UK: The UK as a Location for a Holding Company - Income Aspects

Originally presented to the International Bar Association, Taxes Committee on 10 April at the IBA conference in Dublin for Best Location for Holding Companies.

Corporate groups often set up holding companies to provide a command and control function or clear reporting lines for their organisation in a particular region or, more unusually, a product or service line. Although it would be possible to hold a group's operational branches or subsidiaries directly from the ultimate parent, an intermediate holding company makes it easier to control the relevant business segment. Holding companies are also used to finance group activities or expansions and to hold intellectual property.

An ideal holding company jurisdiction would have:

Whilst tax can and does influence the location for holding companies, non-tax factors are important and often override any tax planning. The other factors that are often considered include:

The UK probably has one of the best combination of non-tax attributes. It has excellent communications and is in a time zone between the US, Europe and the Far East. It prides itself on its legal system and the commerciality of its judiciary and depth of the UK legal system can provide legal certainty on most issues. In terms of the tax attributes, the UK has the world's most comprehensive tax treaty network. The historic disadvantage of the UK as a holding company jurisdiction has been the tax costs of locating a holding company in the UK, but in recent years, these have been addressed by changes in law. This memorandum will examine whether the UK is currently a useful location for a (primarily European) holding company.

Rather than considering the tax regime applying in the case of holding companies, it seems more useful to examine the major activities undertaken by holding companies. These are: setting up; acquiring and selling subsidiaries; receiving and paying dividends; receiving and paying interest; holding and licensing intellectual property; and exiting the structure. This paper will deal primarily with income related aspects of the tax implications of these activities but will touch on some capital related assets for the sake of completeness.

The first question is whether to incorporate the company within the UK or to use a non-UK incorporated company that is resident for tax purposes in the UK. Companies can be incorporated quickly in the UK or, alternatively, off the shelf companies are available almost immediately. UK incorporated companies are cheap to set up, but will be subject to UK corporate law. Often a non-UK incorporated company is used to reduce the compliance burden and effectively elect for the usually lower burden of the company law of the jurisdiction of incorporation. Typically such companies are incorporated in Jersey, Guernsey, the British Virgin Islands or the Cayman Islands, jurisdictions which charge no significant tax where companies can easily be incorporated cheaply and quickly. So long as a company incorporated in one of those jurisdictions has its central management and control in the UK, it will become tax resident in the UK.

In addition, there is no UK stamp duty on the transfer of shares in a non-UK incorporated company, so long as it does not maintain a share register in the UK.

No capital duty is charged in the UK on equity subscriptions, whether a company is UK incorporated or not.

The UK does not charge any direct tax or VAT on the acquisition of shares in a subsidiary. If the subsidiary is incorporated in the UK, stamp duty will arise, but as this will arise wherever the acquiror is located or incorporated, the jurisdiction of the holding company is irrelevant.

Under the loan relationships rules, UK companies are generally entitled to a deduction for interest and finance costs on the same basis as debits are recognised in their accounts. The loan relationship rules do not differentiate between capital and income so that loans taken out for capital purposes (including buying shares) will give rise to deductible interest which can reduce the UK company's taxable profit. By contrast, some jurisdictions generally refuse a deduction for interest on a loan used to acquire shares in a subsidiary.

Under the UK group relief scheme, losses in one group company can be surrendered to another 75% group company. It is also possible for a company owned by a consortium (or its 75% group company) to surrender losses to the consortium members (and their groups) and vice versa. Effectively, therefore, finance costs could be surrendered to most joint venture companies as well as group companies. The advantage of the deductibility of interest on acquisition finance can be enhanced where the acquiring group has other operations in the UK which can use the additional deductions. In other jurisdictions, tax consolidation is limited to a 90% group. Anti-avoidance rules can apply in the UK to the deductibility of interest and these are discussed in 5.2 below. In addition, there is the rule requiring interest owned by a non-UK resident to be paid within 12 months of the end of the accounting period in which it accrued in order to obtain a deduction in the period of accrual. The House of Lords in MacNiven¹ in a different context held that "paid" meant legally paid, i.e. round tripping the interest is permissible.

3.2 Selling Subsidiaries

In Finance Act 2002, the UK introduced an equivalent to a participation exemption for "substantial shareholdings" (i.e. a 10% or more economic interest has been held for at least 12 months in a trading company or group). Where the substantial shareholdings legislation applies, a complete exemption is provided from UK tax on gains arising on a disposal of the shares. The exemption is subject to certain conditions, the detail of which is beyond the scope of this paper.

For some time the UK has charged tax on dividends paid by non-UK resident companies to a UK resident company. All dividends within the UK are exempt from tax. Credit is given to the UK resident company against UK tax on the dividend for withholding tax on the dividend. Credit is also available for "underlying tax" i.e. tax on the profits out of which the dividend is paid provided that 10% or more of the voting power in the paying company is held, directly or indirectly, by the recipient's group. In determining the amount of underlying tax, the UK includes tax at all levels from and including the paying company down to its subsidiaries at the bottom of the ownership chain.

Traditionally, the UK permitted "mixing" of underlying tax. For example, suppose a mixer company (i.e. a non-UK resident subsidiary of a UK company) received dividends from its subsidiaries as follows: (1) a net dividend of 85 which had suffered tax of 15 from "Low Tax Sub" with (2) a net dividend 55 which had suffered tax of 45 from "High Tax Sub." blended rate of underlying tax of 30%. When the mixer company paid the aggregated dividends on to the UK, the UK would tax the full amount plus underlying tax (85+15+55+45=200) but would give credit for 60, being the blended amount of tax. This had the result that the UK tax on dividends from overseas companies (on an aggregate basis) would not generally increase the effective tax rate over the rate of UK tax (30%).

When the 2000 Finance Bill was first published, it effectively abolished mixer companies and had the effect of treating each sub-subsidiary as a separate pool of profit with a separate amount of underlying tax allocated to it. In the above example, the dividend from High Tax Sub paid through the mixer company would not suffer additional tax in the UK due to the presence of underlying tax in excess of the UK effective tax rate. The dividend from Low Tax Sub would suffer additional UK tax of 15 bringing the effective tax rate to 30% on that dividend. The overall effective tax rate would be 37.5%, i.e. in excess of the UK rate of 30%. These proposals caused much debate and opposition from the UK corporate sector which led to their amendment during passage through Parliament. When finally enacted, Finance Act 2000 introduced an "On-Shore Pooling" regime in addition to the effective abolition of mixer companies. Certain highly taxed dividends give rise to Eligible Unrelieved Foreign Tax (EUFT) which can be set against UK tax on lowly taxed dividends. In the above example, the additional unused tax on the dividend from High Tax Sub may be treated as EUFT which could be credited against the additional tax on the dividend from Low Tax Sub resulting in an effective tax rate of 30%.

As the UK rate of corporation tax is of the lower end of the European range, it is still possible to manage dividend flows to eliminate UK tax on dividends from subsidiaries by ensuring that sufficient EUFT is created to credit against dividends from lowly taxed subsidiaries. This is not as simple as the pre-Finance Act 2000 mixer company system or an exemption system operated by some jurisdictions, but may not result in additional UK tax to pay if dividends flows are properly managed. A point in favour of the system is that the holding required to avail of underlying tax is 10% of the voting power which compares favourably with some "exemption" jurisdictions such as Denmark which requires a 25% for the exemption to apply.

The UK and US have recently negotiated a tax treaty which will, when it comes into force, permit dividends to be paid from a US subsidiary to its UK parent without US withholding tax. The 0% rate applies to dividends paid by a US corporation if the beneficial owner is a UK resident company holding 80% or more of the voting power in the US corporation and meets certain other requirements. UK pension funds are also entitled to the 0% rate. If the 0% rate does not apply, a 5% rate is available if 10% of the voting power is held by the UK company. Otherwise a 15% rate applies. The treaty is expected to come into force in the next month or so.

As noted above, the UK generally exempts from the charge to UK tax any dividend paid by one UK resident company to another but charges to tax dividends received by a UK resident company from a company resident in another member state of the EU, subject to credit for withholding and possibly underlying tax. In the Verkooijen² case, the European Court of Justice (ECJ) reviewed a Dutch tax provision exempting individuals from Dutch tax where they received dividends paid subject to Dutch corporate withholding tax. The ECJ found that dividends paid subject to Dutch corporate withholding tax were effectively the same as dividends paid by a Dutch resident company. It found that the restriction of the Dutch exemption from tax for dividends paid on shares in a Dutch resident company Dutch was a breach of the free movement of capital. Accordingly, Mr. Verkooijen was entitled to the same exemption from Dutch tax on his Belgian shares.

As the free movement of capital provisions do not distinguish between individuals and companies, there are good arguments that the exemption from UK corporation tax on dividends from UK resident companies should be extended to apply to dividends paid by all EU resident companies. If this view is upheld (and it is understood that it is currently being litigated before the UK courts), the UK will become an even more attractive location for a holding company.

