Back to top
Link to our global home page
Print |

The use of offshore holding and finance companies – a UK angle

Jason Short of Ernst & Young’s International Tax Services group discusses the main exemptions from UK controlled foreign company taxation for groups that continue to hold and finance subsidiaries through an offshore structure, and the double tax relief implications of repatriating foreign profits.


Historically, many UK groups with foreign subsidiaries have used offshore holding and finance companies as an essential part of their group structure and tax planning. However, recent changes to the UK controlled foreign companies (CFC) and double tax relief (DTR) rules, particularly in the 2000 Finance Act (FA2000), have made it ever more difficult for groups to hold and finance foreign operations without giving rise to UK taxation, and to manage their foreign tax credit position through an offshore structure.

All UK groups with foreign subsidiaries have to take into account the CFC rules, whether merely through the completion of their self assessment returns, or in an M&A planning context, when looking to tax-efficiently hold and finance a foreign acquisition. Furthermore, the UK’s DTR rules must also be considered in a post-acquisition context, as the UK continues to operate a credit system for relieving foreign dividends from UK tax.

This article explores the main exemptions from UK CFC taxation for groups that continue to hold and finance subsidiaries through an offshore structure, and the DTR implications of repatriating foreign profits. Before doing so, we consider briefly why groups often want to set up an offshore holding or finance company.



Offshore holding company – why?

UK groups have traditionally used an offshore holding company (HoldCo), typically in a participation exemption regime such as Luxembourg or the Netherlands, to own foreign subsidiaries for the following reasons:
  • gains on disposals by HoldCo are exempt both locally and under the UK CFC rules
  • foreign profits of one subsidiary can be paid into HoldCo as a dividend and reinvested as capital into another subsidiary without local or UK tax
  • efficient management of foreign tax credits on dividends paid to the UK (the so called “mixer” effect – see below for more details), and
  • sheltering offshore finance income from UK tax under the CFC ‘holding company’ exemption.
However, the above benefits have been eroded significantly through recent UK law changes, so much so that most UK groups are seriously considering abandoning existing offshore structures and replacing them with direct UK ownership of foreign subsidiaries. In fact, a number of groups have already done so, with the most common restructuring method being the migration to the UK of the tax residence of a HoldCo, through the transfer of all management functions of the company to the UK.

Back to the top



Offshore finance company – why?

Many groups take advantage of offshore companies to centralise group finance in a cost efficient way.

The availability of a low-taxed finance regime, together with other benefits such as good treaty networks, low inbound interest withholding tax rates and a business friendly environment, led many groups to set-up companies in the Netherlands and Luxembourg with Swiss branches to finance subsidiaries in high-tax countries giving significant tax arbitrages (see figure 1).

Figure 1 – offshore financing with no UK taxation

[<IMG Height=84 WIDTH=152 SRC="/Global/CCR.nsf/Images/DA0A9B39F37C70A580256CB5004D8CD2/$FILE/Offshore_Fig_1.gif">]

  Lo-tax    Hi-tax

  Interest

100
  
  Profit

200
  Tax at 2%
2
    Interest
(100)
      PBT
100
    Tax at 40%
40
  Total tax
42
  
  Effective tax rate
21%
  

The problem for UK groups with such a structure is that, in the absence of a CFC exemption, the offshore interest income will be taxed in the UK at 30%, which significantly increases a group’s effective tax rate (see figure 2). Prior to FA2000, the CFC legislation specifically exempted certain offshore finance structures; however, Revenue policy has changed such that the income of a number of offshore finance companies is now subject to UK taxation.

Figure 2 – offshore financing with UK CFC taxation

Structure as in Figure 1

  Lo-tax    Hi-tax

  Interest

100
  
  Profit

200
    Interest
(100)
  UK tax at 30%
30
    PBT
100
    Tax at 40%
40
  Total tax
70
  
  Effective tax rate
35%
  

Back to the top



Controlled foreign company rules

The controlled foreign company rules apply to a company (CFC) that satisfies all three of the following conditions:
  • CFC is not resident in the UK
  • CFC is controlled by UK residents, and
  • CFC is subject to a lower level of tax (LLT).
Control broadly means the power of a person(s) to direct that the affairs of the CFC are conducted in accordance with his/their wishes, and includes a 40% interest in a joint venture (JV) where no other JV partner controls more than 55% of the JV.

The LLT test applies if the CFC’s tax liability in its state of residence is less than three-quarters of the tax it would have paid had the company been UK tax resident. Thus, it is necessary to compare the tax paid locally with the tax that would have been paid in the UK on the company’s profits as computed for UK tax purposes.

