INTM208150 - Controlled Foreign Companies: exemptions - the motive test

The diversion of profits leg of the motive test: would the United Kingdom person have paid more, or been entitled to less relief from, United Kingdom tax?

The third and last question to be answered with regard to the statutory definition is slightly less problematic. What has to be decided is whether (if it would be reasonable to suppose that the whole or a substantial part of the receipts would have been received by a United Kingdom person), that person

1. would have been liable for any United Kingdom tax or for a greater amount of such tax; or
   
   
2. would not have been entitled to a relief from, or repayment of, such tax or would have been entitled to a smaller relief or repayment.
   
   

As with the transaction leg, it is necessary therefore to determine what would have been the tax position if the controlled foreign company’s receipts had been received by a United Kingdom person and to compare that with the actual position where the receipts are received by the controlled foreign company. In most instances, of course, the receipts would have been taxable had they been received by a United Kingdom person and therefore the United Kingdom person would have paid more United Kingdom tax - or would have been entitled to less relief from United Kingdom tax.

So, except in exceptional circumstances it will nearly always be the case that, in accordance with statutory definition, the existence of a controlled foreign company does indeed achieve a reduction in United Kingdom tax by way of a diversion of profits from the United Kingdom. The fact that the existence of virtually every controlled foreign company achieves a reduction in United Kingdom tax by way of a diversion of profits from the United Kingdom has led to suggestions that:

1. it is impossible to pass the motive test; and that therefore
   
   
2. the Revenue’s interpretation of the motive test must be wrong as Parliament cannot have intended to introduce a test that is impossible to pass.
   
   

As with the transaction leg, the statutory definition element is clearly a tight one but that does not mean that it is impossible to succeed in a claim to pass the diversion of profits leg of the motive test nor that the Revenue’s interpretation is incorrect. As noted with regard to the transaction leg, the statutory definition is quite deliberately worded to have the widest possible application since it is simply intended to set the context of what is, after all, a motive test.

As such, all it is seeking to do is to establish what is meant by 'a reduction in United Kingdom tax by a diversion of profits from the United Kingdom' so that there is a firm basis on which to assess the reasons for the existence of the controlled foreign company. In such a context, it seems sensible to ensure that the definition has an appropriately wide application.

The important part of the diversion of profits leg is whether the achievement of the reduction in United Kingdom tax (as defined by ICTA88/SCH25/PARA19) was the main reason or one of the main reasons for the controlled foreign company’s existence in that accounting period. Even if the controlled foreign company’s existence does achieve a reduction in tax by way of diversion of profits, the motive test will be passed if it was not the main reason or one of the main reasons for the controlled foreign company’s existence to achieve that reduction.

Presumption of receipts

All that said, the Inland Revenue’s interpretation is not shared by everyone. One question that regularly arises is that, if the controlled foreign company does not exist, how can there be any receipts? The only logical answer to that is that, since one is required to identify the destination of the receipts, whilst the entity is deemed not to exist, its receipts must be presumed to continue to exist. After all, if one deems both the controlled foreign company and its receipts out of existence, ICTA88/SCH25/PARA19(1)(a) does not make a lot of sense. If there are no receipts, there is nothing for one to determine if it is reasonable to suppose that a United Kingdom person would receive.

Clearly, this is not an easy concept. It has been suggested that, if Parliament had intended that:

• the controlled foreign company should be deemed not to exist; but that
• its receipts must be presumed to continue to so exist

it would specifically have provided for that outcome in the legislation.

There is a superficial logic to this view. A more persuasive logic, however, is that it is so obviously implicit in the legislation that it does not need to be made explicit. It is clear that:

• notwithstanding that the controlled foreign company is deemed not to exist,
• the question of whether it is reasonable to suppose, in the controlled foreign company’s absence, those receipts would have been received by a United Kingdom person is to be considered on the basis that all of the receipts arose notwithstanding its deemed absence; and
• those receipts must be received by someone.

On the additional assumptions that:

• there are no overseas associates of the controlled foreign company which can fulfil the same functions as the controlled foreign company; and
• one can invent a United Kingdom company as the recipient if it is reasonable to do so

what one is required to determine is whether, given all that, it is reasonable to suppose that the recipient of the receipts would be a United Kingdom person.

Presumption that actual receipts continue to exist

Another argument that has been put forward is that:

• even if the deemed absence of the controlled foreign company does not automatically deem its receipts not to exist,
• there may be circumstances where the only reasonable supposition to be made, in the absence of the controlled foreign company, is that the receipts would not have arisen at all or at least not in the same form
• because the actual transactions undertaken by the controlled foreign company would not have been carried out (or have been carried out differently) if the controlled foreign company did not exist.

The argument continues that it is entirely reasonable to suppose that, had the controlled foreign company not existed, the group would have done things differently. If the different options open to them would not have led to any United Kingdom tax consequences, the controlled foreign company’s existence cannot have been to achieve a reduction in United Kingdom by a diversion of profits.