Dividends paid from the UK are, in all circumstances, paid without withholding tax or any economic equivalent of withholding tax. This represents a significant advantage over a jurisdiction such as the Netherlands which, even under the most favourable treaties, charges a minimum of 5% withholding tax or Denmark which charges 25% rate for non-EU and non-treaty countries (unless, in either case, the Parent-Subsidiary Directive applies).

In addition, a recipient of a UK dividend may be treated, depending on its local law and/or a tax treaty, as receiving a "grossed-up" amount of dividend (i.e. grossed-up by the tax credit attaching to UK dividends). The tax credit may then reduce the recipient's liability to tax. As the tax credit is cost free, it can significantly increase the after-tax return to the recipient.

The standard rate of withholding tax from interest paid by a UK company is 20%, subject to treaty relief. Many of the approximately 117 tax treaties to which the UK is a party reduce the rate of withholding tax on incoming and outbound interest to 0%. To obtain the treaty rate of withholding tax for payments from the UK, it is necessary for the UK payer to apply in advance for clearance to pay at the treaty rate.

If no treaty relief is available, it is possible to avoid UK withholding tax by structuring a loan as a discounted bond or by issuing quoted "Eurobonds."

Within the EU, only the UK treaties with Belgium (15%), Italy (10%), Portugal (10%) and Spain (12%) permit withholding tax on interest. The ECJ found in the "open skies" series of cases that EU law overrode bi-lateral treaties entered into by member states. In the joined cases of Hoechst³ and Metallgesellschaft⁴ that the imposition of UK advance corporation tax (a kind of withholding tax) on dividends from a subsidiary to a non-UK resident parent company where a UK to UK payment would not have suffered advance corporation tax was a breach of the right of establishment. On this basis, it is arguable that all payments of interest to companies resident in Belgium, Italy, Portugal or Spain should be made free of withholding as to single those countries out for special treatment seems to breach both the freedom of establishment and free movement of capital and payments guaranteed by the EU Treaty.

5.2 Interest Deductibility

As mentioned above, under the loan relationships rules, UK companies are generally taxed or relieved for interest and other finance costs on the same basis as credits or debits are recognised in their statutory accounts prepared under UK GAAP.

Both the capitalisation and transfer pricing rules exist to limit deductibility in cases where a UK company pays interest to a recipient that is not subject to UK corporation tax in respect of that interest. The rules only apply where the amount paid exceeds an arm's length amount. The UK Revenue has traditionally been willing to accept quite high levels of debt, provided the UK taxpayer can justify the basis in which interest is charged.

In the Lankhorst case,⁵ the ECJ found that the German thin capitalisation rules breached the principle of freedom of establishment. The payments of interest in question fell foul of the German thin capitalisation rules. Had the payments been made to a company subject to German corporate income tax (rather than to an EU company not so subject), the German rules would not have applied. The ECJ specifically rejected the argument that the application of the arm's length principle saved the German rules. The UK thin capitalisation and transfer pricing rules apply to interest payments only where the recipient is a person not subject to UK corporation tax and, based on the Lankhorst case should not be applied to payments of interest to EU resident companies.

Companies which hold intellectual property are often located in tax havens so that profits arising from licensing the intellectual property can "roll-up" tax free. High levels of withholding taxes on royalty payments to such jurisdictions can significantly reduce the tax benefit. Many of the UK's tax treaties provide an exemption from withholding tax on royalties.

The UK introduced an intangible asset regime in the Finance Act 2002 which, broadly, gives a tax deduction for the accounting amortisation of intangible assets acquired from third parties or created, in either case, after 1^st April 2002. Depending on (1) the royalty payment profile (2) the cost of the intangible asset and (3) the rate of withholding tax in the licensee's jurisdiction it may be more efficient to hold intangible assets in a UK resident holding company rather than in a tax haven company. Outbound UK withholding tax could be eliminated by a treaty or avoided by licensing to the UK for a capital sum.

If the UK resident company is incorporated in a tax haven (and does not have a share register in the UK), no stamp duty will arise on the transfer of its shares, so long as the document effecting the transfer in such companies is executed outside the UK. A UK incorporated company will, however, give rise to a 0.5% stamp duty charge. The UK does not levy capital gains tax on the sale of shares in a UK resident company unless the seller is subject to UK tax.

If the UK holding company sells the shares in its subsidiaries, the substantial shareholdings exemption may eliminate UK tax.

The UK compares well with the ideal holding company jurisdiction, in particular for its non-tax attributes. Groups looking for a complete exemption from taxation will not find it in the UK. With careful structuring, however, the UK can provide a good location for a holding company of a multi-national group, particularly in view of the UK's commercial infrastructure and legal and finance expertise.