Application of CFC definition to holding and finance companies
As offshore holding and finance companies of UK groups will typically be 100% subsidiaries, they will always be controlled by UK residents for the purposes of the CFC rules.

In applying the LLT test to, say, a Luxembourg FinCo with a Swiss branch, it is necessary to compare the tax paid in Luxembourg with the tax that would have been paid in the UK after taking credit for Swiss tax paid on the branch profits.

In practice, a FinCo will always be subject to a LLT as very little tax is usually paid in, say, Luxembourg.

In applying the LLT test to, say, a Luxembourg HoldCo, it is necessary to compare the tax paid in Luxembourg with the tax that would have been paid in the UK after taking credit for third country taxes, including taxes paid by at least 10% owned subsidiaries on the profits out of which they have paid dividends to HoldCo (known as underlying tax – see DTR discussion later).

A HoldCo will in practice nearly always be subject to a LLT, as it usually pays no tax at all in its home territory due to the availability of the participation exemption on dividends and gains. The exception is where HoldCo’s income consists entirely of dividends paid by companies that have been subject to a rate of tax of at least 30%, as in such a case HoldCo would have paid no tax at all if it had been UK resident.

Thus, virtually all offshore finance and holding companies will be CFC’s for UK purposes and will need to satisfy an exemption to avoid their UK shareholders being taxed on their profits (a process known as apportionment).

CFC exemptions
There are six exemptions from the CFC rules, namely:
  • the de minimis test
  • the exempt activities test (EAT)
  • the excluded countries regulations (ECR)
  • the public quotation condition (PQC)
  • the motive test
  • the acceptable distribution policy (ADP).
In general, holding and finance companies will breach the de minimis test (taxable profits less than £50,000 per annum), fail the ECR as this broadly requires at least 90% of a CFC’s income to be derived from the same country as the holding or finance company, and fail the PQC as this requires at least 35% of the CFC to be owned by the public. We have therefore only considered the other three tests in detail.

Exempt activities test (EAT)
The EAT has two general requirements, relating to the substance and structure of a CFC. There is an additional income requirement that is relevant for holding companies as defined below.

(i) Substance

A CFC must, throughout a particular accounting period:
  • have a business establishment in its state (territory) of residence, and
  • have its business affairs in that territory effectively managed at that establishment.
The business establishment test is aimed at ensuring that the CFC has a reasonable physical presence, rather than just a brass plate or use of a hotel room, and includes the use of premises such as an office, whether owned or leased, that is available to the CFC at all times. An office used by a holding or finance company does not have to be permanently occupied as such a company’s business may only take up a few hours a week most of the time. However, the office must be permanently available even if not occupied for a period of time.

A CFC’s business affairs are regarded as effectively managed at its business establishment provided the number of persons employed by the CFC in its territory of residence is adequate to deal with the volume of the company’s business. Revenue guidance indicates that the staff concerned must be sufficient in numbers, qualifications and experience to carry out the bulk of the company’s profit making activities. The staff must be employed by the CFC or be seconded from another company resident in the same country, but do not all need to be in that country; the CFC may operate elsewhere through a branch provided its main business is not in the branch.

(ii) Structure

In order to satisfy the EAT, a CFC’s main business must not be investment business, which includes the holding of securities (including shares) or intellectual property, leasing of any description, and the investment, in any manner, of funds of connected parties.

There is no definition of ‘main business’ and it will normally be clear what a company’s main business is. However, in cases of doubt, Revenue guidance indicates that factors to be considered are levels of turnover, amounts of capital investment and levels of profitability of a company’s various activities.

Although the holding of shares is generally regarded as ‘bad’ investment business, this is not the case if a CFC satisfies one of three holding company exemptions, being a superior holding company (SHC), a local holding company (LHC) and an international holding company (IHC).

The three tests are aimed at different tiers of holding company, with the broad requirement being that the CFC’s business consists wholly or mainly in the holding of shares or securities of companies which are greater than 50% owned trading subsidiaries.

(iii) Income

Although the income tests for LHCs, IHCs and SHCs are complicated, the broad rule is that a holding company must derive at least 90% of its gross income from controlled trading subsidiaries, and that income must:
  • be directly derived from a company resident in the same territory as the holding company, and be received in that territory (rather than in a foreign branch), or
  • be qualifying dividends, being dividends that are not tax-deductible for the company paying the dividend.
Application of EAT to holding and finance companies

Provided sufficient substance is established in, say, the Netherlands or Luxembourg, and that the underlying foreign subsidiaries are controlled trading or operating companies, a HoldCo should satisfy the EAT as a holding company provided it has a ‘good’ mix of income. This will be the case if 90% or more of the company’s income consists of dividends that are not tax-deductible in the paying company’s jurisdiction.

