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Application of the CFC regime to IP

The previous Government's 2007 proposals for reform of the CFC regime foundered for a variety of reasons.  One of the difficulties was resolving how the regime should apply to CFCs with IP income.  The Government and HMRC took the view that the CFC regime should be a tool to deter the transfer of IP from the UK, whilst taxpayers and advisers generally disagreed with this approach.

IP under the proposed new regime

Three territorial business exemptions (TBE) are proposed in the new regime.  They effectively replace the existing exempt activities test.  The TBEs exemptions are for (i) a CFC with a low profit rate; (ii) a CFC which carries on a manufacturing trade and (iii) a CFC which carries on commercial activities.  Each TBE is subject to a local management condition. 

Under the proposed new regime, only CFCs with "low risk" IP activities are intended to benefit from the TBEs.  Income from foreign IP with no UK connection, local IP integral to a CFC's genuine overseas manufacturing trade and IP royalty income that is incidental or ancillary to a CFC's trade should all fall into this category.

The TBEs will not, however, apply to CFCs which carry on "high risk" IP activities.  These CFCs will need to look to the last resort exemption, the general purpose exemption (GPE), which replaces the existing motive test.  A CFC which exploits IP will be regarded as carrying on high risk activities if it acquired the IP from the UK (within a specified period) or if more than 50% of its business expenditure is paid to UK related parties or more than 20% of its gross income comes from the UK.  The TBEs will also not apply if a CFC is a passive owner of IP (ie an IP moneybox). 

The GPE will exempt a CFC's profits to the extent that they are "commensurate with" the CFC's own activities and have not been diverted from the UK for tax purposes.  There is no default presumption that profits received by a CFC would have arisen in the UK if the CFC did not exist. 

In testing whether this exemption applies, the first step is to identify any assets and risks which the CFC would "more likely than not" own and bear under "uncontrolled conditions".  It seems that a comparison will then be made between the situation that would have obtained under uncontrolled conditions and the actual situation.  The effect of this rule is shown by an example in the consultation document: if a transfer of IP from the UK has taken place which would not have taken place had the CFC been uncontrolled, the profits from exploitation of that IP (which would otherwise have remained in the UK) are to be treated as having been artificially diverted from the UK, even if the transfer was priced in accordance with OECD transfer pricing guidelines.  The CFC charge would be on the diverted profits less any profits commensurate with the CFC's activities. 

The consultation document contains a list of factors to determine whether a transfer of IP is tax driven (with a shorter list of factors which will suggest that a transfer is not tax driven).  These factors will also be helpful for judging the extent to which profits arise to a CFC as a result of its actual activities (they include issues such as the relative seniority and expertise of UK IP staff as compared to that of the CFC staff and where IP maintenance functions are performed).  

The GPE's "more likely than not" approach imports transfer pricing type considerations, and the "commensurate with profits" approach has echoes of the much criticised EEA business establishment exemption which was introduced as a sticking plaster to make the existing regime EU compliant.  That this exemption is not going to be easy to apply is hinted at by the fact that detailed guidance will be published and there will be a non-statutory advance clearance procedure. 

Despite representations to the contrary, the Government continues to believe that the CFC regime should apply to profits from IP which has been transferred from the UK to a CFC even though the capital gains or transfer pricing regimes may apply to attribute an arm's length price if the transfer did not take place at full value.  The potential for unfairness is recognized in the consultation document as comments are sought on options for eliminating any double taxation. 

The Government says that its CFC proposals are part of its aim of moving towards a more territorial tax system.  But applying the CFC regime to profits from IP which has been transferred out of the UK on an arm's length basis (or has been taxed as if transferred out at an arm's length price) is not consistent with this.  The consultation document effectively acknowledges as much when it asks whether the CFC charge on profits from transferred IP should taper because, even if the transfer of IP from the UK was tax driven, in time the proportion of profits artificially diverted from the UK will reduce.

For IP: a step forward or a step back?

On IP, the latest CFC proposals are far from finalised; comments are sought on some key issues.

However, the broad approach is fairly clear: the Government is planning to use the CFC regime to counter the transfer of IP from the UK - even where it is transferred out on arm's length terms.   This is a high risk strategy.  If income from all IP that starts off in the UK is forever within the UK tax net, surely multinational groups will question whether it makes sense to develop IP here.   If the proposed new patent box were very attractive, this might not be a problem.  But the patent box proposals are too limited to neutralise the negative impact of the CFC proposals.  The danger is that the UK is pushing IP development offshore. 

There was no suggestion at last week's open event on the CFC proposals hosted by The Treasury and HMRC that Government is minded to change its proposals so far as they relate to transferred IP.  There are bound to be more representations on this issue in forthcoming months.  We must hope that Government listens and engages in some joined-up thinking in this area. 

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