Controlled Foreign Companies (CFC) rules are applicable to entities resident in foreign jurisdictions and controlled by UK residents. In some cases, CFC rules are also applicable to permanent establishments of UK resident companies abroad.
As provided by subsection 3 of Section 371AA of Taxation (International and Other Provisions Act) 2010 any person (natural or legal) resident in the UK may be controlling person of a CFC.
Nevertheless, the main aim of CFC rules declared in the UK is countering tax evasion in form of transferring of profits abroad by additional charge of tax on such profits. This aim is concerns corporation tax only, the payers of which are legal entities. The CFC charge may be applied only to legal entities in situations prescribed by CFC rules.
Thus, natural persons resident in the UK formally may be treated as controlling persons of CFCs because the definition of control over CFC provide that any person resident in the UK may exercise it, however this circumstance will not have any legal effect on natural persons.
The abovementioned fact may be proved by absence of separate CFC notification forms, as well as by absence of any CFC section in income tax return of natural persons. Also, the obligation to pay CFC charge is not established by legal acts regulating taxation of natural persons, mainly by current version of Income Tax Act 2007.
This means that only legal entities resident in the UK may be controlling persons of the CFC for purposes of corporation tax. Legal entity is resident in the UK if it was incorporated in the UK or if the management and control over it is exercised from the territory of the UK. It is necessary to take into account that English Limited Partnerships are out of scope of CFC regime because they are not considered to be legal entities and independent taxpayers.
Definition of control
The definition of control established by CFC rules in the UK provides that such control may be exercised in the following manners:
- Legally – the direct or indirect ownership of shares, interest in capital or voting rights or other similar rights which enable a person to manage CFC’s activity in accordance with its intentions. Said similar rights may be established by memorandum and articles of association of CFC or by other documents even not required for issue by foreign law.
Legal control can be exercised by one or by several UK resident persons jointly, which are not necessarily affiliates in relation to each other. The definitive matter is ownership of rights which enable a person to control the CFC in accordance with its intentions, and in case such ownership is joint all of joint owners are considered to be exercising legal control over the CFC.
If the legal control over the CFC is being exercised jointly by UK residents and non-residents, UK resident must own not less than 40% of interest, shares or voting rights of CFC in order to obtain a status of controlling person if non-residents own from 40% to 55% of the same interest, shares or voting rights of CFC.
The abovementioned “40% rule” is applicable only if a joint control over CFC by both UK residents and non-residents takes place. The particular numeric expression for threshold of ownership of interest, shares or voting rights is not applicable in other cases.
In contrast with some other jurisdictions where such numeric expression is established by law for purposes of detection of CFC’s controlling person status, most often as 25%, in the UK only the ability of a person to control the CFC in accordance with its intentions is definitive and is to be assessed in each case individually without using of any number or proportion.
It is important that the tax for CFC’s profits must be paid only by those controlling persons which are entitled for at least 25% of CFC’s profits, and if the ownership is less, the obligation to pay tax does not arise even if the person meets all other criteria of control over CFC.
- Economically – direct or indirect ownership of rights to receive the most of profits of CFC in case of
- Sale of all shares of CFC;
- Distribution of all CFC’s profits;
- Disposal of company’s assets, including in case of liquidation or in other cases.
The indirect receipt of profits for purposes of determination of economic control may take place in situations when UK resident person receives money not from the CFC itself, but from other non-resident companies which form the same group and pay the money from one to another.
The profits may also take a form of financial benefit. In particular, such benefit arises when one company sells the shares of other company of a same group and set the proceeds of sale off its debt to a controlling person.
In certain cases, the economic control rules are not applicable to organizations which carry on banking business: their right to receive profits from sale of subsidiaries’ assets in case of default on a loan is out of scope of economic control.
In line with legal control, the economic control may be exercised by several UK residents jointly, so that each of them will be recognized as controlling person of a CFC in circumstances indicating the economic control over the CFC.
The “40% rule” is applicable for joint economic control over the CFC by UK residents and non-residents to the same extent as for joint legal control: the resident is deemed to be the controlling person of the CFC if it owns not less than 40% of economic rights when the ownership of same rights by non-residents is from 40% to 55%.
- Control of accounting – if a foreign entity form the same group of companies together with UK resident entity and this group issue consolidated accounts, the foreign entity will be a CFC and the UK entity will be a controlling person.
This rule is applicable when not less than 50% of foreign subsidiaries’ profits are to be distributed to parent company resident in the UK. At the same time, the fact of issue of consolidated accounts by the group of companies is not taken into consideration: the essential matter is the relation of parent company and subsidiary between the CFC and its controlling person, if the obligation to issue consolidated accounts could be imposed on a group in accordance with UK accounting standards.
For example, the UK accounting standards provide that small groups of companies are exempt from duty to consolidate accounts. However, when foreign subsidiary of UK company is included in such small group even hypothetical (not real) applicability of the requirement to consolidate group’s accounts means that UK company is exercising control of accounting of a CFC.
CFC taxation exemptions
Income of a controlling person in a form of undistributed profits of CFC is not subject to taxation in the UK in the following cases:
- Exempt period. During the first 12 months from the date of starting or resumption of control over the CFC UK resident is not subject to CFC charge. The controlling person is entitled to use exempt period if CFC’s accounting period ends before the last date of controlling person’s accounting period chosen as an exempt.
The second condition necessary to apply exempt period exemption is that CFC must have some other exemptions (see below) in the accounting period which follows the exempt one. If this condition is not met, CFC charge may be applied to profits of the first accounting period thereafter.
- Excluded territories. If CFC is a tax resident in a country for which English law prescribes CFC regime exemption, then the profits of CFC do not increase tax base of the controlling person resident in the UK. As of June 2020 the list of exempt jurisdictions consist of 103 foreign states and territories, including the majority of EU Member States (20 out of 27), and such countries as Russia, Belarus, Ukraine, Panama, Belize, USA, China, Canada, Turkey.
