This is the second blog in a two part arrangement covering the proposed changes to the UK CFC rules. As explained last time around the issue of CFC legislation for SMEs has been largely dealt with by HM Treasury (HMT) by the introduction of a £500k de-minimus profit limit – that means that most SMEs will fall outside the CFC regime.

Nevertheless, it’s my belief that there will continue to be a material number of SMEs operational overseas which fall into CFC territory. Take a property development company overseas which will report much of its profit in one or two years – any worthwhile investment is likely to return more than £500k of profit, and whilst the property project might last three to five years or so, those profits will probably get reported in one go. As a result that entity will be a CFC (if the low tax test is met) and unfortunately the overseas entity will be within the main CFC rules. I’m sure that there are other examples out there to consider as well.

So what can we do to avoid an apportionment of profit back to the UK parent? Well we need to walk through the exemptions that are proposed.

The first test to check is probably the excluded territories exemption. HMT will publish a list of those jurisdictions where they are happy that the local corporation tax will be no less than 75% of the UK equivalent liability. Any companies resident in these jurisdictions will not be CFCs.

We’ve already done the low profits exemption of course, so the next one to consider might be the low profit margin test. Essentially the CFC must have a very low profit margin of less than 10% of cost. Cost cannot include any related party expenditure.

Next we move onto the business trading income safe harbour. Here the CFC needs to meet a variety of tests. These include having a business premises available locally, incurring no more than 20% of overall expenditure on supplies from UK sources, invoicing no more than 20% of total turnover to UK customers, there being a limited connection to UK orientated intellectual property rights, and the management cost of the CFC being at least 80% incurred outside the UK. This safe harbour approach is helpful, but currently the rules are conceptual and there is little in the way of guidance or examples. The area of IP is one of the great uncertainties of the CFC legislation as the way in which ‘connection’ is determined is still largely up for debate.

There is an exemption for CFCs that only let property in the foreign jurisdiction. There are also exemptions for incidental non trading finance income.

There is a new exemption for finance companies set up in low tax jurisdictions which meet a number of criteria. This reduces the rate of UK corporation tax that might be levied down to just 5.75%. It is unlikely that there will be too many SMEs affected by this specific provision and others related to it including the captive insurance business rules.

Overarching the CFC rules will be a ‘gateway test’. This test supposedly will allow taxpayers and advisers to very quickly rule a company out of the CFC regime where it meets a number of criteria. Currently these are largely conceptual with very little practical commentary of example of application. They rely heavily on the understanding of SPFs (significant people functions) and KERT functions (key entrepreneurial risk taking) which are concepts which have been largely developed in the study of profit attribution to related business units by the OECD. Clearly for most advisers with SME clients phrases such as SPFs and KERT functions are a different language. The hope is that HMRC and HMT will produce extensive guidance over the coming weeks prior to the introduction of the legislation in Finance Bill 2012.

At Francis Clark we’re pretty much concerned with SMEs attempting to exploit new markets and access new resources of a human or tangible nature. We’re focused on the trading safe harbour and the gateway test and hope to feed into HMT in the consultation process in due course.

We see plenty of UK business sub licence UK IP to overseas entities to exploit locally or regionally. SMEs are often run by entrepreneurs who keep the management of their businesses close. Sometimes there will be an overseas director or two, rarely will there be a fully functioning board in the foreign entity. These issues are where we expect to see clients affected by CFC legislation really having to grapple with the way they run their businesses or face being taxed in the UK.

I think it’s fair to say that in the last six months I’ve seen a number of UK SMEs with Guernsey based subsidiaries, and the client has no idea that it’s a CFC and has underpaid tax by potentially hundreds of thousands of pounds. Those types of clients now need proper advice. However, whilst a smaller number of UK corporates will be affected by the CFC legislation, those who are will find the rules just as complex as they were before, perhaps even more onerous.