At the same time as David Cameron was extolling the virtues of “tax transparency” and putting in place intergovernmental agreements for the automatic exchange of tax information between the U.K. and its Crown Dependencies and British Overseas Territories, such as the Cayman Islands, Bermuda and Guernsey, the U.K. Treasury was bedding in its new Controlled Foreign Company rules which actually make EU subsidiaries, including captives, more tax efficient, and help to clarify and reduce the tax burden for a number of U.K.-owned multinational companies with foreign subsidiaries.
Since captives are not per-se intended to simply reduce their parent’s tax burden, but are designed to be a risk-management tool, which should hopefully lead to an increase in their parent’s taxable profits, the focus by the U.K. and other European leaders on addressing tax avoidance should not pose a significant threat to the continued use of captives as a risk-retention tool.
However, there is still significant mistrust and misunderstanding by the U.K. and EU tax authorities of the use of captives.
Meanwhile, the U.K.’s Chancellor, George Osborne has shown dogged determination to reduce the U.K.’s corporation tax rate year-on-year to a level which is at least as competitive as other EU member states. The 2014 U.K. corporation tax rate of 21 percent is significantly down on the 28 percent it was in 2010.
One might be forgiven for thinking that the U.K. Government has developed some form of split personality by both trying to minimize its corporate tax rate, whilst at the same time maximizing its corporation tax take. However, it is simply recognizing the inevitability that big corporations have a responsibility to stakeholders to minimize expenses, including tax expenses, in order to maintain competitiveness, market share and good corporate governance. To this end, all developed countries are competing to attract big business by keeping corporate taxes low, whilst recognizing the indirect benefit of increased personal income tax take and a more vibrant economy as senior business leaders and management relocate to the U.K. with their companies.
Turning to the new Controlled Foreign Company rules, the U.K. got into trouble with the European Court of Justice back in 2006 when it imposed a higher tax rate on the profits of Cadbury Schweppes’ Irish subsidiary through its CFC rules than was legal under the EU tax rules. These rules stated that where an EU-based subsidiary is taxed according to the rules of the EU member state in which the subsidiary is resident, it is illegal for the EU member state of the parent company to impose a further tax on such profits.
This ruling prompted a complete overhaul of the U.K. Controlled Foreign Company rules, which has resulted in the new regime introduced in January 2013. These rules clarify the position of subsidiaries of U.K. companies within the EU, as well as those outside of the EU. More importantly, they come at a time when tax transparency is high on the agenda, so that compliance with these rules should be sufficient to evidence transparency even if the company in question is saving tax as a result. Bear in mind that tax transparency doesn’t automatically mean an end to avoidance – it might actually allow greater avoidance, so long as it is in accordance with the rules.
Let’s start by looking at a Maltese captive insurer of a U.K. parent. Malta is an EU member state, and under the old CFC rules the captive’s profits may well have been subject to U.K. corporation tax if the captive was unable to meet any of the limited exemptions for captives. Under the new rules, because the captive is in the EU, so long as mind and management are based in Malta, and the company is not based there only to avoid U.K. tax, the profits generated in Malta are only taxable in Malta, and not in the U.K. Furthermore, any dividends paid to the U.K. are also tax free under the dividend tax exemption rules for subsidiaries. This is great news for non-Maltese shareholders of Malta captives, because the effective rate of corporation tax which they will incur is just 5 percent, as compared to 21 percent in the U.K.
As the Cadbury Schweppes ruling related to EU subsidiaries, the position is different for non-EU jurisdictions such as Guernsey or Cayman. In particular the U.K. Treasury still believes that captives are designed to avoid tax, so that there are specific rules for non-EU captives which state that captives cannot take advantage of certain “gateways” to avoid the CFC rules. However there are two important areas which mean that captives are, perhaps, treated more favorably than under the old rules.
Firstly, the new CFC rules suggest that it is only profits on insurance risks located in the U.K. which are subject to U.K. corporation tax. This means that, for multinational companies with U.K. headquarters, where the captive is writing an international program of risks (such that very few relate to U.K. insurable risks), the profits on such a subsidiary are not subject to U.K. tax, apart from the proportion of profits, if any, relating to the U.K. insurable risks. This is a significant change to the old rules, where all profits under the control of the U.K. parent were taxable. It means that captive centers such as Guernsey, Bermuda and Cayman should be much more attractive to U.K. parented multinational groups with limited exposure to U.K. risks. As all dividends from U.K.-owned subsidiaries are exempt for tax under the dividend exemption rules, this non-U.K. generated profit becomes “tax free” even when returned to the parent.
Secondly, the de minimis profit limit for captives has increased from £200,000 to £500,000, where the non-trading income or investment income attributable to shareholders is less than £50,000. This means that smaller captives’ profits are not subject to U.K. tax, even if the risks are located in the U.K. Whilst captives are not set-up to avoid tax, there is clearly an advantage to be gained for larger U.K. companies in setting up a captive to write a limited portfolio of risks, as the company can save 21 percent of the cost of the premiums payable to a captive, as opposed to insuring on the balance sheet, although it may have to pay 6 percent IPT if the insurance is direct.
The new intergovernmental agreement between the U.K. and its Crown Dependencies, such as Guernsey, and its Overseas Territories, such as Cayman, might be seen by some as a hindrance to putting in place new tax-efficient captive structures. In fact, the IGA is really only designed to flush out those companies and individuals who have not, to date, accounted properly for their U.K. tax. It provides a “disclosure facility” for the U.K. tax payer to declare their unpaid tax liabilities with a sort of amnesty in relation to penalties and fines. However, most major corporations, or at least those who have a risk management function sophisticated enough to have a captive, have been accounting properly for their U.K. tax for many years, such that they have no need to worry about an automatic exchange of information, and rather, they are well positioned to take full advantage of the new CFC rules to, perhaps, reduce down their U.K. tax liability even further – legally. This is not tax avoidance, it is merely applying the tax rules in a way which everyone else does – in a manner which is tax efficient. The primary reason for having a captive still remains risk management, rather than tax avoidance, just as it always has done.