The ebb and flow of on-shore pooling

The United Kingdom system of double tax relief applying to dividends received by United Kingdom companies after 31 March 2001 was radically changed by the Finance Act 2000. The new system is very complex and has imposed many new restrictions. Further amendments were announced in Budget 2001 to resolve some of the potential unfairnesses identified. These represent the most recent of numerous proposals and amendments since the new system was announced in March last year, and this article reviews the new system as it now stands and considers how far the changes go towards solving some of the practical problems. While draft legislation on some points has been released, the position on other aspects remains to be clarified in the Finance Bill, or in the continuing dialogue between the Inland Revenue and business on specific issues.

Background

The initial proposals at Budget 2000 were substantially altered before enactment in the Finance Act 2000. Further changes were announced in the November 2000 Pre-Budget Report which the Budget has now confirmed, but others were indicated to be under consideration which have not been pursued.

Eligible unrelieved foreign tax

Dividends paid to the United Kingdom on or after 31 March are eligible for double tax relief under the rules imposed by Finance Act 2000 as further changed by Budget 2001. The Finance Act 2000 rules restricted the benefits of offshore mixer companies. They capped to 30 per cent the underlying tax rate on a dividend paid by a foreign company (including dividends paid up a chain of companies to the United Kingdom). The cap did not apply to dividends paid between companies resident in the same territory. Under the original rules, the capped tax up to a 45 per cent rate represented eligible unrelieved foreign tax (commonly known as 'EUFT') provided that the mixer cap did not apply further up the chain.

Onshore pooling

Again under the original provisions, eligible unrelieved foreign tax could be offset under onshore pooling rules against the residual United Kingdom tax liability on certain foreign dividends, known as qualifying foreign dividends. Qualifying foreign dividends are essentially any Schedule D, Case V dividends apart from dividends which are paid by controlled foreign companies to meet an acceptable distribution policy, or dividends which include dividends received from other foreign companies to which the mixer cap has been applied. The latter restriction meant that when mixer companies paid a dividend to the United Kingdom out of both low tax and capped dividends received, that dividend would not be a qualifying foreign dividend. If the mixer company's dividend had a blended underlying tax rate of less than 30 per cent as a result of the cap, it would give rise to a residual United Kingdom tax liability which could not be settled by eligible unrelieved foreign tax arising on other dividends.

Modifications in the Pre-Budget Report

The Government announced two modifications to the new double tax relief régime as introduced in last year's Pre-Budget Report. These changes were confirmed by the Budget press releases earlier this month.

Calculation of eligible unrelieved foreign tax

One restriction in the calculation of eligible unrelieved foreign tax under the Finance Act 2000 rules was that it only arose at the highest level in a chain of foreign companies where the mixer cap applied. In practice, this 'highest level' rule gave rise to a number of anomalies; for example, if an offshore holding company had expenses and received capped dividend income, then the capped tax at the level of its subsidiaries would not qualify as eligible unrelieved foreign tax. If the expenses at the level of the holding company had the effect of increasing the holding company's underlying tax rate above 30 per cent, only eligible unrelieved foreign tax arising at that level would be available (see example below). A proposed amendment to allow such tax to arise at more than one level in a chain of ownership was announced in the Pre-Budget report, and this relaxation is now confirmed, although the precise mechanics remain to be seen.

Mixer cap formula

The Pre-Budget Report also announced that the mixer cap formula would be amended because it was perceived to operate unfairly in the way it restricted the amount of eligible unrelieved foreign tax available in respect of dividends with an underlying tax rate of more than 45 per cent.

The original formula was as follows:

D = amount of the dividend
M = maximum relievable rate
U = underlying tax paid

The Pre-Budget Report indicated that the Government was considering changing the mixer cap formula to:

(D + U) x M

Both the Finance Act 2000 and the Pre-Budget Report formulae substitute 45 per cent for 'M' in calculating the maximum available eligible unrelieved foreign tax.

Original mixer cap problems

An example of the potential unfairness that could arise based on the original mixer cap formula is set out below by way of comparison with the Pre-Budget Report formula. For the purposes of this example, it is assumed that a United Kingdom company has two directly held subsidiaries (A and B), each with pre-tax profits of 100. Company A, a high tax company, is shown with two different underlying tax rates, 45 per cent and 60 per cent. Company B has an underlying tax rate of 15 per cent so the residual United Kingdom tax liability on its dividend needs to be offset by eligible unrelieved foreign tax arising on dividends received from company A.

Example

Company B: Calculation of United Kingdom tax liability (mixer/eligible unrelieved foreign tax cap not applicable)

As can be seen from the above example, under the Finance Act 2000 rules there is insufficient eligible unrelieved foreign tax on a 60 per cent underlying tax rate dividend to offset completely the residual United Kingdom tax liability arising on the low tax dividend, although enough eligible unrelieved foreign tax arises on a 45 per cent underlying tax rate dividend to offset this liability. This problem is solved under the Pre-Budget report method since the eligible unrelieved foreign tax arising will always be the same in the case of dividends with an underlying tax rate of 45 per cent or more.

Post Pre-Budget Report consultation

Since the Pre-Budget Report the Inland Revenue has been consulting with taxpayers, the CBI and professional bodies about revising the mixer cap formula and methods of changing the legislation in Finance Act 2000 to remove the double eligible unrelieved foreign tax cap. It is understood that details of the discussions can be found on the CBI website.

