In June 2007, HMRC released a discussion document titled Taxation of foreign profits of companies'. The proposal covers widespread changes by the government to make the UK more competitive and attract capital investment to boost the economy.
The changes to the taxation of foreign profits have been driven by pressure from business concerning the complexity of the UK tax system. The other main reason of the reform is the uncertainty as to whether the UK's current regime is consistent with EU law, owing to the recent rulings of the European Court of Justice (ECJ) in current cases (Anon 2007).
Current UK Tax System
Currently, UK companies receiving dividends from other UK companies suffer no tax. Dividends from foreign companies on the other hand are currently subject to tax. The UK maintains a firm distinction between foreign direct investment (FDI) and portfolio investment. FDI (active) occurs when shareholdings greater than 10% are held, whilst, portfolio (passive) income is the term used when shareholdings are less than 10%. The UK allows double tax relief (DTR) for both underlying tax (foreign corporation tax) and withholding tax (WHT) on FDI dividends, however, passive income only gains WHT relief not underlying tax (ULT) (Miller & Oats 2006).
Until the Finance Act 2000 the UK operated a credit system with no onshore pooling, known as the strict source by source' method. The Act was intended to modernise the UK method and make it a more attractive location for holding companies. However, the changes were met with fierce criticism as advantages of offshore pooling were removed without new provisions for onshore pooling being introduced. Eventually, UK government bowed to pressure and reluctantly introduced a limited onshore pooling system (Miller & Oats 2006).
Limited Onshore Pooling
Normal onshore pooling allows high foreign tax credits to be used against tax liability from other sources of foreign income. The UK's method of limited onshore pooling rules that tax relief cannot exceed 45% of the gross foreign income (before WHT and ULT, thus, protecting the UK from having to give DTR for unreasonably high effective rates of foreign tax. (Miller & Oats 2006)
The UK's tax regime interacts with controlled foreign companies (CFC) legislation to discourage UK groups having intermediate holding companies in other countries.
Controlled Foreign Company Legislation
The UK's existing CFC (anti-haven) legislation prevents companies from avoiding tax by accumulating funds in subsidiaries with low tax rates (tax havens) (Anon 2007). It uses an all-or-nothing approach, where profits are either exempt or taxed in their entirety. According to the HMRC (2006) a company is defined as a CFC if it matches any of the following criteria: Resident outside the United Kingdom,
Controlled by persons resident in the United Kingdom
Subject to a level of taxation less than 75 per cent of the level that it would have paid had it been resident in the UK
The UK mostly targets portfolio income as it is easier to switch to tax havens often requiring only paper transactions. Examples of these include interest, dividends and royalties (easy to sell patent to subsidiary in low tax country), otherwise known as mobile income. The reason for this is that if a company has gone to the trouble of purchasing a factory, assembling a workforce and establishing trade it is unlikely it has done so purely for tax avoidance reasons (Miller & Oats 2006).
What has influenced the proposals?
Although downplayed in the report, major influences of the reform are the rulings by the European Court of Justice (ECJ) on two cases in 2006. The Cadbury Schweppes case (13 September 2006) occurred when the UK sought to apply CFC rules (Ireland CT of 10% less than 75% of UK tax (30%)) against two subsidiaries of Cadbury Schweppes located in Ireland. Cadbury...