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Today's Budget announcement that the Government will introduce the foreign profits reform package in Finance Bill 2009 is the latest development in more than two years of discussion and consultation on this topic. The Government's stated aim of this reform is to enhance and support the competitiveness of the UK tax system. The key question is does the reform package announced meet this aim?

The Government has described the package of foreign profits reform as 'balanced and affordable' so it is clear this is not intended to represent a tax saving. Therefore, in order for the package to enhance UK competitiveness, reform should offer compliance savings. It is, however, not clear this will be achieved under the current package.

Dividend Exemption

Today's announcement states that an exemption from corporation tax will apply to qualifying dividends received on or after 1 July 2009. The original proposals suggested exemption would only apply to medium and large enterprises but has now been extended to all companies. This is a positive development in terms of UK competitiveness. Many multinational businesses are expected to benefit from the introduction of exemption, even though for many this will not result in lower actual cash taxes, but will reduce their compliance burden, and extending exemption to include small businesses (who were not offered exemption in the original announcement at the November Pre-Budget report) is a welcome development. However, recent EU case law already supports the position that dividends from EU subsidiaries are not currently taxable in the UK anyway and it must be remembered that the corollary of the fact that many foreign dividends will become tax exempt in corporate hands is that the current blanket exemption for UK-UK dividends is being removed.

Most domestic dividends should still remain exempt under one of the available exempt classes and today's press notice states that 'the vast majority of distributions are expected to be exempt'. However, extra thought will have to be given to UK-UK dividend flows in the future to be certain of the exemption and some technical difficulties with the earlier draft legislation might leave those receiving dividends from UK or foreign associates (between 10% and 50%) relying on a motive clearance from HMRC. For these provisions to truly reduce compliance obligations detailed guidance should be published which sets out when the motive test is not satisfied.

Adding dividend exemption to the existing UK exemption from tax on disposals of qualifying shareholdings (the substantial shareholding exemption) and the UK's lack of domestic withholding tax on dividend payments are all positive indicators of the competitiveness of the UK tax system, especially in relation to attracting foreign investment. However, there are some negative elements to this equation.

Interest Restriction - the Worldwide Debt Cap

One of the most competitive features of the UK tax system in the past has been the lack of any general limitations on the tax deductibility of interest. The UK does have rules to limit interest deductions in certain circumstances including transfer pricing/thin capitalisation and the anti-arbitrage rules but has not previously had a general rule to restrict deductions for corporate interest in the UK. The announcement today that the worldwide debt cap will apply to interest deductions of large groups for accounting periods beginning on or after 1 January 2010 changes this landscape.

The proposals for the debt cap as amended by the update published by HMRC on 7 April 2009 for the change to the proposed mechanics are an improvement on the complex and wide-ranging proposals originally published for consultation by HMRC in December 2008. For example, the revised mechanics for calculating the 'available amount' based on the gross consolidated interest costs of the group (rather than net of interest income as had previously been proposed) will assist those groups who have external debt but also have surplus cash in their business. Basing the calculation of the 'tested amount' on each entity rather than analysing each individual loan relationship should also simplify the test. These are welcome developments. Unfortunately the provisions remain very complex and represent a major compliance burden for groups even if they will have no ultimate disallowance of interest. In addition the positive steps forward in design are accompanied by proposals for a targeted anti-avoidance rule (TAAR) which will aim to prevent back to back arrangements to manipulate the available or tested amounts. The drafting of the TAAR will clearly be crucial and it is likely that this will introduce uncertainty into the calculation.

The policy design of the debt cap is to target situations where the UK has more debt borrowed from other group members than the worldwide consolidated group has borrowed from third parties. This policy will penalise those groups with debt in the UK borrowed from other group members who do not have significant levels of debt borrowed from third parties at a consolidated level and so are managing their group balance sheet in a conservative manner. Such groups will be at a disadvantage if bidding for a UK project against another investor who has a debt-laden balance sheet. How can this be the right answer - so long as the debt is arm's length in both cases then where is the avoidance mischief which HMRC is so keen to correct? It is important to note that no other territory has attempted to introduce an interest restriction with a similar policy design. The introduction of the debt cap cannot be regarded as a move which will enhance and support UK competitiveness and this aspect of the policy design of the debt cap seems more likely to damage the UK's competitive position than to enhance it.

The original foreign profits package announced at the November Pre-Budget Report included proposals to extend the current anti-avoidance 'unallowable purpose' rule which applies to interest and derivative contracts. Today's announcement has dropped this element of the package, which is a welcome development given the very wide drafting proposed in the December draft legislation, but states this area will be kept under review.

Controlled Foreign Companies

The other potentially negative element when measuring the competitiveness of the UK tax system is the current CFC regime. In the 2008 Pre-Budget Report, the Government announced reform in this area will be the subject of separate consultation running to its own timetable. However, it is not expected that legislation for reform in this area will be introduced before 2011, leaving two years of potential uncertainty over the direction this reform will take.

The Government has said it wants a reformed CFC system to protect against diversion of UK profit and not tax profits genuinely arising overseas, but nobody knows yet what they mean by this. This uncertainty is increased by the question as to whether elements of the current UK tax system, especially the CFC rules, are compliant with the UK's obligations under the EC treaties. In the meantime, the removal of some of the existing CFC exemptions may be regarded as tightening the UK tax net in the intervening period.

Take the example of a UK group which has significant levels of profits earned and located offshore. The introduction of dividend exemption may seem like the ideal opportunity to return those profits back to the UK tax free. However, if there is a possibility under a reformed CFC system for transactions between foreign entities which do not represent diversion of UK profit being regarded as exempt, will repatriated profits be tainted, so that this sort of CFC exemption will not be available in the future if these funds are needed to invest offshore?

This sort of uncertainty is very damaging for groups and makes it difficult for them to appraise the tax impact of investment decisions and to forecast what their effective tax rates and tax capacity may be going forward. Certainty and stability in the tax system is one of the goals of this Government but the possible two year delay UK groups will face over the future of CFC reform does not sit well with that objective. This leads to the question of whether more UK headed groups will choose to relocate elsewhere in the meantime, rather than wait to see what future reform may bring.

One possible solution to this problem could be for the Government to introduce an exemption into the current CFC system for transactions between foreign entities where these do not represent diversion of UK profit. This could be an interim measure to alleviate the pressure on the current CFC rules and to counteract some of the attractions which inversion offers to some UK headed groups. Even confining such an exemption to allowing financing between offshore entities outside the CFC net where this does not represent erosion of the UK tax base would be a welcome development, and would signal the Government's commitment to enhancing the competitiveness of this area of UK taxation.

The Government does have a real opportunity now to demonstrate it is committed to supporting and enhancing the competitiveness of the UK's tax system and to build on the positive step forward which dividend exemption represents. A good example of this is the statement made today that the Government will work with business representatives to consider evidence for changes to the way the tax system encourages the location of innovative activity in the UK. Introducing an incentive based regime to attract IP ownership into the UK could be a really positive development for UK competitiveness. The key to enhancing the UK's competitive position will be what happens with CFC reform and we would urge the Government to do whatever it can to allay the uncertainty over this area in the short term.