At the same time, the following jurisdictions are not included in the list: Bulgaria, Cyprus, Estonia, Hungary, Ireland, Latvia and Lithuania from the EU; offshores like British Virgin Islands, Cayman Islands, Seychelles, Saint Kitts and Nevis, Mauritius; other jurisdictions like Hong Kong, Singapore, Liechtenstein, Switzerland.
- Low CFC profits. If profits of a CFC do not exceed 500 000 GBP in its accounting period, and not more than 50 000 GBP out of which proceed from non-trading financial activities (see section 2 of the table “CFC charge” below), then such profits are not taxable in the UK in tax base of controlling person resident in the UK.
- Low CFC profit margin. If profits of CFC according to its financial statements do not exceed 10 per cent of its operational costs, they are not subject to taxation in the UK.
- Corporation tax rate of CFC. This exemption is applicable when CFC’s profits are taxable in the jurisdiction of its tax residency at a rate not less than 75 per cent of UK corporation tax. Provided that current corporation tax rate in the UK is 19%, the profits of CFC must be taxed at a rate not less than 14, 25% in its jurisdiction in order to be exempt from taxation in the UK.
The abovementioned exemptions are applicable to profits of any type if all necessary criteria are met. Besides it, there is one special exemption in addition to those general exemptions for those profits of CFC which were received as a result of granting qualified loans to affiliates.
The loan is deemed to be qualified if granted to an affiliate of CFC using the profits from non-trading financial activities (see section 2 of the table “CFC charge” below), and the CFC has premises (office) in its jurisdiction of tax residency which in fact is used to conduct business activity there.
Most often, the 75% of profits received as a result of granting qualified loans are subject to exemption from tax in the UK, however full exemption of such profits is also possible in some cases. In particular, the profits of CFC from qualified loans are fully exempt if received in a jurisdiction of tax residency of the borrower as a result of additional issue of shares of holding company for group financing purposes.
If profits of CFC do not fall within any exemption criteria, their parts received from particular types of business activity of the CFC must be added to the tax base of controlling person in the UK. This system is named ‘CFC charge gateway’ because profits are filtered by types of business activity for purposes of taxation.
There are 5 CFC charge gateways passing of which makes some profits of CFC taxable in the UK:
1. Profits attributable to UK activities
Reference is made to the situations when profits received as a result of using the assets or risks are artificially transferred to CFC in order to reduce the tax in the UK, however such assets or risks are in fact managed by controlling person mainly from the territory of the UK.
This general rule has several exceptions:
2. Non-trading finance profits
The following operations of CFC may be qualified as non-trading financial operations:
If profits from such non-trading finance transactions do not exceed 5% of all profits of CFC in its accounting period, they are not included in the tax base of the controlling person in the UK.
3. Trading finance profits
If the abovementioned financial operations form the main business activity of a CFC and the profits received by it are result of UK resident’s contribution to CFC capital, such financial operations are recognized as trading ones. This will lead to apportionment of CFC’s trading finance profits to tax base of UK resident controlling person who made a capital contribution.
4. Captive insurance
CFC charge is levied in the UK if the main business activity of the CFC during its accounting period is the provision of insurance services to:
5. Solo consolidation
This gateway is designed for banks and other financial institutions in the UK whose activity is subject to regulation by Prudential Regulation Authority. Profits of CFC which are subsidiaries of banks or financial institutions are subject to CFC charge in the UK.
Thus, it is necessary to complete the following steps in order to know whether UK resident must pay CFC charge on undistributed profits of a CFC:
- Check if any of exemptions described in previous section are applicable to CFC.
- Determine whether the CFC has received chargeable profits in its accounting period. The chargeable profits are deemed to be ones subject to taxation in tax residency jurisdiction of the CFC and passing through CFC charge gateway which lead to its inclusion to tax base of controlling person.
- Calculate tax payable by CFC in its jurisdiction to deduct it from the amounts of CFC’s profits subject to apportionment to tax base of controlling persons resident in the UK.
- To include amounts which pass the CFC charge gateways to the tax base of controlling persons in respective proportions (e.g. according to their share in CFC’s capital) and fill them in the correspondent section of corporation tax return. The corporation tax return must be filed with HMRC in 12 months after the end of accounting period of controlling person.
- Determine the status of controlling person as a taxpayer if he owns not less than 25% of rights on CFC’s profits.
- Calculation and payment of CFC charge at a standard tax rate 19%.
Liability for non-compliance with CFC rules
As it was mentioned previously, the obligations under UK CFC rules in fact are imposed only on legal entities which are controlling persons of CFCs. The main obligations are filling in the CFC section of corporation tax return and payment of CFC charge if it arises.
Filing of tax return with HMRC with false information about the CFC (if not corrected in reasonable term) will lead to imposition of a default penalty in the amount of 30% of potential damage to UK budget caused by provision of false information. Usually, the potential damage to UK budget is represented as unpaid amounts of tax.
However, the amount of penalty may be increased based on guilt of taxpayer, so that it will be 70% for deliberate but not concealed action and 100% for deliberate and concealed action, and also depends on foreign jurisdiction to which the contravention relates. The maximum amount of penalty is 200% of the potential damage to UK budget.
Commonly, the penalty for provision of false information in tax return is imposed on a legal entity itself which is controlling person of a CFC; but in some cases when officer of a company (director, manager, secretary) acts deliberately, the penalty may be imposed on him/her wholly or partially.
The standard time limit to arrange an assessment and impose a penalty for infringement is 4 years after the end of accounting period of controlling person, but may be extended up to 6 or 20 years depending on different circumstances.