Mishcon Deals - Issue 1

On 21 June 2007, HM Treasury and HM Revenue & Customs issued a discussion document containing proposals for reforming the taxation of foreign profits. If enacted, the reforms would mean some of the most fundamental changes to the UK corporate tax system for decades.

As things stand, if a UK company establishes a foreign subsidiary, any dividends paid by the subsidiary are subject to UK tax. However, the profits of the foreign company (out of which the dividend was paid) may already have been subject to tax in the foreign country. Absent any mitigation, the result would be double taxation.

This is an issue for many countries around the world and not just the UK. Two basic methods have been adopted to address the problem. The first method is to exempt foreign dividends from domestic tax. But this has not been the UK approach. Up to now, the UK has adopted the second method. It does tax foreign dividends but then allows a company to credit the foreign tax against the UK tax. The credit system is formidably complicated and does not even generate that much tax revenue for the UK government once the credit has been given.

The discussion document therefore, proposes that the UK would move to the first system, with foreign dividends simply being exempt from UK tax. To qualify for this exemption, the UK company would need to have at least 10% of the shares in the foreign company. In addition, the exemption would be limited to foreign dividends received by large or medium sized UK companies, on the basis (so the document maintains) that small companies do not normally establish operations abroad. The exemption would be a positive development, but then there are two pieces of bad news.

First, there could be restrictions on the ability of UK companies to deduct interest in calculating their taxable profits. Although there is uncertainty as to how exactly these restrictions would work, the main one seems to be that a UK company, which is part of a global group, would be limited in claiming a deduction for interest by reference to the interest cost of the overall group.

The second piece of bad news has to do with the rules designed to stop UK companies diverting their profits to subsidiaries based in offshore tax havens. The discussion document proposes reforming the rules so that the focus would no longer be on particular entities, but would instead be on types of income such as passive income, including interest, dividends, rent and royalties, of a controlled company. This would mean that a UK company could be taxed on certain types of undistributed income of any company it controlled, whether the company was based abroad or here. As these are potentially highly significant changes it is vital that UK companies doing business abroad should keep a close watch on developments in this area.

Reforms to the UK Taxation of Foreign Profits