The UK’s CFC Rules

The UK’s Controlled Foreign Companies (CFC) rules are designed to prevent UK taxpayers from avoiding UK tax by shifting profits to low-tax jurisdictions. These rules apply to companies that are controlled by UK residents and derive their income from activities that are not carried on in the UK.

A controlled foreign company (CFC) is a company which is resident outside the UK, but controlled by UK residents (along with any relevant overseas associated enterprises). “Control” for these purposes is shareholding control – which is different from central management and control.  The profits of a CFC are attributed to UK companies in accordance with their interest in the CFC (whether direct or indirect). These profits are then subject to an amount of tax equivalent to corporation tax, with a credit for a proportion of any overseas tax paid by the subsidiary.

An attribution is only required if the UK company has an interest of at least 25% in the subsidiary.

Special rules apply to offshore funds, insurance companies and companies which hold shares in a CFC as part of their trading stock.

The rules are complex and this article outlines the main provisions only.

Key Aspects of the CFC Rules:

• Control: A company is considered a CFC if UK residents control it. Control is generally defined as owning more than 50% of the company’s voting shares or having the power to influence its management.
• Foreign Activities: The CFC must derive its income from activities that are not carried on in the UK. This includes activities such as trading, manufacturing, or providing services.
• Low-Tax Jurisdiction: The CFC must be located in a jurisdiction with a corporate tax rate below 50% of the UK’s corporate tax rate.
• Substantial Activities: The CFC must not have a substantial business presence in the low-tax jurisdiction. This means that the company must not be actively involved in the management and control of its own business operations.

If a CFC meets these criteria, its income will be subject to UK tax, regardless of whether the income is distributed to the UK shareholders.

Controlled foreign company rules

The controlled foreign companies rules only apply if profits pass through an initial ‘gateway’, which means that an attribution of profits will only be required if there are arrangements to reduce or eliminate UK tax, and the profits of the subsidiary are increased as a result.

Further gateways then apply depending on the nature of the underlying profits.  For trading profits, there is no attribution of profits required if:

• No assets or risks are managed by connected parties in the UK;
• Any assets or risks which are managed by connected parties in the UK could be replaced by unconnected parties; or
• The subsidiary holds assets or risks for bona fide commercial purposes, and not for the purpose of avoiding tax.

Finance profits (both trading and non-trading) and insurance profits are subject to different gateways.

Controlled foreign companies exemptions

In addition to the gateway, there are a number of exemptions:

• Low profits: This exemption applies where the accounting profits of the subsidiary are not more than £50,000, or not more than £500,000 provided non-trading income is not more than £50,000.
• Low profit margin: This exemption applies where accounting profits are less than 10% of operating expenditure. This exemption will typically apply to low-risk overseas subsidiaries, such as those providing services to other group companies which are charged on a cost-plus basis.
• Excluded territories: This exemption applies where the CFC is resident in one of the excluded territories, which are specified in regulations. In addition, specified income must not be more than the higher of 10% of profits or £50,000.
• High tax: The exemption applies if the local tax paid is at least 75% of the UK corporation tax which would have been paid on the same profits.
• Exempt period: A CFC is exempt for the 12 months after it first becomes a CFC, for example if it is acquired by a UK company from a third party.

Attributable profits

Where a CFC does not satisfy an exemption, the profits which pass through the relevant gateway are attributed to UK companies in accordance with their interest in the CFC.

Attributable trading profits are broadly those which arise from a ‘significant people function’ (SPF) or a ‘key entrepreneurial risk-taking function’ which is located in the UK. The profits are calculated in accordance with the Organisation for Economic Co-operation and Development’s 2010 Report on the Attribution of Profits to Permanent Establishments.

Within the gateways, there are exclusions for certain types of income, for example:

• All trading profits are excluded from an attribution, provided certain conditions are satisfied. For example, the CFC must have local premises and derive no more than 20% of its income or management cost from UK residents,
• Non-trading finance profits (for example, interest income) are only attributable if they arise from funds provided from the UK or certain loans to UK connected companies,
• Where the exclusion for non-trading finance profits does not apply, only 25% of any non-trading finance profits are attributed, provided certain conditions are satisfied,
• Property income is excluded entirely from the CFC rules.

The CFC rules are complex and can have significant implications for UK taxpayers with interests in foreign companies. It’s essential to seek professional advice from a tax advisor to understand how the rules apply to your specific circumstances.