Introduction

Although the UK has not historically set out to compete with countries such as Holland and Denmark, which set their cap at international businesses with extremely permissive taxation structures, reckoning that the gain from extra employment and trade would outweigh the loss of tax, the UK has nonetheless been an acceptable place in which to have your headquarters, if that was where it needed to be.

Thus, large international companies with listings on the London Stock Market, or which had British origins, could put up with being based in the UK even if it wasn't ideal from a tax point of view, because the rules for the treatment of overseas profits were reasonably flexible. In particular, it was possible to 'mix' highly-taxed profits from some overseas markets with lowly-taxed profits from other markets, generating a blended rate which would offset the maximum amount of mainstream UK corporation tax and reduce double taxation. It was also possible to retain profits in overseas companies in many circumstances without incurring UK taxation.

These threats are not thought to be serious, yet, but pressure from business has nonetheless caused the Treasury to back off some of the measures it had originally proposed. The ongoing discussion between Government and the tax profession, in effect representing international business, has now moved up from worries about the detail of particular taxes to consider the overall subject of the UK's international fiscal competitiveness.

International Tax Issues

There are three main issues which dominate the international tax competitiveness argument:

1. Double Tax Avoidance

This is mostly the 'mixing' question. The Finance Act 2000, after changes made in response to pressure from business, allowed some types of 'onshore mixing', that is, companies could mix highly-taxed and low-taxed income streams in the UK, but there are so many limitations ('anti-avoidance' provisions) that what started as a good idea, to allow companies to do at home what they had previously had to do in offshore or tax-privileged overseas countries such as the Netherlands, became an expensive straight-jacket. For example, the mixing privilege only extended to the first layer of subsidiaries, unless the intermediate company was in the UK, which would have forced on many groups a complete global restructuring, with other incalculable tax consequences.

Onshore mixing (called 'pooling' by the Treasury) was also limited to 30% for many foreign income streams, with some allowance for tax paid up to a maximum of 45% in some special circumstances. The 2001 Budget however went a long way towards allowing flexible mixing of income streams, mostly removing problems caused by the 'first layer only' problem.

The Holy Grail for international businesses would be a 'participation exemption', such as exists in both Holland and Denmark, for both income streams and capital gains (see below). A widely-drawn participation exemption would allow foreign income to remain untaxed in the hands of an onshore parent, regardless of its origin. Some of the Dutch and Danish rules were in fact attacked in the Primarolo Code of Conduct Committee 'harmful tax practices' report.

The Budget 2001 included some quite open discussion of the possibility of an income participation exemption for the UK, and promised a consultation paper. But these good intentions have been overtaken by events, and a participation exemption for income is now on the farthest edge of what is likely.

In February 2005, in advance of the budget, UK Paymaster General, Dawn Primarolo, announced a package of new measures to 'prevent tax avoidance by companies', including a rule that relief for foreign tax on income received as part of a company's trade will be restricted to the UK tax on the net profit derived from that income. The change was initially due to enter into force on Budget day. However, the Treasury saw fit to bring the rule forward so that it will apply to income received from February 10.

The budget itself in March 2005 contained threatening wording: "The disclosure rules have revealed a number of areas of the tax system at risk from high levels of tax avoidance. International transactions have emerged as a particular concern, with increasing globalisation presenting new opportunities for those attempting to avoid their obligations."

"Building on the action taken in the 2004 Pre-Budget Report, the Government is introducing two new anti-avoidance rules which will allow the Inland Revenue to issue a notice to counter a tax advantage in specific circumstances where a UK tax avoidance motive is present. These new measures will tackle arbitrage, where companies seek to gain a tax advantage by exploiting differences within and between tax codes and excessive claims for double taxation relief."

Slaughter and May tax chief, Tony Beare observed that: "This is a major change and one that could make the UK far less attractive to business if it is stringently applied." Meanwhile, global head of tax at Linklaters, Guy Brannan commented: "I am sceptical that they will raise any more money as people will stop doing deals. In the short-term we will see lots of plcs unwound and restructured, but in the long term there will be a slowing down in derivatives and structured finance-type deals."

2. Controlled Foreign Companies

The Finance Act 2000 tightened up on the definition of control, and changed the detail of the various tests concerned with the character of income, i.e. whether it should be permitted to remain in the foreign jurisdiction or not. Business protested (it was this that caused Vodaphone to make its threat rather than loss of offshore mixing), but the Treasury has not backed down on the CFC regime.

Predictably, the 2001 Budget did not contain any loosening of the CFC rules, since they are mainly directed at offshore jurisdictions, and whatever may be changing in Washington's now firmly Republican Treasury, Gordon Brown remains aligned with the OECD's anti-offshore (say, pro-onshore) campaign. Indeed, buried in a footnote of one of the Inland Revenue's budget documents is a threat to tighten the rules still further: the Finance Act 2001 contained new rules against 'artificial avoidance schemes, which exploit a loophole in one of the exemptions from the UK's Controlled Foreign Company regime'.

Of course, if there was a participation exemption for foreign income, there wouldn't need to be CFC rules - but that's too much to hope for. Small countries like Denmark and Holland can afford to do without the tax from foreign income streams, because they never had much of it, but larger countries with many multinationals are in a more difficult position (that's the Treasury's stock response to requests for a participation exemption).

