Can you use an offshore recharging company to reduce your UK corporation tax charge?

Note - This is an archived article and does not reflect the recent tax changes. Visit the members area for an uptodate version of this article.

Many UK companies now trade overseas. This could involve numerous trading arrangements, with materials purchased in one country, assembled in another, and sold to the final consumer in another country.

If the company undertaking the activity is a UK company it will be charged to UK corporation tax on the entire profit generated. This will therefore effectively ensure that the profit from all of the underlying activities is subject to UK tax. In essence you're looking at a tax charge based on the final sale price, less the costs to manufacture it.

If the shareholders are also UK resident, and have no desire to leave the UK, the company could be looking at a 30% tax charge on its trading profits, and a further 25% income tax charge on the extraction of those profits. In this case, any methods available to reduce this are sure to be high on the list of the shareholders 'wish list'.

Offshore sheltering is probably the most common plan that entrepreneurs have, and this will typically go something like this:

'... Lets incorporate an overseas subsidiary. This can then buy some of the parts from the US, and sell them to the UK company at a market rate. The profit from this stage of the trading process can then be held offshore, and provided a company is chosen in a no tax jurisdiction, there should be no UK tax charge...'

How effective is this?

You could do this however there are a number of obstacles to achieving a UK tax reduction. In essence this is a recharging arrangement with the overseas company being established to retain the profit from the overseas activities.

There are a number of issues that would need to be considered in UK tax terms.

The first aspect is the company residence. Although the company is incorporated overseas, whether it can be classed as non UK resident will depend on where its central management and control was located.

Establishing the company as resident overseas is crucial, as if it was classed as UK resident, it would be taxed in the UK on its profits.

Therefore in order to avoid the company being classed as UK resident you would need to establish it as controlled from overseas. How you can support this would depend on how you planned to establish the new overseas company.

Overseas 'parallel' company

If it was owned directly by you or by a UK company it would be difficult to show it was controlled from overseas unless you had overseas directors actually running the company. You could establish the company as owned by an offshore foundation or trust. In this case you would need overseas trustees and directors to run the company.

If you could satisfy the company residence requirements, you would then need to consider the key anti avoidance provisions that can apply in this area.

The other issue with the use of an offshore company is the transfer of assets abroad provisions principally contained in S739.

The conditions for S739 to apply are:

• There must be a transfer of assets by an individual
• As a result of the transfer income becomes payable to a non-resident person (eg an offshore company or trust).
• The transferor must have power to enjoy that income
• The transferor must be ordinarily resident in the UK in the year of liability.

If all of these conditions are fulfilled, the income which becomes payable to the offshore company is deemed to be that of the individual who made the transfer for UK tax purposes.

This is a wide provision and therefore any disposal of assets by an individual to a non-resident company or trust is a transfer of assets for the purposes of Section 739.

The main exemption to this would be to argue that the motive exemption applied. Under this you would essentially need to argue that the purpose of the transfer was not to avoid tax, and that it was a bona fide commercial transaction.

The main application of the motive defence is to trading scenarios where a taxpayer carries on business abroad. It will be in point where a taxpayer carries on business abroad, and where for example a trader incorporates a local company for commercial reasons 739 should not apply.

In order to use a directly owned offshore company you would therefore need to argue that the motive defence applied. As such you would need to provide reasons to support the use of an offshore company to ensure that the primary reason for using the company were the business benefits.

Overseas subsidiary

You could also consider establishing an overseas company as a subsidiary of another UK company. In this case the above S739 provision would not apply, but the company would then need to consider the controlled foreign companies ('CFC') rules that could apply to attribute profits of the overseas company to the UK company.

You may however be able to establish an overseas subsidiary as exempt from the CFC rules if it satisfied the exempt activities test.

This exclusion covers a wide range of trading activities and many overseas subsidiaries which carry on a trade are likely to satisfy the test. However, the conditions are strict.

To satisfy the exempt activities test a CFC must satisfy all of the following conditions:

• It must have a territory of residence for the purposes of the test
• It must have a 'business establishment' in its territory of residence throughout the accounting period
• It must be 'effectively managed' in its territory of residence throughout the accounting period
• It must not have as its main business any of the activities precluded by the legislation.

On the basis that any overseas subsidiary was a trading subsidiary it may well qualify for the exclusion. It would however need to satisfy the other conditions including having a business establishment overseas and being effectively managed from overseas.

Therefore whilst the recharging scenario first described above is not categorically prevented from applying you would need to ensure that the company residence was overseas and that there was a commercial motive involved when using any offshore company.