There is, again, a superficial logic to this but it requires more assumptions than the legislation directs should be made. As with the transaction leg, it needs to be noted that ICTA88/SCH25/PARA19 simply provides a definition of what is meant by the existence of a controlled foreign company achieving a reduction in United Kingdom tax by a diversion of profits from the United Kingdom. The definition is based on comparing the tax position resulting from the existence of the controlled foreign company with the tax position that would have resulted had the controlled foreign company (or any non-United Kingdom affiliate that could perform the same function) not existed.

In this context, all the statute directs is that an assumption is to be made that the controlled foreign company (and any non-United Kingdom affiliate that could perform the same function) did not exist. Beyond enabling one to deem the existence of a United Kingdom company to carry out the same function, it does not direct that any further assumptions are to be made. So, as with the transaction leg, there is no scope for considering hypothetical scenarios which might have taken place instead of what did happen - however reasonable such a hypothesis might be. Proceeding on that basis would be to write words into the legislation.

In any event, if this interpretation were correct, there would be hardly any circumstances in which a controlled foreign company would not pass the motive test. Take, for example, the archetypal example of United Kingdom tax avoidance, a money box - one of the types of company for which the diversion of profits leg was specifically designed. Its receipts will typically be deposit interest from an offshore bank.

If the above view is correct, it could be argued that, had the controlled foreign company not existed, it would be reasonable to suppose that the controlled foreign company’s receipts would not have arisen because:

• the offshore deposit would not have been made; and
• no equivalent deposit would have been made in the United Kingdom because the return after tax would not be economic.

Instead the deposited funds would have been used, say, to pay off existing group debt in the United Kingdom. In such a situation, no receipts would have arisen because there was no deposit on which interest could accrue.

That was clearly not Parliament’s intention when passing the legislation. On any interpretation, the money box exists to divert profits from the United Kingdom. It would be absurd if a definition of what is meant by diversion of profits did not cover such a company because it was possible to argue that:

• there was no diversion of tax because
• in the absence of the controlled foreign company, it is not reasonable to suppose that the receipts would be received in the United Kingdom because
• it would mean United Kingdom tax would have to be paid on the receipts.

One must therefore make the determination of whether it is reasonable to suppose that the receipts would be received in the United Kingdom on the basis that the actual receipts received by the controlled foreign company continue to exist.

Context and meaning of 'would have been received by a United Kingdom person'

It has been suggested that the Revenue’s interpretation of ICTA88/SCH25/PARA19 (1) amounts to a distortion of the statutory language in that it essentially amounts to interpreting the question as to whether 'it is reasonable to suppose that … the receipts … would have been received' by a United Kingdom person as: could the receipts received by the controlledforeign company have been received by a United Kingdom person?

Those who suggest this argue that, given that the legislation could easily have included those latter words had that been the intended meaning, the fact that it uses quite different words must mean that the Revenue’s interpretation is incorrect. The words actually used must mean something different. The Revenue accepts that the word 'would' is quite different from 'could'. HM Revenue and Customs’ view, however, is that, in the context of the rest of ICTA88/SCH25/PARA19, its interpretation is the only one that makes sense.

Controlled foreign company with receipts from overseas associates

There is one further point of interpretation that has been the subject of some debate. It concerns the requirement to deem all overseas associates of the controlled foreign company out of existence. Some have questioned what happens if the person from whom the controlled foreign company receives its receipts is such an associate.

HM Revenue and Customs’ view has always been that this is irrelevant to the situation the legislation requires us to consider. Since it requires that the receipts continue to exist notwithstanding the deemed non-existence of the controlled foreign company, it is entirely irrelevant from whom the receipts are received.

In any event, the statute directs that only a related company that 'fulfils, or could fulfil, directly or indirectly, substantially the same functions as the controlled foreign company' is to be assumed not to exist. It is axiomatic that a person cannot transact with himself. A connected party that is the payer of the receipts of the controlled foreign company cannot therefore 'fulfil, directly or indirectly, substantially the same functions as the controlled foreign company'. It follows that a connected party that is the payer of the receipts of the controlled foreign company is not to be deemed out of existence.

This has been of particular interest following the change to the exemption for offshore holding companies. It has been argued that all the borrowing subsidiaries (as 'related' companies) must be deemed out of existence as well as the holding company. As such, the argument goes, it is not reasonable to suppose that the receipts would be received by a United Kingdom person since there would be no receipts. It follows from what is discussed above that this is based on an incorrect interpretation of the statute.

Summary

In summary, the statutory definition part of the diversion of profits leg is applied as follows:

• the controlled foreign company is deemed not to exist; but
• notwithstanding its absence, the question of whether it is reasonable to suppose that the receipts would be received by a United Kingdom person can only be considered on the basis that the receipts continue to exist;
• those receipts must be received by someone;
• in determining who that someone might be, one must assume that:
• there are no overseas associates of the controlled foreign company which can fulfil the same functions as the controlled foreign company; and
• one can invent a United Kingdom company to be the recipient if it is reasonable to do so.

As such, with very few exceptions, it will nearly always be reasonable to suppose that the receipts would be received by a United Kingdom associate of the controlled foreign company because it is not reasonable to suppose that the receipts could accrue to anyone outside the group

As noted above, however, that is not the end of the matter. Even if the statutory definition is fulfilled, a controlled foreign company will only fail the diversion of profits leg of the motive test if the motive element is failed.