3. Capital Gains Tax On Disposals Of Substantial Shareholdings

In the UK, capital gains tax for corporates has been to a great extent a voluntary tax, in the sense that there was usually some kind of structure for a deal which would avoid it - but the consequences in terms of loss of economic efficiency were often severe, and it takes teams of expensive professionals to optimise on each occasion. As a result, the corporate CGT rules are of hideous complexity. Far simpler would be a 'substantial participation exemption' which exempted gains from corporate restructurings and disposals altogether. A number of foreign countries have this, including several EU member states.

The Treasury is coming at this from the opposite direction, of course, in order to preserve the existing tax base, although there were glimmerings of light in the Government's consultation document, reflecting a Blairite take on UK plc:

'Developments in technology are fast opening up new markets and increasing international competition. The Government's aims are to ensure that in the new global economy the UK is seen as an attractive place in which to do business, and UK businesses can compete successfully.'

'To achieve these aims, the Government is promoting innovation and modernisation in UK business, as well as working to make the UK a more competitive environment for businesses generally.'

' Certain aspects of the current tax code for capital gains can hinder businesses' international competitive position and distort their commercial decisions, forcing them to adopt structures that they would not have needed otherwise. It may also act as a disincentive to companies that are investing to innovate and modernise. In particular, it can result in a charge to tax where a company sells a shareholding in a successful business that it has developed in order to invest in further developing the business or in developing another business.'

' To address these problems, the Government is considering introducing a substantial relaxation in the taxation of corporate capital gains by introducing a new tax relief for companies alongside the existing rollover relief so that the charge to tax is deferred where a company realises a gain on the sale of a shareholding in a business or assets of that business; and invests the proceeds in developing that business or another business or acquires shares in another business.'

But then the Treasury takes over, and starts talking about trading companies v non-trading companies, taper relief, etc. The whole emphasis is on a carefully limited loosening of the current rules; although to be fair the Government did propose to reduce the definition of 'substantial' from 30% to 20%.

The possibility of a participation exemption has to be considered as part of an overhaul of the entire corporation tax system. There is the issue of whether a participation exemption should apply to holdings in overseas companies as well as UK ones and whether it should extend to income as well as gains.

Tax Efficient use of UK Companies for International Trading Purposes

It is possible to arrange for an enterprise in a low or nil tax jurisdiction (the “principal”) to make use of a UK company for cross border trading purposes. The main benefit of such a structure is that the participation of the principal in the transactions does not need to be directly disclosed in the trading documentation.

Trading Arrangements

Trading operations will be entered into by the UK company on instruction from and on behalf of the principal, with a representation agreement in place between the two parties. The agreement should be in writing and would provide for a fee to be paid by the principal for the services that the UK company will perform on its behalf. All selling and purchasing transactions will be performed by the UK company on behalf of the undisclosed principal.

Fee

It is recommended that the fee payable to the UK company is at a rate commensurate with the work and responsibility assumed by the UK company. This fee will be retained within the UK company to meet its operating costs and professional management fees. After these costs, the balance of monies remaining in the UK company will be subject to normal UK corporation tax.

The appropriate fee depends very much on the value of the invoices being raised. Individual discussion between the UK company and the overseas principal would need to take place. On large low-profit contracts a smaller percentage remuneration might be appropriate, but in general a rate of 5% may well be the applicable remuneration to recognise the value of the services being provided by the UK company.

Taxation

Receipts from the trading activities will be received into the bank account of the UK company and the net amount after the agreed fee will be remitted to the principal. The UK company will be subject to UK corporation tax on its profit, being the fee for services provided less any expenses of the company.

Non-UK companies are subject to UK tax only on their UK source income, broadly defined as:

• dividends from UK companies
• interest from loans made to UK resident borrowers
• royalties from the grant of intellectual property for use in the UK
• income from a trade or business carried on by the company within the UK.

As long as the income does not fall into one of the above categories, the principal will not be subject to UK tax on its share of the income, notwithstanding the fact that it has chosen to trade through the medium of a UK tax resident company.

To help ensure that the overseas principal is not liable to UK tax it is important that the agreement between the two companies, together with all trading contracts, are executed outside of the UK. The purpose of this is to be able to confirm that no trading is conducted in the UK either by the principal or the UK company and that there is no UK source income.

Control

It is also essential that the UK company is not connected by ownership or management control to the principal and that both companies are independent in ownership and management and are seen to be so.

Formation and Operation

In order for there to be no trading activity within the UK, the directors of the UK company must be resident outside of the UK and all transactions carried out outside the UK.

If desired, the bank account of the UK company could be established within the UK with authority and confirmation on the operation of the account at all times coming from the directors outside of the UK.

Invoices will be issued to customers by the UK company upon receipt of formal instructions from the principal. Invoice payments will be directed into the bank account of the UK company which, after retaining its agency fee, will arrange to remit the balance to the principal.

Advantages

The main advantage of this concept is that a structure incorporating an overseas principal can be established with an arrangement for the use of a UK company for trading purposes without the participation of the principal being disclosed in the trading documentation.