Chris Morgan and Paul Keeble explain the concept of a controlled foreign company, and the UK tax changes which affect Dublin-based captives.

Under the UK tax rules, a `controlled foreign company' (CFC) is a non-UK resident company which is controlled by UK residents and which pays tax in its local jurisdiction which is less than three-quarters of the amount it would have paid had it been UK resident.

The legislation dealing with CFCs was introduced to prevent UK companies reducing their UK tax liabilities by diverting profits to overseas companies located in low tax jurisdictions or benefiting from favourable tax regimes. In broad terms, it does this by subjecting the UK parent company to UK tax on the profits of the CFC on a current year basis. There are a number of statutory exemptions from the CFC charge. One of those exemptions is the `excluded countries regulations' which allow CFCs resident in jurisdictions on the list of excluded countries and which derive the vast majority of their income from local sources to avoid the CFC rules.

The Inland Revenue announced on 23 July 2002 that Ireland was to be removed from the list of excluded countries. The changes apply to accounting periods of Irish CFCs beginning on or after 11 October 2002.

The reason given for this change was that the progressive reduction in the rate of Irish corporation tax (down to 12.5% from 1 January 2003) means that it is no longer possible to readily distinguish between Irish CFCs which have been established there for genuine commercial, as opposed to tax, reasons.

Who is affected?
The proposed change means that Irish CFCs (including captives) will no longer be able to qualify under the excluded countries regulations. Ireland is commonly used as a location for group finance and treasury activities and where the companies involved rely upon the excluded countries regulations, the structures will no longer be effective. However, the change only applies for accounting periods beginning on or after 11 October 2002, so for those companies with accounting dates such as 30 June or 30 September, the current structure is still effective and there is time to consider any unwind and replacement strategy.

Irish CFCs will continue to be able to satisfy any of the other exemptions from the CFC legislation should they meet the necessary conditions.

Contrary to EU law?
It is very likely that the Inland Revenue has received advice that the proposed change is not contrary to EU law. However, there is clearly an argument that it is contrary to the principle of freedom of establishment, as it hinders UK companies that wish to establish subsidiaries in Ireland. This is the first time that an EU member state's general corporation tax regime has not been accepted by the UK for inclusion on the excluded countries list. It is possible that companies will seek to challenge the new legislation.

Action to be taken
UK companies will need to revisit the basis for claiming the CFC exemption for Irish subsidiaries. Does one of the other exemptions apply or could it be made to do so with minor restructuring?

Where the CFC in question does not satisfy one of the other CFC exemptions but is carrying on a commercial activity and has genuine substance, companies should consider applying for the motive test. The Inland Revenue has recently issued expanded guidance on how it interprets the application of the motive test.

Where the motive test is not applicable, companies should, if they have not already done so, consider suitable restructuring.

By Chris Morgan and Paul Keeble

Chris Morgan is partner in charge of KPMG's international corporate tax group in London, and can be contacted on: +44 20 7311 2972, e-mail:
chris.morgan@kpmg.co.uk . Paul Keeble is a manager in the group, and can be contacted at: +44 20 7694 4120, e-mail:
paul.keeble@kpmg.co.uk .