption applies to dividends received from UK and from non-UK companies; and
- 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 claim relief under a tax treaty.
If a company moves its tax residence out of the UK, there is a deemed disposal of all of its assets. The company also must make arrangements with HMRC for the post-migration payment of taxes.
vi Stamp taxes
Stamp duty is a tax on certain documents and is usually borne by the purchaser. The main charge is levied 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 holding such stock or securities). In practice, stamp duty is generally payable only 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. Subject to some exceptions, 'chargeable securities' are stocks or shares issued by a company incorporated in the UK, and units in a UK unit trust scheme. SDRT is imposed at the rate of 0.5 per cent of the 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 legislation imposes an entry charge at the rate of 1.5 per cent on issues or transfers 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 rarely chargeable. Absent an express change in law, this should remain the position following Brexit (even after the end of the 'transition period').
Stamp duty land tax
Stamp duty land tax (SDLT) is a tax on transactions involving land 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. Similar tax rules apply in Scotland and Wales.
The UK has had VAT since 1973, in line with EU law. There are three rates of VAT:
- the standard rate is 20 per cent;
- the reduced rate is 5 per cent (e.g., for domestic fuel); and
- the zero rate covers, for example, books, children's wear and most food.
Additionally, 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.
The UK will leave the EU VAT regime on 31 December 2020. While the fundamental VAT rules within the UK may not change much immediately (not least because VAT generates over 20 per cent of all UK tax receipts), transactions in both goods and services between the UK and the EU27 are likely to be affected significantly.
International developments and local responses
i OECD-G20 BEPS initiative
The UK has enthusiastically applied the BEPS initiative, although it also pre-empted the BEPS project and introduced DPT in 2015. In relation to BEPS, the UK:
- was the first country to commit formally to implementing the country-by-country template;
- modified its patent box regime in response to Action 5 (Countering Harmful Tax Practices);
- introduced an anti-hybrids regime from 2017, which to some extent has a broader reach than the BEPS recommendations;
- enacted legislation to implement Action 4 (Deductibility of Interest); and
- ratified the Multilateral Instrument and notified most of its treaties to the OECD.
The UK has also extended its royalty tax regime, from 2019, such that any company in a low- or no-tax jurisdiction is itself liable to pay UK income tax at 20 per cent on royalties to the extent they are attributable to (eventual) sales to UK customers. This charge applies even if the royalty income is subject to a CFC or GILTI charge, and is supported by secondary liability provisions, under which the UK tax can be collected from affiliates if the royalty recipient fails to pay.
ii EU proposals on taxation of the digital economy
The UK has imposed a digital services tax from April 2020. This is imposed at the rate of 2 per cent of UK revenues from certain search engines, social media platforms and online marketplaces. The UK regards the rules as an interim measure, pending reform to the international rules on profit allocation.
iii Tax treaties
The UK has one of the most extensive treaty networks in the world, with over 130 comprehensive treaties in force. One of the consequences of Brexit (assuming the UK loses the benefit of the Parent–Subsidiary and Interest and Royalties Directives) will be greater reliance on the UK's treaty network to provide exemption from withholding taxes. The practical applications of the typical limitation on benefit clauses present in many US treaties may also be affected.
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. The UK has also opted for this in the OECD multilateral instrument.
iv 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 front against tax avoidance. The UK has made some amendments to its existing anti-hybrids and CFC rules to ensure they are ATAD compliant.
The DAC6 Directive imposes disclosure requirements for cross-border arrangements involving at least one EU Member State. In January 2020, the UK implemented DAC6 into domestic law, with effect from 1 July 2020. The UK legislation largely follows DAC6 and requires intermediaries to report arrangements with characteristics of higher risk tax planning, although the drafting is sufficiently broad to include some arrangements that are not motivated by tax planning. For this reason, it may raise uncertainties as to whether transactions need to be disclosed, and HMRC is expected to produce guidance for compliance before the rules take effect. Companies will need to notify from 1 July 2020, but notifications will need to be made in respect of arrangements from 25 June 2018.
The UK tax authorities take a robust approach where they perceive aggressive tax planning and recently have a strong track record in the courts. Nonetheless, some taxpayers have enjoyed success too.
i Perceived abuses
Taxpayers should take care that all potential anti-avoidance rules are considered before entering into a transaction even where HMRC have been alerted to, and even cleared, that transaction. In Oxford Instruments,2 the taxpayer restructured existing debt into a variation of a 'tower structure' (this had been a common method for funding US subgroups before the introduction of the hybrid rules). The taxpayer obtained clearance from HMRC on the application of the UK's anti-arbitrage rules and, in so doing, agreed with HMRC a level of interest expense disallowance to limit any potential UK tax advantage. HMRC then challenged the deductibility of interest expense on the restructured debt under the 'unallowable purpose' rule (a separate anti-avoidance rule). The anti-arbitrage and unallowable purpose rules both contained avoidance 'purpose tests' but they tested the purpose of different things and so HMRC won notwithstanding the pre-existing clearance.
Separately, we may be starting to see a trend towards HMRC willingness to litigate transfer pricing cases, which traditionally have been settled rather than litigated. For example, in IBRC v. HMRC3 two Irish banks operated in the UK through PEs and so were subject to UK corporation tax on such profits as were attributable to their PEs. The case concerned what was, and was not, properly attributable (to be determined as if the PEs were separate enterprises engaged in similar activities at arm's length with their head office).
ii Recent successful tax-efficient transactions
The Upper Tribunal found for the taxpayers in Development Securities,4 which concerned a scheme to enable the taxpayer group to access latent capital losses. It involved a transfer of assets to companies in Jersey, and it was critical that those companies were tax resident there. Rather surprisingly, HMRC challenged the scheme only on residence grounds. At first instance, the Jersey companies were found to have their central management and control in the UK: while their directors met in Jersey, they followed the instructions of their UK parent company (therefore 'abdicating responsibility'). This was reversed on appeal, where it was clarified that acting in line with shareholders' wishes is not enough to bring a company onshore if the directors properly make their decisions abroad. If this is not reversed on appeal, this is a welcome decision for groups using non-UK SPVs that are wholly-owned by UK companies.
The Court of Appeal in Smith & Nephew5 considered a group restructuring to eliminate some intra-group receivables. Eliminating the receivables, of itself, did not have a tax avoidance purpose. However, the restructuring was designed to trigger a change in the taxpayers' functional currencies which, in combination with the taxpayers' chosen accounting method, triggered tax deductible exchange losses. HMRC unsuccessfully argued that the exchange losses did not reflect 'real world' loss and sought to deny deductibility under a specific rule regarding whether the taxpayer's accounts 'fairly represent' the profits and losses from the debt. That rule has since been repealed, but the case nonetheless shows there can be limits to when the courts will override the accounts for tax purposes.
Outlook and conclusions
Alongside the impact of the covid-19 outbreak, Brexit continues to be the biggest uncertainty for the UK. Although the UK government has indicated that it does not anticipate long-term alignment with EU rules, it seems unlikely that there will be a fundamental shift in the tax regime for corporates after the end of the Brexit transition period. Another significant uncertainty is the outcome of the OECD's task force on the digital economy, which could lead to a shift away from the arm's-length principle (and, in the absence of international agreement, is likely to lead to a number of unilateral measures such as the UK digital services tax).