Anne Fairpo discusses CFC reform and IP

CFC reform and IP

In order to reduce the risk of companies diverting profits overseas without good commercial reason, UK companies are subject to tax on the profits of their ‘controlled foreign companies’.  A controlled foreign company (CFC) is one which is resident outside the UK, controlled by persons resident in the UK - the reform of the rules removes the requirement that the company be in a lower tax jurisdiction than the UK, although there is an exemption for CFCs in countries with effective tax rates similar to the UK.


‘Control’ is determined by considering the rights of the UK residents with an interest in the company, together with any rights held by persons connected with the UK resident. Broadly, a person will have control of they have power to secure that the affairs of the company are conducted in accordance with their wishes, where that power arises through shareholdings, voting power, or by the documents governing the non-UK company (ICTA 1988, s747 – being replaced with an equivalent provision under the current reform proposals in Finance (No 4.) Bill).

When do the new CFC rules apply to IP profits? Let-out 1: the gateway

Where an entity is capable of being a CFC, the profits have to pass a gateway test in order to be capable of being caught by the rules.  For an IP holding company, the relevant part of the test is Chapter 4, covering profits attributable to UK activities. The other parts of the gateway test relate to finance profits and captive insurance businesses, and so will be less relevant to IP businesses.

Chapter 4 will apply, so that the test is met and the profits are within the scope of the CFC charge for the UK shareholder unless one of the following four conditions is met.

The first condition is that the assets and risks of the CFC must not be held under an arrangement which has as its main purposes, or one of its main purposes, the reduction or elimination of liability to tax in the UK of another person, and the CFC expects its business to be more profitable than it otherwise would be.

The second condition is that the CFC does not have any UK managed risks or assets.

The third condition is that, if it does have UK managed assets and risks, then the CFC would be commercially effective even if it did manage the assets and risks directly.

The fourth condition cannot be met by a company whose business is the exploitation of IP, so it is not considered further.

It should be possible for a non-UK company holding intellectual property to meet one of these conditions so that the profits are outside the UK tax charge.

In particular, a CFC with appropriate substance should be able to have no UK managed assets and risks. One of the points of the new CFC rules is that they should not catch companies with appropriate substance and management in their local jurisdiction, even if that company pays little local tax. The key is to ensure that profits are not artificially diverted from the UK – HMRC are finally beginning to accept that businesses are not required to operate solely from the UK and that it is open to a business to move some or all of its operations outside the UK.

Let-out 2: Taxable profits

Where the gateway test cannot be met, so that the profits of the cell could fall within the CFC charge for a UK shareholder, the profits within the UK tax charge are calculated.  Excluded from those profits are profits from ‘trading income’, which will include IP profits unless the profits come from IP that was transferred to the UK within the previous seven years or so.  There’s no bona fide commercial exclusion, so it’s questionable whether this meets EU law requirements post-National Grid but, in practice, it means that profits from non-UK connected IP will be outside the CFC tax charge.

Let-out 3: exemptions

If the CFC fails the gateway test, and can’t exclude the IP profits, there are still a number of exemptions available. The principal exemption likely to apply to an IP business in this case would be the general exemption for CFCs with low profits; in particular, the profits of a CFC with accounting profits (or assumed UK-equivalent taxable profits) of less than £500,000 and non-trading profits of less than £50,000 will be exempt from the charge (proposed TIOPA 2010, s371LB following Royal Asset for Finance Act 2012).

Other exemptions

There are other exemptions which could apply but the main ones have a requirement that the IP not be UK connected, so companies that fail the second let-out above will probably fail to qualify for these as well:

IP holding company exemption

There is a IP holding company exemption (Sch 25A, PArt 2B, ICTA 1988, inserted by Finance Act 2011): this exemption applies, however, only for profits of a CFC whose sole business is foreign-to-foreign licensing of IP with a minimal UK connection.

The IP itself must have a minimal UK connection, which is to say that it cannot have been transferred from someone (related or otherwise) in the UK in the accounting period or the previous 6 years before the accounting period started.

Where the CFC itself creates (or subcontracts someone else to create) the IP, then the IP will not have a substantial UK connection, provided that the R&D was not done in the UK by a connected person or paid for by a UK connected person. The IP must also not be maintained or enhanced in the IP by a connected person.

In addition, the CFC itself cannot have substantial income from the UK (substantial is not yet defined), hence the focus on foreign-to-foreign licensing.

Excluded territories exemption

Finally, there is an exemption for CFCs in particular named territories – but this is subject to the same test for IP income as the taxable profits exclusion: it must not be derived from IP transferred by related parties from the UK in the accounting period or the six years before that.


The revised CFC rules provide a reasonable territorial exclusion for IP income from the UK tax charge on CFCs, with the principal issues being with IP that has had some connection with the UK in the last seven years or so.  It’s questionable whether the rules properly comply with EU law but, in general, it is a substantial improvement on the old CFC rules (which rather seemed based on the view that any non-UK IP ownership was tax avoidance).

Anne Fairpo

Written by Ellie MacKenzie

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