In overview, it is proposed broadly that the mixer and eligible unrelieved foreign tax caps should be applied to each separate stream of foreign income at the level of each offshore company in the chain below the United Kingdom. The Schedule D Case V income which is taxable in the United Kingdom will be the net dividend ultimately received in the United Kingdom plus the total foreign underlying and withholding tax suffered on the various components of the dividend as it is paid up the chain to the United Kingdom.

The intended effect of these proposals is to ensure that relief as eligible unrelieved foreign tax is not given for foreign tax in excess of 45 per cent. The Inland Revenue has said that it is committed to preserving the limited amount of in-country mixing that is still possible under Finance Act 2000. However, taxpayers have concerns that a side effect of the proposals could be that the mixing of low tax dividends into high tax companies will also be limited to 45 per cent, i.e. any underlying tax in excess of 45 per cent on the high tax company's own profits would not be available for mixing with low tax dividends which it receives.

The precise mechanics of the proposals should emerge as part of the Finance Bill.

Qualifying foreign dividends

As stated above, dividends paid by mixer companies where the mixer cap applied lower down the chain do not represent qualifying foreign dividends under the Finance Act 2000 rules. Many taxpayers have lobbied the Inland Revenue to scrap this measure since it was originally announced. In response to this pressure the Inland Revenue has said that it will instead allow companies to disclaim part of the foreign tax on a dividend so that the underlying tax rate does not exceed 30 per cent. As a result, the mixer cap will not apply and the dividend can therefore represent a qualifying foreign dividend.

The disadvantage of this measure, however, is that the unclaimed double tax relief will not be treated as eligible unrelieved foreign tax. Consequently, United Kingdom companies with capacity to utilise foreign tax in this category, such as those receiving substantial amounts of qualifying foreign dividends from low tax companies held directly from the United Kingdom, are unlikely to want to take advantage of this measure. As a result, despite the changes, most groups will need to undertake a thorough rethink of their international structures.

Draft regulations

Group surrender of EUFT

The Inland Revenue has now published draft regulations on the above. Despite lobbying from taxpayers during the consultation process, surrender of eligible unrelieved foreign tax will not be available in the case of consortium companies according to the draft regulations. On the positive side, it appears that 75 per cent United Kingdom subsidiaries held through intermediate offshore companies and United Kingdom branches of non-United Kingdom companies in a 75 per cent group will be within the scope of the regulations.

While the recipient company will be able to utilise eligible unrelieved foreign tax as though it has arisen in that company, the amount available for surrender is restricted to the foreign tax of this type remaining after the surrendering company has fully utilised as much as possible of the unrelieved tax in the current or previous accounting periods.

The regulations import other provisions from the United Kingdom group relief rules in sections 402 to 413, Taxes Act 1988. For example, surrender of eligible unrelieved foreign tax will be denied in the case of dual resident companies or where there are arrangements in place for a company to leave a group.

In-country mixing

According to the Finance Act 2000 rules legislation, the mixer cap only applies if the recipient and payer of the dividend are not resident in the same territory or in such other cases as may be required by regulations made by the Treasury (i.e. the Treasury has powers to restrict in-country mixing by regulations in situations where it considers this to be necessary).

The draft regulations indicate that disapplying the cap on dividends paid between companies in the same territory will be mandatory and not by election, while a dual resident company will be regarded as tax resident in only one territory for the purposes of the mixer cap. The residence of a dual resident company will be decided by tests similar to those in section 749, Taxes Act 1988 (tests of tax residence for a controlled foreign company). If those tests are not conclusive, it is understood that the regulations will allow the taxpayer to make an election as to the company's territory of residence, although the current draft of the regulations does not contain the clauses that will deal with this point.

The commentary posted on the Inland Revenue website indicates that no further restrictions will be included in the regulations with regard to controlled foreign companies nor are any other anti-avoidance measures thought to be needed for the time being.

Other Budget measures

A 30 per cent underlying tax rate will be imputed to United Kingdom source dividends. This will mean that there is no further tax on United Kingdom dividends paid back into the United Kingdom via an intermediate overseas company. This will also prevent United Kingdom source dividends from potentially 'tainting' low-tax dividends in mixer company structures. However, where the underlying tax rate is over 30 per cent (over time the underlying tax rate on United Kingdom source dividends may exceed 30 per cent due to permanent differences) the excess will not generate eligible unrelieved foreign tax.

There are no proposals as yet to introduce a system of onshore pooling for branch profits despite lobbying from many companies during the consultation process. This leaves an inconsistency in the legislation compared with overseas subsidiary investments which many tax experts consider to be contrary to European Union law and double tax treaty non-discrimination principles.

Conclusion

Most of the additional changes announced in Budget 2001 are welcome although they do make the new system more complex. As many problem areas of the new system remain unresolved for the time being, it is likely that additional changes will be necessary and taxpayers should take the opportunity to lobby the Government and the Inland Revenue before this year's Finance Act is passed.

The Budget press release on double tax relief states that the Inland Revenue has had some very useful discussions with business about the double tax relief régime and that the Government intends that this dialogue will continue both on specific issues and to ensure that the double tax relief régime fits with other elements of the system for taxing companies.

In this respect, there are already questions concerning the position of the United Kingdom system of taxing dividends from European Union and European Economic Area companies with regard to European Union law, since dividends received from other United Kingdom companies are afforded an exemption under United Kingdom domestic law.

Alastair Munro leads KPMG's double tax relief specialist group, and can be contacted on alastair.munro@kpmg.co.uk. Frances Corrie leads KPMG's business structuring group, and can be reached on frances.corrie@kpmg.co.uk.

Issue: 3800 / Categories: Comment & Analysis