U.K. taxation: a quiet revolution.

One of the most striking features of the last two decades has been the genuine globalization of business. Multinational corporations have been around longer, but it is only in the last 20 years that the worldwide shift towards a more open economic philosophy, partly through the influence of bodies such as the European Union (EU), has permitted multinationals to plan their activities on a global basis. One of the more surprising (and indeed welcome) consequences of this trend is that national governments have recognized that their taxation systems are not merely tools to raise revenue, but are also key factors in attracting inward investment.

In the last five years or so, the United Kingdom has firmly embraced this philosophy. There have been a number of significant reforms that substantially increase the country's competitiveness on the world tax stage.

Corporate tax

In common with many countries, the U.K. has lowered its corporate tax rate, from 52% to 33%. The 33% rate was in fact the lowest general corporate tax rate in the EU until Sweden and Finland (with rates of 28% and 25%, respectively) joined the Union at the beginning of 1995.

The U.K.'s effective tax rate can be even lower when dividends are repatriated to a U.S. shareholder, through the U.K.'s Advance Corporation Tax (ACT) system. When a U.K. corporation pays a dividend, it is required to make an additional tax payment (ACT) currently equivalent to 25% of the dividend. As its name would suggest, this advance tax payment may be set off against the company's final gross mainstream corporate tax liability.

Under the U.K./U.S. tax treaty, a U.S. shareholder is able to recover part of the ACT. A corporation owning a least 10% of a U.K. company can in fact recover half of the ACT, less a 5% withholding tax. The overall effect is that on distributed profits the effective U.K. tax borne by a U.S. shareholder, after taking the refund into account, is 28.4%.

The Xerox case

The treatment of U.K. dividends for U.S. foreign tax credit (FTC) (Sec. 902 deemed paid credit) purposes can be complex, as was recently highlighted in Xerox Corp., Fed. Cir., 1994. Before the Xerox case, in general terms, an indirect credit under Sec. 902 was given for the gross mainstream tax paid on the profits when a dividend was sourced, including any ACT (except the half refunded under the treaty) used to offset, or reduce, the gross mainstream tax liability. When, for whatever reason, the ACT was paid on a dividend but could not immediately be used, through offset of the mainstream tax, an interim or provisional credit would be given for the unrefunded ACT. This was later recaptured once the ACT was used to settle the tax due on later profits, and in its place credit was given once dividends were paid out of those profits.

Xerox successfully challenged this position. The precise scope of the decision is unclear, but in simple terms the position appears to be that the ACT is treated as a separate tax. Credit must be given for the unrefunded portion of the ACT attached to a particular dividend, as well as for the actual net mainstream tax paid on the profits out of which the dividend is sourced (the net mainstream tax being the corporate tax paid after reduction through any ACT offset). On that footing, it is irrelevant for Sec. 902 purposes where or when the ACT attached to a particular dividend is used, since credit is given when the dividend is paid.

There is no doubt that the Xerox case will prove to be a fertile ground for future repatriation planning (assuming there is no appeal). ACT planning within a U.K. subgroup (which may be tax neutral within the U.K.) may enable a group to either maximize or minimize the overall rate of FTC as desired. For example, although the effective rate of U.K. tax on dividends repatriated to the U.S. might be 28.4%, ACT planning techniques can increase the credit rate to a level of 34%/35% (or even higher).

U.K. headquarter companies

The U.K., partly for linguistic reasons, has often been the natural first choice for U.S. groups setting up European regional headquarters. Paradoxically, the Netherlands has frequently been the more tax efficient location for a U.S. group setting up a European holding company.

The U.K.'s inefficiency has its roots in the ACT system. While dividends received from foreign sources could be sheltered from taxation in the hands of a U.K. holding company through FTCs, when those same dividends were paid on to the U.S., the ACT still had to be paid. If there was no mainstream corporate tax to offset, the ACT greatly increased the effective tax rate.

After years of representations on the unfairness of this system, the U.K. government introduced relief effective July 1, 1994. Under the new scheme, an International Headquarters Company (a company 80% owned by non-U.K. shareholders) could pay foreign income dividends (dividends sourced from foreign income) without incurring any ACT liability.

The U.K. has no other withholding tax on dividends. Thus, dividends from other EU countries could be paid through the U.K. and to the U.S. shareholder without any withholding tax. Thus, dividends could be paid from EU companies to the U.K. without withholding tax under the EU "Parent Subsidiary" Directive, suffer no further tax in the U.K. through FTCs and, finally, be paid to the U.S. shareholder without any ACT or withholding tax.

Foreign exchange and financial instruments

The U.K.'s taxation system has struggled to cope with modern foreign exchange transactions--especially derivatives. Following several years of planning and consultation, comprehensive new rules are being introduced, designed to simplify and clarify, remove anomalies and generally ensure that the tax treatment of foreign exchange transactions, including the use of financial instruments, follows the real economic and commercial consequences.

There is no doubt that the new rules are a dramatic improvement, and the certainty they introduce will enhance the U.K.'s role in the world's financial markets. Many devices that multinationals previously incorporated into their European groups, such as Dutch or Swiss roundabouts, will become redundant. A U.S. group with U.K. subsidiaries, especially when those subsidiaries are used to finance other European operations, needs to plan for the introduction of the new rules, which in most cases will take effect on Jan. 1, 1996. The legislation is complex, and under the transitional provisions there may be planning opportunities to record a one-time tax savings.

Conclusion

None of these reforms are headline grabbing in the same way as, for example, the Irish 10% tax incentives, but such temporary incentives have a different political objective: to help the smaller and weaker EU members "converge" their economies towards the European norm. The U.K. reforms, on the other hand, seek to clear away some long-standing obstacles to the U.K. as an investment location, and to give it the competitive yet stable tax infrastructure it needs to capitalize on its other advantages.