EXPLANATORY NOTE

1. This clause protects the UK tax base by closing a loophole in the anti-avoidance rules for CFCs. It puts a stop to an avoidance scheme which enabled UK companies to avoid CFC tax by routing UK dividends through CFCs.

2. A CFC is exempt from the CFC rules if it pursues an acceptable distribution policy (ADP) - that is, if it pays a dividend to the UK equal to at least 90% of the profits on which it would have been chargeable to tax had it been resident in the UK.

3. Some UK companies have exploited an anomaly in the wording of the ADP exemption by routing UK dividends through CFCs which hold low-taxed profits. This has enabled the CFCs to satisfy the ADP exemption without paying any of their low-taxed profits to the UK.

4. This clause closes the loophole by providing that dividends which a CFC pays to the UK will no longer count towards satisfying an ADP if they are paid out of UK dividends (or other distributions) which do not count towards computing the chargeable profits of the CFC.

DETAILS OF THE CLAUSE

5. Subsection (1) inserts a sub-paragraph (1B) into Paragraph 2 of Schedule 25 of the Taxes Act.

6. New sub-paragraph (1B) provides that a dividend paid by a CFC shall not count towards an ADP to the extent that the relevant profits out of which the dividend was paid derive from dividends (or other distributions) paid to the CFC on which it would not have been chargeable to tax had it been resident in the UK.

7. New sub-paragraph (1B) also provides that "relevant profits" has the same meaning as in section 799 of the Taxes Act (which determines how dividends are to be related to the profits out of which they are paid for the purposes of double taxation relief - DTR) - thus ensuring parity of treatment between the CFC and the DTR rules.

8. Subsection (2) provides that the amended rules have effect for dividends paid by CFCs on or after 9 March 1999 for accounting periods ending on or after that date.

9. A CFC is a company which is not resident in the UK (but which is controlled by persons who are) and which is subject to a level of taxation of less than three quarters of that which it would have been subject to had it been resident in the UK.

10. The CFC rules are designed to stop UK companies avoiding tax in this country by diverting income to CFCs in tax havens and other preferential regimes. The rules work by making UK companies pay an amount of CFC tax equal to any tax that would otherwise be avoided.

11. There are a number of exemptions, one of which is where a CFC pays to the UK a dividend equal to at least 90% of its chargeable profits. This is called pursuing an acceptable distribution policy (ADP).

12. The rules require that a CFC’s chargeable profits should be computed as if it were resident in the UK for tax purposes. Under the normal UK tax rules at section 208 of the Taxes Act, dividends (and other distributions) received by one UK company from another UK company do not normally count towards the recipient company’s chargeable profits for UK tax purposes. As such, UK dividends (and other distributions) do not normally count towards working out how large a dividend a CFC must pay to satisfy the ADP exemption. But, because of an anomaly in the wording of the ADP exemption, an ADP can nevertheless be satisfied out of such dividends.

13. Some UK companies have entered into avoidance schemes designed to exploit this anomaly, and so enable their CFCs to pursue an ADP without paying any of their low-taxed profits to the UK. The schemes typically involve a UK multi-national transferring ownership of one of its normally taxed UK subsidiaries to one of its CFCs which has undistributed low-taxed profits.

14. By channelling dividends from the normally taxed UK subsidiary through the CFC:

the CFC can satisfy an ADP without distributing any of the low-taxed profits at which the CFC rules are aimed; and

its UK parent can avoid any tax on the ADP dividend because the profits out of which the dividend has ultimately been paid have already been taxed in the UK (on its UK subsidiary).

15. New sub-paragraph (1B) ensures that dividends which a CFC pays to the UK will no longer count towards satisfying an ADP to the extent that they are paid out of UK dividends (or other distributions) which do not count towards computing the CFC’s chargeable profits.

Suppose a CFC’s relevant profits are made up as follows:

Chargeable profits 200

Dividends from UK 300

Relevant profits 500

To satisfy the ADP exemption, the CFC would need to pay to the UK a dividend of at least 450. This is calculated as follows:

Dividend to UK persons 450

Excluded by Clause 79 270 (450x300/500)

Balance 180 (= 90% of chargeable profits)

The amount of the dividend excluded from the ADP by Clause 79 is calculated on a pro rata basis as follows: