Double Tax Relief Onshore Poolin by fjwuxn


									Double Tax Relief: Onshore Pooling – The Caucus Race?

Peter Cussons, International Tax Partner, PricewaterhouseCoopers, discusses the new Double Tax Relief
onshore pooling rules published as part of the Finance Bill 2000

Those of you with young children (or who are still children at heart) will remember that when the Lory
suddenly announced that the Caucus race in Alice in Wonderland (to dry everyone out who had fallen into
the pool of Alice’s tears) had finished, the Lory also declared that everyone was a winner, and Alice had to
find prizes.

Although not everyone will be a winner, there should be fewer major losers, as compared to the post-
Budget 2000 starting position, with the publication on 13 July of the Report stage amendments introducing
onshore pooling.

The legislation covers 16 pages and is densely drafted. The hand of the Tax Law Rewrite Committee is not
discernible. However, what is on offer is mainly welcome, with the exception of relief being restricted to
the upper cap where there is more than one cap in a vertical outbound chain and the treatment of
withholding tax on high tax dividends into a mixer as potentially triggering an upper mixer cap (so that
excess underlying tax above 30% is lost – see below).

Structurally, the Report stage amendments introduce new sections 801C and 806A-806M, after the new
Section 801B (Paragraph 11 of Schedule 30 FB2000), which is the welcome relieving provision as regards
foreign tax paid history of companies involved in legal mergers, or other Memec-type situations, where
relevant profits move from one company to another via a partnership or say trust, otherwise than by way of

Section 801C, which covers 2½ pages, requires the separate streaming of dividends in so far as they
represent an Acceptable Distribution Policy (ADP) dividend of a Controlled Foreign Company (CFC). The
Section proceeds by unbundling an ‘intermediate dividend’ (defined in Section 801C(11)) into an ‘ADP
dividend’ (defined in Section 801C(5)(a)) and a ‘residual dividend’, (defined in Section 801C(5)(b)).
Section 801C(11) defines an ‘intermediate dividend’ as any dividend paid by a non-UK resident company
representing one or more ‘initial dividends’(defined in Section 801C(10)(b) as a CFC ADP) and which
either is the ‘subsequent dividend’ (defined in Paragraph 4(1)(b) Schedule 25 ICTA 1988) or is itself to any
extent represented for Paragraph 4 Schedule 25 purposes by a subsequent dividend.

As regards each of the ADP dividends, the intermediate company is then treated as if it were a separate
company with distributable profits equal to the amount of the ADP dividend (Section 801C(6)). This
effectively quarantines a CFC dividend for DTR purposes. There are then rules (Section 801C(8),(9))
dealing with circumstances where an intermediate company (between the CFC and a water’s edge UK
resident company) pays an ‘independent dividend’ which is not an ‘intermediate dividend’.

The good news starts with the Section 806A and B definition of ‘eligible unrelieved foreign tax’, the UK’s
version of US excess foreign tax credits (FTCs). Section 806A(2) begins by specifying that ‘eligible
unrelieved foreign tax’ can arise on any dividend chargeable to tax under Schedule D Case V, other than
dividends which are or may be treated as trading income for Section 393 ICTA 1988 (Schedule D Case I
loss carry forward) purposes, or a dividend caught by the Section 801A bought in excess foreign tax credits
legislation, or a bank receiving a dividend within Section 803 reflecting withholding tax loans in respect of
which Section 798 would have applied, or a dividend where Double Tax Relief is given by deduction under
Section 811 ICTA 1988.

‘Eligible unrelieved foreign tax’ on a Schedule D Case V dividend (other than the exclusions noted above)
then arises in three circumstances.
The first is where a UK resident water’s edge company receives a Schedule D Case V dividend (subject to
the above exclusions) directly, and the Section 797 ICTA 1988 restriction of Double Tax Relief by
reference to the UK corporation tax on the foreign income applies but not the Section S799(1)(b) ‘mixer
cap’ (Case A as defined in Section 806A(4)). Secondly, where the new Section 799(1)(b) ‘mixer cap’ (as
defined in Section 806J(7)) applies to a Schedule D Case V dividend (even though there may be no mixer),
although it then becomes a Case B dividend (Section 806A(5) and Section 806B(3)).

Thirdly, where the new Section 799(1)(b)/(1A) 30% mixer cap applies to a dividend between overseas
companies, and the Double Tax Relief is consequently less than it would have been (Section 806A(5) and
Section 806B(4)). Worryingly, this only applies to ‘eligible unrelieved foreign tax’ in respect of the top
cap, where the mixer cap applies more than once in an outbound chain from the UK (Section 806(B)4(b)).
This suggests that groups with third country companies held via a mixer and via a second country company
will urgently need to restructure.

