INTM205090 - Controlled Foreign Companies: exemptions - Exempt Activities Test ('EAT')
Wholesale, distributive, financial or service business
ICTA88/SCH25/PARA6(2)(b) and PARA11
Where a controlled foreign company is mainly engaged in wholesale, distributive, financial or service business, it cannot meet the requirements of the exempt activities test if 50% or more of its gross trading receipts are derived from certain affiliates or unconnected UK persons (see INTM205050). Each of the following activities constitutes wholesale, distributive, financial or service business. The list is exhaustive.
- Dealing in any description of goods wholesale rather than
retail.
- The business of shipping or air transport.
- Banking, deposit-taking, money lending or debt factoring, or
any business similar to these businesses.
- The administration of trusts.
- Dealing in securities in the capacity of a broker, as defined
in ICTA88/SCH25/PARA9(2) (see
INTM205070).
- Dealing in commodity or financial futures.
- Effecting or carrying out contracts of insurance, as defined in
Article 3(1) of the Financial Services and Markets Act 2000
(Regulated Activities) Order 2001.
- The provision of services not falling within any of the above.
The definitions of wholesale, distributive, financial and
service business and of investment business (see
INTM205070) are not mutually exclusive
and it is possible, although unlikely in practice, for a
company’s main business to be both financial and investment
business. In such a case it is unnecessary to apply the 50% gross
trading receipts test as the company will inevitably fail the
exempt activities test by virtue of ICTA88/SCH25/PARA6(2)(a)(i).
Where the gross trading receipts of a company include the
sale proceeds of any property or rights, the cost to the company of
the property or rights is to be deducted in computing its gross
trading receipts for the purposes of ICTA88/SCH25/PARA6(2)(b). The
effect of this for a company dealing in goods or other property is
that its gross trading receipts are taken to be its gross trading
profit after deduction of the cost of the goods.
The definitions in ICTA88/SCH25/PARA11 (1) are, in the main,
self explanatory. The word 'services', for example in the last of
the above definitions – 'the provision of services' - takes
its ordinary English meaning (albeit in the context of
ICTA88/SCH25/PARA11 (1)). It covers a very wide ambit of
activities, including, for example:
- a business providing group management services (such as administration, treasury or property management services);
- a business providing international services to third parties but through another group company based, for example, in the territory of the third party; and
- a business developing software on behalf/for the use of other group companies.
If a company is unsure about whether a controlled foreign company is involved in the provision of services, it can ask Business International, Outward Investment Team for guidance or a clearance. Where a company is mainly engaged in either (i) banking, deposit- taking, money lending, debt factoring or any similar business, or (ii) insurance business, (that is, (c) and (g) above respectively), there are modifications to the application of the 50% rule for transactions with associates etc. in ICTA88/SCH25/PARA6(2)(b).
Directly and indirectly
In most cases, it should be clear whether a transaction has been
made directly with an affiliate or with an unconnected UK company,
permanent establishment or 'habitually resident' individual (see
below for the meaning of 'habitually resident').
This principle is harder to apply when the transaction is
indirect. There will be many occasions when a UK person does
business with an intermediary third party which is unconnected to
the controlled foreign company but which also does business with
that controlled foreign company. If that intermediary is in the UK,
then any receipts of the controlled foreign company will fall
within the list, as they come directly from a UK person. If the
intermediary is not in the UK, the transaction may still fall
within the definition of receipts indirectly derived from UK
persons.
The test to be applied here is no different in principle
from the test applying under the existing legislation to payments
indirectly derived from connected or associated companies. However,
we recognise that, in practice, controlled foreign companies may
not always have access to information on indirect transactions with
third parties. We will therefore accept that it may be reasonable
to rely on assumptions as to the source of funds received
'indirectly' in the light of this guidance. In the vast majority of
cases, identifying whether or not payments are derived directly or
indirectly from UK persons will be so straightforward that the
result of the 50% test will be very clear. In such cases, precise
identification of 'indirect' customers will not be needed. However,
in marginal cases, those companies that operate at or close to the
50% limit will need to pay closer attention to demonstrating
entitlement to the exempt activities test.
