For those of you who know your international tax matters well (or those who have followed my blog), from 1 July 2009 dividends received by UK resident corporate from overseas companies are generally exempt from UK taxation. This was a major change to the UK tax system because it sees the beginning of a move to a territorial system of taxation (i.e. value is taxed where it is created, not where the taxable person is resident).

So everyone must have been ecstatic with this change mustn’t they......? Not quite. The most popular industry of our times - the banks. But why would the banks dislike such a nice exemption? Well banks don’t and can’t operate using subsidiaries abroad. They use branches, and they do business like this because as we now all know (thanks to Robert Peston) banks need capital to absorb losses. Using a branch structure means a bank can have offices in various jurisdictions, all of which rely upon the central capital of the same company. If you structured each office as a separate subsidiary banking rules would require each company to hold much more capital of its own, and this in turn would drive up the cost of borrowing.

So the banks have to operate a branch structure. Foreign branches of UK companies are taxed firstly in the local jurisdiction, and then in the UK as part of the UK company’s own results. Any foreign tax already paid is offset against the UK liability. If the foreign rate is lower than the UK rate then additional tax is due to HMRC up to the level of the UK rate. Contrast this with the subsidiary / dividend system – if the foreign rate is lower, no further UK tax is due. A clear difference.

Thus the British Banking Association lobbied the government for a change to the foreign branch rules and I’m hoping now you can see why. But then the other most popular industrial sector in the UK (oil and gas) stepped in to throw a spanner in the works. They spend years drilling for oil and gas and sinking funds into projects which don’t immediately return a profit. The ability to offset foreign branch losses against UK company profits meant that for the oil and gas companies the cost of investment was lower under the existing regime – a move to an exemption would drive up the cost of exploration.

Something of a challenge from HM Treasury and HMRC to deal with then..... Following lengthy consultation we eventually got the new legislation several months back, and the Finance Bill was given Royal Asset on 20 July 2011 meaning that the exemption is now live and available.

So exciting times ahead for all with an exemption for foreign branches in low tax jurisdictions! Not quite. Small companies (using the EU definition of 50 people and less) and SMEs more generally need to think very carefully about using the branch exemption and here is why.....

Each company can choose whether they opt into the regime or not so there is some planning to do here. The election is irrevocable and applies to all branches in the company. The legislation requires a qualifying election needed to be made prior to the period in which the exemption is desired.  Whilst “relevant profits” are exempt under the regime, losses cannot be used against other UK company profits and so opting in may not be the right thing to do.

Where a company has a foreign branch that is now profitable opts into the regime one has to look to the previous six years to determine what losses have been claimed against UK profits. To the extent that this loss has not unwound the profit remains taxable until the notional loss has been fully used up. This mechanism is known as ‘loss recapture’ and means that for a company that has had the benefit of foreign branch losses previously, the upside of opting in will be delayed until that loss has reversed. A simple numerical example helps to bring this to life (where we assume all foreign branch losses are offset against UK profits) :

A small company can only take advantage of the regime if the jurisdiction in which it has a branch has a full double tax treaty with the UK – that means one with a non discrimination clause. So if you are looking at Dubai or Guernsey for example, the branch exemption won’t apply.

For all companies there is an anti profit diversion test which needs some thought too. If the foreign jurisdiction is a low tax jurisdiction (less than 75% of the UK) then again the exemption may not apply unless you can pass a tough commercial purpose test. There are also provisions to prevent abuse with capital allowances although these are mainly aimed at plant and machinery leasing, but they may catch others. As you’d expect OECD concepts (see Blog Two) are used to ensure consistency in the calculation of profits.

For companies owned by tight groups of shareholders (close companies), there is a restriction on the profits that can be exempted. The rules generally include capital gains in the exempt profit calculation – but if the company is ‘close’ those gains remain taxable in the UK. There are some similarities here with s.13 TCGA 92. Again, this is something very specific for SMEs to be aware of.

Where gains are exempt, the rules do allow UK gains to be rolled into foreign branch assets using rollover relief. When the foreign branch asset is sold, whilst the gain on that asset is exempt, the gain on the first asset comes back into charge.

Other planning a UK company might consider is to house profitable and loss making branches in separate subsidiaries so that elections can be made (or not as the case may be) to get the best tax outcomes.

This seemed such a straightforward concept at the outset didn’t it?! The bottom line is the branch exemption is complex, and it’s most complex for the small companies who don’t have masses of cash to spend on expensive advisers. If you are an SME then the regime has some curve balls to deal with. If you are rubbing your hands at the prospect of locking in a low foreign corporate tax rate, then again don’t get too excited – the exemption might not apply.

All in all the foreign branch exemption seems attractive, and it is, but a great deal of care is required before concluding that it’s an election worth making.