Moreover, where high tax dividends into a mixer suffer withholding tax (basically dividends other than
from the EU or Switzerland), unless there is low tax income (for example Dutch 7% regime) in or going
into the mixer, the withholding tax could cause the mixer dividend to the UK to itself be capped, with a loss
of lower tier capped tax. A similar problem could arise with expenses in a mixer.

Section 806B then goes on to limit the amounts of ‘eligible unrelieved foreign tax’ in all cases by reference
to the ‘upper percentage’, which is 45% (see Section 806J(7)).

An interesting dichotomy emerges at this stage as regards the treatment of withholding tax. In Case A and
the second version of Case B (a Schedule D Case V dividend received by a UK resident water’s edge
company), the ‘eligible unrelieved foreign tax’ appears to include any withholding tax, in so far as that is
an ‘amount of credit for foreign tax which under the arrangements (normally a treaty) is allowed against
corporation tax in respect of the dividend’ (Section 806A(4)(b) as applied by Section 806B(2)(a) and
Section 806A(5) as applied by Section 806(B)(3)(a). So in Case A and the Schedule D Case V version of
Case D, the underlying tax and the withholding tax all have to come within the 45% ‘upper percentage’
ceiling (Section 806B(2)(b) and Section 806B(3)(b)).

However, as regards the second version of Case B, the ‘eligible unrelieved foreign tax’ is defined by
Section 806B(5) by reference to the amount of underlying tax available by virtue of Section 801(2) or (3),
as compared with the greater amount of underlying tax that would have been available had the 30% cap
been computed with reference to 45%. So withholding tax between a third company and overseas company
or mixer or indeed between a fourth and a third company, and so on, does not go immediately into the
onshore pool, but is dealt with as underlying tax of the next company up the chain.

The above suggests that, in so far as we are dealing with dividends received by UK water’s edge
companies, the 45% ceiling has to cover both withholding tax and underlying tax, but at least the
withholding tax goes straight into the onshore pool. By contrast, with withholding tax leakage between
third companies and overseas companies (in Section 801(1),(2)), or indeed between third and fourth
companies and so on, the withholding tax becomes part of the underlying tax of the next company up the
chain and can potentially itself trigger a higher level mixer cap.

There are then dividend tracking rules (Sections 806B(6)-(8)) dealing with identification of the quantum of
‘eligible unrelieved foreign tax’ where there is less than 100% distribution of the initial dividend right the
way up the chain to the UK water’s edge company.

The really good news starts at Section 806C, which specifies the type of ‘qualifying foreign dividend’
against which ‘eligible unrelieved foreign tax’ may be offset. As heralded in the 16 June Press Release,
‘qualifying foreign dividends’ are defined to be any Schedule D Case V dividend (subject to the exclusions
in 806A(2) discussed above), other than a CFC ADP dividend or so much of any dividend paid by any
company as represents an ADP dividend paid by another company which is a CFC, and other than a
dividend in respect of which an amount of ‘eligible unrelieved foreign tax’ arises. So a ‘qualifying foreign
dividend’ is basically going to be a non-CFC ADP dividend which is low tax, either directly received by a
UK water’s edge company, or via a mixer, but where the 30% cap does not kick in at any level.

‘Qualifying foreign dividends’ are then divided into the sheep (‘related qualifying foreign dividends’)
where the Section 801(5) 10% direct or indirect voting control exists, and the goats (‘unrelated qualifying
foreign dividends’) where the 10% voting threshold is not satisfied.

Section 806C(3) then, for purposes of Double Tax Relief, requires the ‘related qualifying foreign
dividends’ to be aggregated; the ‘unrelated qualifying foreign dividends’ to be aggregated; the underlying
tax in relation to the ‘related qualifying foreign dividends’ to be aggregated, and the foreign tax paid other
than underlying tax (withholding tax) in relation to the ‘qualifying foreign dividends’ to be aggregated.

Section 806C(4) then provides that Double Tax Relief shall be given by attributing to the ‘single related
dividend’ the underlying tax in relation to the ‘related qualifying foreign dividends’, and pro-rating the
withholding tax on ‘qualifying foreign dividends’ between the single related and the single unrelated
dividends. The latter would presumably be relevant where there is, say, a 9% minority shareholding in a
non-UK resident subsidiary of a Plc.

Section 806D then defines ‘eligible underlying tax’ (Section 806D(1)) and ‘eligible withholding tax’
(Section 806D(2)) and provides that upon a claim (Section 806G in relation to Section 806D(4) or (5)), the
‘relievable underlying tax’ and/or ‘relievable withholding tax’ (as defined in Section 806D(3)) shall be
allowed as Double Tax Relief with respect to the single related dividend in the current accounting period,
or the next accounting period, or the three preceding accounting periods. So whereas Section 806C sets out
the basic onshore pooling definitions, Section 806D provides for the current period offset and carry-
forward and/or carry-back of eligible unrelieved foreign tax.

