OFFSHORE SUBSIDIARIES Is it possible for a UK resident company to establish an offshore subsidiary in order to shield itself from what would otherwise be taxable UK profits? The answer is that it very much depends on circumstances. The four questions you will need to consider if your company is considering setting up an offshore subsidiary are: * Where the offshore subsidiary is located? * What the offshore subsidiary actually does? * Who controls the offshore subsidiary? * Who the offshore subsidiary trades with and on what terms? Many UK companies have offshore subsidiaries carrying on a wide variety of activities including sales operations, investment services, shipping and holding activities and in doing so successfully avoid UK corporation tax without breaching UK tax legislation. THE FIRST TEST For an offshore subsidiary of a UK company to fall outside the UK tax net it must: * be formed and registered at an overseas address; * have overseas directors who genuinely meet and manage the company; and * be completely independent of its UK parent company. If the company simply does what its parent tells it to then the tax avoidance scheme will completely fail. The UK parent must confine itself to the role of shareholder. TAXABLE PRESENCE The second condition by which an offshore company can avoid UK tax is to ensure that it does not have a taxable presence in the UK. This in turn is determined by whether it is trading with the UK (in which case it would be deemed to have no taxable presence) or in the UK which will give it a tax presence. Incidentally, if the offshore company has a UK-based branch or agent it is likely to be deemed to have a taxable presence. The following quote by Lord Bridge provides useful guidance to the whole issue: "The broad guiding principle ... is that one looks to see what the taxpayer has done to earn the profit in question. If he has rendered a service or engaged in an activity such as the manufacture of goods, the profit will have arisen or derived from the place where the service was rendered or the profit-making activity carried on. But if the profit was earned by the exploitation of property assets as by letting property, lending money or dealing in commodities or securities by buying and reselling at a profit, the profit will have arisen or derived from the place where the property was let, the money was lent or the contracts of purchase and sale were effected." In plain English everything turns on what the operations were that produced the profit and where those operations took place. It may help you to know that in some cases the situation is clear cut and in the offshore company's favour: * Where, for instance, the subsidiary has purchased goods or services in the UK for use abroad. * Where the contracts of sale and other trading activities are made or carried on abroad a representative office, sales promotion and after sales service within the UK are permissible. The long and short of it is that an offshore subsidiary of a UK company must stay offshore! It can provide services and sell things to UK clients but those services must be performed and those things made in an offshore location. TRANSFER PRICING When an offshore subsidiary is set up clearly the purpose is to avoid tax in the UK and, therefore, it is likely to be established in a low or zero tax jurisdiction. Once established it will do one of two things. Either it will be dealing with independent third parties or else it will be supplying goods and/or services to other members of the same group - possibly for onward sale. In the latter case it is important to bear in mind the transfer pricing rules. To quote Giles Clarke in Butterworth's Offshore Tax Planning "transfer pricing is an international issue, and most sophisticated jurisdictions now have legislation allowing the revenue authorities to substitute market value on connected party sales. The UK is no exception ... and its practical effect is to make it difficult to divert profits from the UK if goods or services are supplied to a UK entity at an overvalue or supplied by it at an undervalue". For the purposes of this article it is probably not necessary to go into transfer pricing in any great detail. The important thing to remember is that any transaction between the offshore company and a UK company must be on an arm's length basis e.g. at market prices. If, for example, an offshore subsidiary is simply used as an invoicing company then it will immediately fall foul of UK transfer pricing legislation. On the other hand providing the subsidiary is supplying genuine services, and providing the subsidiary's margin and/or profit is in line with the industry standard, then transfer pricing legislation does not come into play. Of course, it is also worth mentioning here, that transfer pricing does not come into play where the offshore subsidiary is dealing with unsophisticated jurisdictions where there are no transfer pricing laws. Quoting again from Butterworth's Offshore Tax Planning: "as a result of transfer pricing rules it may be said that offshore subsidiaries may principally be used to shelter three kinds of profit: 1) Profits from business carried on with unconnected third parties. 2) Profits resulting from genuine services provided on arm's length terms for other group members. 3) Profits resulting from transactions with group members located in unsophisticated jurisdictions without modern transfer pricing rules". CONTROLLED FOREIGN COMPANY LEGISLATION As if all the above was not confusing and complex enough, a UK company with an offshore subsidiary must also take into account the controlled foreign company legislation. Basically this legislation is designed to tax offshore subsidiaries which are not subject to a local rate of tax of at least three quarters the equivalent UK tax. In other words, the idea is to make the UK parent subject to corporation tax on its subsidiary's profits where the subsidiary is avoiding tax due to being located in a low or zero-rate corporate tax jurisdiction. Happily, however, the legislation can be 'got round' in certain circumstances. To begin with there is a fairly long list of "exempt activities". To be exempt the subsidiary must not be a quasi investment business such as leasing. If the business is involved in trading then its partners must be unconnected to it and also located outside the UK. If the business is engaged in "wholesale, distributive, or financial activities" then at least half of its total income must come from unconnected third party business transactions. Most importantly the subsidiary must have genuine premises in the offshore jurisdiction where it is based and must be able to point to genuine management who actually operate its affairs on a day-to-day basis. Incidentally, if you have a number of overseas subsidiaries then it may be possible to use something called a 'mixer company' to blend their profits and thus reduce UK taxation. WHY DIVERT PROFIT? Obviously, diverting profits to an offshore subsidiary will only be a deferral of taxation if it is intended to repatriate those profits eventually to the UK. After all, as soon as a dividend is paid or the company is sold or liquidated any gain is chargeable to corporation tax in the UK. However, there are a number of ways in which offshore subsidiaries may be used to permanently avoid UK tax. For example, if accumulated profits are repatriated from the offshore subsidiary where the UK parent has losses, loss relief may be claimed. Note, however, that losses will not be available to set against future profits. It may also be possible to import the subsidiary by making the company a UK resident. This is not straightforward and when the offshore company becomes UK resident the Inland Revenue may argue that the subsidiary was UK resident from the moment it was set up. Furthermore it may be vulnerable for an attack under anti-avoidance legislation. Nevertheless, many UK companies have successfully imported subsidiaries and reduced their tax bills. Mixer companies will also have the effect of reducing UK taxation. CAPITAL GAINS It is also to be noted that offshore subsidiaries in quoted groups may also be used to shelter from capital gains tax as well as income from profits since in the case of capital gains neither transfer pricing nor controlled foreign company legislation applies. The principle of this is far easier than the practice since a lot depends on whether the subsidiary is a "close company" which in turn has to do with a number of shareholders. TAKE ADVICE There are a number of well-documented and highly controversial tax cases relating to the use of offshore subsidiaries. The fact is that setting up an offshore subsidiary should not be undertaken lightly and nor should it be done without specialist legal advice. In the worst case scenario advisers and company directors have had to go to prison (or flee the country) as a result of incorrectly established tax avoidance schemes using structures of this nature. On the other hand, offshore subsidiaries do offer an opportunity to substantially reduce UK corporation tax liability and for an organisation of any size with even minor international activities it could be well worth exploring this avenue.