Thus, it should be possible for a ‘pure’ HoldCo to satisfy the CFC rules and avoid UK taxation of its underlying profits.

A ‘mixed’ activity HoldCo/FinCo may satisfy the EAT, but only if no more than 10% of its gross income is interest received from companies outside the HoldCo/FinCo territory of residence. This is unlikely to be the case for most, if not all, groups as a FinCo is usually established to finance a number of foreign subsidiaries in different countries.

This last point is the main change from the pre FA2000 days, as interest and royalty income used to qualify as ‘good’ income under the EAT, even if earned outside the territory of residence of the HoldCo/FinCo.

Motive test
The profits of a CFC will not be subject to UK tax by virtue of the motive test if:
  • a transaction(s) in the results of the CFC has achieved a reduction in UK tax, but either the reduction was minimal or it was not one of the main purposes of the transaction(s) to achieve that reduction; and
  • it was not one of the main reasons for the company’s existence in the period to achieve a reduction in UK tax by a diversion of profits from the UK.
Although it is often possible to argue that the first leg of the test is satisfied, by demonstrating that a transaction in the CFC’s books has not achieved a specific reduction in UK tax, it is more difficult to demonstrate that a CFC’s existence has not diverted profits from the UK. It is therefore necessary to have strong non-UK tax reasons to satisfy the motive test.

Application of motive test to holding and finance companies

A FinCo is unlikely to satisfy the motive test, and the Revenue would be likely to contest such a claim on the basis that funding could have been provided from the UK, unless strong non-UK tax reasons exist for offshore financing.

A HoldCo is more likely to satisfy the motive test, where there are strong reasons for its existence, such as reduced rates of dividend withholding tax compared to direct ownership from the UK.

Acceptable Distribution Policy (ADP)
The ADP exemption is very commonly used, and applies if a CFC distributes at least 90% of its profits as computed under UK tax principles, less any local tax paid, to the UK within 18 months of the end of the year in which the profits were earned.

Although this is a CFC exemption, it clearly does not give much of a benefit as groups are able to save only 3% tax (by leaving up to 10% of profits offshore) and delay paying the remaining 27% to the Revenue by up to 18 months. The costs of setting up and running an offshore structure are unlikely to merit this saving, unless significant income is earned offshore or there are other reasons for using an offshore structure.

Summary of CFC exemptions
As can be seen from the above, it can now be difficult for groups to exempt income of a FinCo from UK tax under the CFC rules. It is easier for income of a HoldCo to be left offshore, but often this requires the EAT holding company exemption to apply which has substance requirements as well as stringent income requirements.

It is likely that fewer and fewer groups will maintain an offshore finance structure going forward. However, as there are still opportunities to fall within the various exemptions with additional planning, some groups will retain offshore financing as a key element of their international structure due to the significant benefits available as shown in figures 1 and 2 above.

Furthermore, some groups will retain an offshore holding structure, particularly those that have significant low-taxed profits that are not needed in the UK. These groups will seek to rely on the EAT or motive test exemption from CFC taxation, and may wish to obtain advance clearance from the Revenue that one of these exemptions applies.

Back to the top



Double tax relief

As mentioned above, the UK operates a credit method for relieving foreign dividends from UK taxation. Although the rules are complicated, particularly after the wide ranging changes made in FA2000 and FA2001, the broad principles are that foreign dividends are subject to UK corporation tax at 30%, and credit relief is given for both dividend withholding tax and tax paid on the profits out of which the foreign dividend has been paid (underlying tax or ULT). ULT is only available if 10% or more of the voting rights of the subsidiary are controlled.

ULT includes all profits based taxes paid by the company paying the dividend, wherever paid, and also taxes of foreign and UK subsidiaries that have paid dividends to that company. However, ULT relief on an individual dividend is capped at a rate of 30%, known as the mixer cap restriction. This was not the case prior to 31 March 2001, and led to a number of groups establishing offshore holding or mixer companies to mix high and low sources of income offshore. The holding company would ideally pay a single dividend to the UK with a mixed DTR rate of close to 30%.

