British government authorities are in the process of changing the taxation situation of UK-owned captives to plug up some holes in current tax law. Stacy Shapiro reports.

The UK's Treasury department is in the process of trying to alter the country's "controlled foreign company" (CFC) legislation in order to close a loophole that was opened by a European Court of Justice decision in September last year. The decision, which found that the UK's CFC legislation is contrary to the spirit of European Union law, has meant that UK-owned captives and other alternative risk transfer entities could save millions of pounds in tax if they are based in low taxation EU countries such as Ireland, Luxembourg, Gibraltar and Malta.

The Treasury's first move will be to include legislation in the UK's Finance Bill of 2007 which will be enforced retroactively to 6 December 2006. The CFC clauses to be included were first introduced at the Pre-Budget Report late last year and a Treasury spokesman said recently that these will be included in the Finance Bill.

In addition, the 2007 Budget Report says that a consultation document will be published later in the spring to consider the taxation of foreign dividends received by UK companies and the CFC rules.

CFC legislation

Since the first US captive insurance companies were set up in the 1950s in offshore domiciles, there has always been a concern by regulators that the purpose of captives is to avoid taxation. This suspicion was brought up in a recent paper by the International Association of Insurance Supervisors (IAIS) on the supervision of captive insurance companies. But the IAIS believes that the accusations are largely unfounded for the 5,500-plus captives which exist today.

"Whilst historically there has been a widespread view that the primary motivation for captive formation is tax mitigation, the fact is that captives are formed for other economic reasons," states the IAIS paper published last October. "Often captives are formed solely as a means of focusing management and the owner's/insured's attention on the costs of the risks inherent in the business by concentrating the costs of insurance in a single cost centre," states the IAIS. Probably the most important reason for forming a captive, in fact, is to "increase awareness and implementation of risk management practices," the IAIS adds.

Over the years, a number of captives have been set up for taxation evasion, but the "tax authorities have largely eliminated this risk today," adds the IAIS report. Many tax authorities have now largely eliminated tax minimisation advantages through "CFC tax legislation" that consolidates the profits of captives with those of the captives' parent companies, says the IAIS captive report.

The UK government has been no exception. Under UK tax legislation, the profits of a foreign company in which a UK resident company owns a holding of more than 50%, are attributed to the resident company and subjected to tax in the UK, where the corporation tax in the foreign country is less than 75% of the rate applicable in the UK. The resident company receives a tax credit for the tax paid by the CFC.

The whole purpose of this complicated formula is to make the resident company pay the difference between the tax paid in the foreign country and the tax which would have been paid if the company had been resident in the UK. So, a UK parent company would pay the same tax on the profits of its offshore single parent captive as it would on the profits of its London-based organisation.

There are a number of exceptions to this application, such as where the CFC distributes 90% of its profits to the resident company or where the "motive test" is satisfied. This is where neither the main purpose of the transactions which gave rise to the profits of the CFC, nor the main reason for the CFC's existence, was in order to achieve a reduction in UK tax by means of the diversion of profits.

The Cadbury ruling

However, on 12 September last year, a European Court of Justice (ECJ) decision criticised the UK's CFC legislation - to the advantage of single parent captives domiciled in the low-taxation EU countries of Ireland, Luxembourg, Gibraltar and Malta. The ECJ decided in a case brought by the UK Inland Revenue against Cadbury Schweppes Plc that the UK's CFC legislation constituted "a restriction on freedom of establishment within the meaning of community law".

The case involved two subsidiaries in Ireland - Cadbury Schweppes Treasury Services (CSTS) and Cadbury Schweppes Treasury International (CSTI) - which were established in the International Financial Services Centre in Dublin, where in 1996 the tax rate was 10% (and still is to this day). In 2000, Inland Revenue commissioners decided that CFC legislation applied to these companies and charged Cadbury Schweppes more than £8.6m for corporation tax dating back to 1996. Cadbury Schweppes appealed to the Special Commissioners of Income Tax, maintaining that the CFC legislation was contrary to community law; and the commissioners asked the ECJ to decide.

The ECJ ruled that just because Cadbury Schweppes decided to establish these companies in Dublin "for the avowed purpose of benefiting from a favourable tax regime, does not in itself constitute abuse and does not prevent Cadbury Schweppes from relying on community law."

Since Cadbury

Since the ECJ judgement, the Inland Revenue has decided to close the gap that had opened by introducing clauses in the Finance Bill of 2007 which were announced in the Pre-Budget Report in December last year. According to sources in the Inland Revenue, these clauses will be included in the Finance Bill when it is drafted and introduced to Parliament.

The intention of these clauses is to get British parent companies to prove that their subsidiaries in low-tax EU countries are genuine and not just letterboxes. However, the clauses force the British parents to prove this by the size of the physical presence they have in each country based on the office, the equipment and the number of personnel that are employed rather than the activity and size of capital of the company.

As a result, captive managers and other British executives are very critical of these new clauses. "Unfortunately, instead of simplifying the issues and implementing changes in line with the ECJ ruling, the proposed changes seem to muddy the waters - particularly for captives and their owners," says Praveen Sharma, associate director of Aon Ltd's captive consultant IRMG in London. "They are inadequate, give rise to greater uncertainty and increase the administrative burden (in the form of increased compliance costs) for captive owners. Furthermore, the proposed changes would mean one set of rules for EU-based companies and another for non-EU companies."

Under the new rules outlined in the Pre-Budget Report, says Sharma, UK companies will need to submit an application annually to the UK tax authorities to prove that a captive based in another country:

- Is resident in an "EEA territory," which includes EU member states and others such as Iceland and Norway;

- Has individuals working for the captive at a business establishment in that state (individuals are not treated as working for the captive in any territory unless they are employed by the captive there or are directed to perform duties on its behalf in that territory);

- Is unable to satisfy any of the CFC exemptions; and

- Is undertaking genuine economic activities.

"The annual application process, providing the tax authorities with all relevant information about the captives, seems extremely onerous and burdensome," observes Sharma.

Jonathan Groves, head of captive consulting at Marsh in London, agrees that the Pre-Budget Report clauses "make an artificial distinction between capital employed versus individuals employed" which isn't reflected in the ECJ judgement. These clauses, in fact, "have taken us 50 years back" to when the size of a company was judged by the number of employees rather than the amount of capital. "Some say that the initial guidance notes (from the Inland Revenue) are not in line with the ruling," said Groves.

Each captive owner must decide on the domicile of its captives based on individual criteria, Groves added. "If you've got the cake right, then you can look at the icing (meaning the tax)." However, Marsh is recommending that UK-owned captives migrate to "onshore" EU domiciles such as Ireland, Luxembourg, Gibraltar, and Malta to take advantage of the ECJ ruling, says Groves.

The future

The confusing situation, however, may be short-lived. Although they are expected to be included in the Finance Bill, the Treasury also announced in the 2007 Budget on 21 March that a consultation document on CFC legislation would be published later in the spring. This is "to open dialogue with companies on the CFC legislation and the taxation of foreign dividends," said a Treasury spokesman following the budget. "The fact that a further consultation guidance is to be issued later this year on not only taxation of foreign dividends but also the CFC rules seems to suggest that the initial draft proposals (which seemed to be a knee-jerk reaction to the ECJ ruling) may not be implemented in law in its entirety," predicts Sharma.

Stacy Shapiro is a freelance journalist.