Examples of direct transactions
If the third party deals directly with the retail customers of
its UK associates, then it would be reasonable to expect the
controlled foreign company to be able to identify those UK
customers. However, if there is no similar connection between the
UK person and the controlled foreign company's group, then the
controlled foreign company may make such assumptions as are
reasonable in identifying indirect UK transactions. The examples
below illustrate this distinction:
Example 1
If the intermediary identified in Paragraph 16 normally
deals with individuals in its own territory, then it would be
reasonable to assume that all transactions between the controlled
foreign company and the third party are not indirectly with UK
individuals. It would not be necessary to identify all customers of
the third party in the absence of a relationship between those
customers and the controlled foreign company's group.
Example 2
If the said intermediary deals with customers introduced by
an associate of the controlled foreign company, then it would be
reasonable for the controlled foreign company to identify those
persons more precisely.
Examples of indirect transactions
It will not always be the case that the payment between the UK
person and the intermediary will be entirely independent of any
subsequent transactions between that party and the controlled
foreign company. A receipt does not necessarily lose its integrity
or identity merely because it passes through a different form or
legal entity. There is a strong presumption that any payment to a
controlled foreign company by an intermediary third party, which is
in some form conditional, dependent or related to a receipt by that
intermediary from a UK source, will fall within the term
'indirectly derived'. However, conditional or dependent in this
context should not be read as including a remote cause. The capital
funding of a non-UK trust or non- resident company may derive from
UK individuals. But this linkage alone would not be sufficient to
deem all subsequent expenditure by those persons as indirectly
derived from the UK. As a general rule, a payment will be
indirectly derived from the UK if the subsequent transaction with
the controlled foreign company transfers a significant part of the
economic risk/return to the controlled foreign company.
Example 3
A controlled foreign company has receipts from the provision
of services to an intermediary which has 51% UK shareholders
(unconnected to the controlled foreign company) but trades outside
the UK. The UK residence of the shareholders will not be sufficient
to make that service income indirectly derived from a UK person in
the hands of the controlled foreign company (provided no special
requirements attach to those UK shareholders' capital investment
e.g. to link that investment with the subsequent service
provision).
Example 4
A UK person takes out a service warranty with a non-UK third
party. That company passes a substantial part of its liability from
that and other transactions with UK persons to a captive insurance
company. The receipts of the captive arise as a direct consequence
of the transaction with the UK person and will therefore be
indirectly derived from UK persons.
Permanent Establishments – ICTA88/SCH25/PARA6 (2c)
The list of non-qualifying transactions includes non-resident UK
companies that have a permanent establishment in the UK. However,
only transactions directly or indirectly with that UK permanent
establishment will come within the extended list. All other
transactions with the non-resident company will fall outside the
scope of the extended list, provided that company does not itself
carry out transactions with UK persons.
Note that for accounting periods commencing on or after 1
January 2003, as a result of the changes made by FA03/S152, this
reference is to the 'permanent establishment' of such a company.
However, for accounting periods commencing on or after 27 November
2002 but before 1 January 2003 the reference is to 'branch or
agency'.
Habitually resident – ICTA88/SCH25/PARA 6(2A)(f)
For the purpose of establishing whether business has been
derived from a UK individual, the new legislation introduces the
concept of 'habitual residence'. Other tests, such as residence,
ordinary residence and domicile, require detailed examination of
facts and circumstances beyond what is necessary for this purpose.
'Habitually resident' is a significantly simpler concept,
essentially focussed on the question 'does this person normally
live in the UK'?
The term 'habitual residence' is used in insurance
legislation to identify classes of business. The term is derived
from Article 2(d) of the second EC non-life insurance
directive.