Section 806E introduces a LIFO rule (Rule 2 in Section 806E(3)) as regards carry-back of eligible
unrelieved foreign tax; that is it must be carried back into the immediately prior period, rather than leap-
frogging to pre-prior periods.

Rule 3 Section 806E(4) then provides that current period relievable tax must be offset first, then brought
forward relievable tax, and finally carried back relievable tax.

There is an overriding rule that carry-forward and carry-back of relievable tax must never cause eligible
unrelieved foreign tax to arise in respect of what otherwise would be a qualifying dividend (that is the
carry-back or carry-forward of eligible unrelieved foreign tax must not exceed the capacity to absorb it).
See Section 806E(5) and Section 806D(6).

Section 806F introduces a new rule requiring the offset of underlying tax under onshore pooling to be in
priority to the offset of withholding tax. This appears partly to be a function of withholding tax being
excluded from the second version of Case B eligible unrelieved foreign tax, but also, possibly, noting that
the level of withholding tax is a function of the treaty policy of the UK and other treaty partner countries,
and of EU Directives such as the Parent Subsidiary Directive.

Section 806G introduces the same claim time limit of six years, or if later, one year after the end of the
accounting period in which the foreign tax in question is paid.

Section 806H is perhaps another step along the road to full tax consolidation in the UK. It provides for the
Board of Inland Revenue to make regulations (by way of statutory instrument) to allow the surrender of
‘relievable tax’ from one company which is a member of a group to another. This should obviate the need
for all 10% or greater foreign shareholdings to be transferred to a single UK resident company (or UK
trading branch - see below) within a group.

Section 806J is interpretational.
Section 806K extends the onshore pooling regime to UK branches or agencies of non-UK resident persons.
Interestingly, the provisions appear to apply to income tax as well as corporation tax (Section 806K(2)(b)-

These sections are presumably in response to the ECJ Compagnie de St Gobain case, in the same way as
Paragraph 4 of Schedule 30 FB2000 amends Section 790 ICTA 1988 to remove the requirement of UK
residence for eligibility for Double Tax Relief.

Sections 806 L&M contain three-year carry-back and indefinite carry forward provisions for unrelieved
foreign tax of overseas branches of the corporation. Each branch is a separate source unless there is more
than one branch in a particular country (Section 806M(4)).

Even if, unlike Alice, you haven’t been running around whilst reading this, to get back broadly where you
started, steam should surely be arising from the cold towel!

Inevitably, there are some comments that should be made from a European perspective. The prospective
abolition of mixing (from 31 March 2001) without the ability, in practice, to take advantage of the new
onshore pooling regime for a UK group with a single Dutch mixer is arguably a restriction on the freedom
of establishment of a UK Plc. On the one hand, if it restructures to hold, say, an Irish and a German trading
subsidiary directly from the UK, onshore pooling should be available for the unrelieved foreign tax on the
German dividend against the qualifying Irish dividend to the UK.

In contrast, if the UK group in question does not restructure, excess German tax above the cap operating
when the German subsidiary pays a dividend to the Dutch mixer can never in practice be relieved unless
German federal and state tax rates (after interaction) fall below 30%, in the next round of German tax
reform. (Even after the tax reform agreed Friday 13 July, the effective tax rate for a subsidiary in Frankfurt
in 2001 is likely to be around 38% - 40%.)

Moreover, UK tax will be paid on the Irish element of the mixer dividend even though there is a carry-
back/ carry-forward of foreign tax.

There is a public policy defence to restrictions on freedom of establishment, but it is hard to see that this
applies even taking into account the EU Code of Conduct. The inability of a UK group with a single non-
UK resident sub-holding company to use the onshore pooling provisions in practice after next year’s
abolition of mixing applies equally to French, German, Italian etc sub-holding companies as it does to
Dutch or Luxembourg sub-holding companies.

The only clear conclusions are:

That practically all groups with overseas operations who can from a regulatory perspective do so will have
to restructure, unless the mixer can generate relievable and qualifying dividends in alternate accounting
periods and
There is a strong compulsion to hold overseas operations directly from the UK, to avoid loss of DTR
because of multiple caps in an outbound chain, and in particular because of the new rules treating
withholding tax into a mixer as potentially resulting in a (small) cap between the mixer and the UK, with
the resulting possible loss of underlying tax relief in respect of the cap between the high tax subsidiaries
and the mixer, and/or lower down the chain, and
That for many groups there will be tax and other costs in doing so.


Tax Journal, 31/07/00

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