Although ULT on a particular dividend is now capped at 30%, it is possible from 31 March 2001 under the UK’s onshore pooling rules, for any credits above 30% (up to a 45% limit) to reduce the UK tax liability on most low-taxed (local rate below 30%) foreign dividends. The main exclusions from onshore pooling are low-taxed dividends that have been paid to satisfy the CFC ADP exemption, and dividends that have been paid by an intermediate offshore company, such as a holding company, from a combination of high (>30%) and low (<30%) taxed dividends. This latter problem is commonly referred to as dividend tainting.

Examples are included at figures 3 and 4 of high and low taxed dividends being paid to the UK directly and via an offshore holding company.

Figure 3 – UK taxation of directly held subsidiaries

[<IMG Height=83 WIDTH=290 SRC="/Global/CCR.nsf/Images/1C74DDF9C005E2DB80256CB5004DCA85/$FILE/Offshore_Fig_3.gif">]

UK tax position
  Hi-tax    Lo-tax

  Dividend

60
  
  Dividend

80
  ULT
40
    ULT
20
  Taxable income
100
    Taxable income
100
  UK tax at 30%
30
    UK tax at 30%
30
  Less:
ULT
(30)
    Less:
ULT
EUFT
(20)
(10)
(20)
(10)
(30)
  Residual UK tax
nil
    Residual UK tax
nil
  Excess credits
(EUFT)
10
  

Figure 4 – UK taxation of directly held subsidiaries

[<IMG Height=114 WIDTH=285 SRC="/Global/CCR.nsf/Images/3C717ABEEA77F3E780256CB5004E01C6/$FILE/Offshore_Fig_4.gif">]

  Hi-tax   

  Dividend

140
  
  UK tax at 30%

60
  ULT: lo-tax
  ULT: hi-tax
20
40
20
40
60
    Less ULT: lo-tax
  Less ULT: hi-tax
20
* 30
20
30
(50)
  Taxable income
200
    Residual UK tax
10
  Excess credits (EUFT)
** 10
  

**  mixer cap restriction applies to restrict ULT to 30% x (60 + 40) = 30
**  eligible unrelieved foreign tax, or EUFT, cannot be set-off against residual UK tax on HoldCo dividend

Application of DTR rules to offshore holding and finance companies
As can be seen from figures 3 and 4 above, there will in most cases be a UK tax benefit for groups that hold their foreign subsidiaries directly from the UK, as there are DTR disadvantages to owning subsidiaries through an offshore HoldCo. This is a reversal of the pre 31 March 2001 position which allowed offshore mixing but not onshore pooling of excess credits. Furthermore, the other main benefit of offshore holdings, being a capital gains exemption, is now available in the UK following the introduction of the substantial shareholdings rules on 1 April 2002.

Furthermore, as an offshore FinCo is unlikely to satisfy a CFC exemption other than the ADP test, its profits will also suffer a DTR disadvantage as ADP dividends are not eligible for the benefits of onshore pooling, and will therefore be taxed in the UK at full rates.

This is a result of a clear move by the Revenue to outlaw the benefits of offshore holding and finance companies, through a combination of both DTR and CFC changes. Thus, in the absence of planning to ensure that ADP dividends are not required for CFC purposes, most UK groups will end up paying significantly more UK tax as they will resort to financing from the UK or pay ADP dividends from offshore finance companies.

Back to the top


What the future holds

In view of the changes noted above, many UK groups will be re-thinking their strategy and offshore holding companies may become a thing of the past for some UK groups, as the previous DTR benefits are no longer available offshore, and the capital gains benefits are now available onshore.

Offshore finance companies are also likely to reduce, although the benefits to some groups will be so great that they will continue to use such companies in the future. This presents a significant challenge to groups, as they will lose the cash tax and effective tax rate benefits brought about by offshore financing.

UK international tax planning has therefore been turned on its head, with onshore holding and financing likely to be more in evidence going forward, although the exact structure to be adopted will vary from group to group, as there is no longer a generic structure that fits all.


Jason Short is a senior Advisor in Ernst & Young’s specialist CFC and DTR planning group.

This article originally appeared in the June 2002 issue of Tax Planning International – M&A edition.
Back to the top

Tax news
Ernst & Young refers to one or more of the member firms of Ernst & Young Global Limited (EYG), a UK private company limited by guarantee. EYG is the principal governance entity of the global Ernst & Young organization and does not provide any services to clients. Services are provided by EYG member firms. Each of EYG and its member firms is a separate legal entity and has no liability for another such entity's acts or omissions. Certain content on this site may have been prepared by one or more EYG member firms.