Press Room

13 Jun 2023

Breaking Control: Protected Cell Companies – Des Hanna


One of the most important functions of any Tax Authority or Government Treasury Department is to protect the tax base of that country, particularly where there are “cross border” transactions which involve the outflow of money or capital from that country.

For example, where a subsidiary company pays a dividend to its parent which may be based in a different (low tax) jurisdiction, or where cross border interest is paid. If the paying jurisdiction doesn’t have any legal means of taxing the outflow of cash, then this arrangement can be manipulated to the extent that huge sums of cash could leave the country without tax being paid in the source country. To protect from situations like this, many jurisdictions will charge a Withholding Tax (WHT) e.g., 15% of the value of the dividend or interest or royalty so that the tax base can be fortified.

However, jurisdictions can’t apply WHT to every transaction, and multinational groups which have companies located all over the world come up with many ingenious ways of diverting profits offshore. From transferring “Intellectual Property” to low tax jurisdictions so that “royalties” suffer no or low taxation, to putting group Treasury Companies in low tax jurisdictions; that Treasury Company is then financed with equity (e.g., from the UK) and that equity is lent around the group at interest and the interest it receives is either not taxed at all or taxed at a low rate.

There is a large amount of anti-avoidance legislation that exists to counter schemes or structures put in place with the intention of avoiding tax across borders, and there is too much to analyse in this article. However, one piece of legislation which is effective (if a little controversial) is Controlled Foreign Companies legislation.

Controlled Foreign Companies Legislation

The UK Controlled Foreign Companies (CFC) legislation is anti-avoidance legislation intended to stop a UK company or group from diverting profits which would ordinarily be taxed in the UK to zero or low tax jurisdictions.

A classic example of this (alluded to above) would be where a UK parent company incorporates a wholly owned subsidiary, for example in Luxembourg. The parent would finance the subsidiary with a large amount of equity – say, £10m – and then the Luxembourg subsidiary either lends that money back to the UK at interest (an upstream loan) or it would use the equity to lend to other group members. If the tax rate on the interest received in Luxembourg is zero, then there will be no tax payable (with a possible tax deduction in the UK on the interest paid).

Also, these profits could be paid back to the UK tax free under the UK’s Dividend Exemption.

The CFC legislation exists to counteract the diversion of profits by, in essence, regarding the use of companies in low tax territories with no demonstrable commercial purpose as to why this jurisdiction is being used instead of the UK, as tax avoidance. The legislation allows the UK to tax profits which effectively arise in other jurisdictions.

The example above is a simple way of diverting profits from the UK; there have been incredibly creative attempts over the years to sidestep the CFC legislation where HMRC has sought to close loopholes in a classic game of cat and mouse.

The OECD in its recent Base Erosion and Profit Shifting (BEPS) project recognised the need for countries to strengthen their Anti-Avoidance legislation so that it would be much more difficult for multinational groups to engage in transactions that achieved a reduction in the amount of tax paid.

At action point 3, “Strengthen Controlled Foreign Companies (CFC) legislation”, the OECD suggested strengthening (or where necessary introducing) CFC legislation.

For countries that didn’t have CFC legislation in place (for example Cyprus: CFC rules were introduced in Cyprus as part of the implementation of the European Union (EU) Anti-Tax Avoidance Directive (ATAD) to tackle aggressive tax planning and base erosion and profit shifting (BEPS) issues. These rules are included in the Cyprus Income Tax Law (ITL) under Article 26A and came into effect on January 1, 2019), slowly but surely, they are introducing the legislation (to the dismay of taxpayers who are used to avoiding tax in those jurisdictions), while the countries that do have the legislation, a great deal of strengthening was required as the rules were easy to circumvent.

All CFC legislation is based on the same principles: the parent has “Control” of the company, and the company is based in a low tax jurisdiction. The legislation provides for certain exemptions as it is recognised that not all companies will be based in low tax jurisdictions just for the avoidance of tax, but if these exemptions can’t be met, the legislation allows the profits in the low tax jurisdiction to be taxed by the home state.

The UK was one of the first countries to introduce CFC rules and they were notoriously difficult to satisfy in the early days, but also quite easy to avoid.

Control

One popular method that multinational groups used to sidestep the CFC rules, was to try and “break control”; because if you could arrange ownership of CFC in such a way that you didn’t control it (while still being entitled to the profits) the CFC rules would not bite and they would therefore not be taxable in the UK.

A game of cat and mouse then ensued. Lawyers and accountants would find ways around the Control provisions, HMRC would discover what was going on and then introduce legislation which would close the avoidance (this became easier for HMRC when DOTAS was introduced).

Countries that have introduced CFC legislation recently will need to be constantly on the lookout for the ways in which multinational groups attempt to sidestep the rules, if there are any loopholes in the legislation, no doubt they will be found.

Protected Cell Companies

A popular method of breaking control within the UK CFC rules approximately 20 years ago, was the use of a Protected Cell Company (PCC); a special purpose vehicle which mainly existed in low tax jurisdictions like the Crown Dependencies.

A PCC can be thought of as being a normal limited company that has been separated into legally distinct portions i.e., cells. The income, assets and liabilities of each cell are kept separate from all other cells. Each cell has its own separate portion of the PCC’s overall share capital, allowing shareholders to maintain sole ownership of an entire cell while owning only a small proportion of the PCC as a whole.

From a legal perspective, a PCC is a single company, but each shareholder/investor retains a separate interest in the company.

Such arrangements can be used to sidestep the CFC rules (including those on control) by allowing UK resident unconnected parties to run their activities alongside each other’s within the structure, whilst only holding a minority of the total shares in the PCC and only being entitled to their proportion of the total profits. These structures are imitating the effect of each shareholder controlling their own separate entity, whilst not falling foul of the control tests with the CFC legislation.

Therefore, in essence, a UK parent may want to invest in a low tax jurisdiction partially for a commercial purpose but also with an interest in avoiding UK tax. If the parent were to incorporate a wholly owned company based in that jurisdiction, it would control that company and absent any CFC exemptions, the profits on the CFC would be taxed in the UK.

However, the UK parent could invest in a protected cell company where it invests the funds into one specific cell of the company, and as long as the company is not controlled overall from the UK, these profits in the low tax jurisdiction will not be caught by a UK CFC charge.

This type of avoidance could only be described as ingenious but when HMRC finally discovered what was going on, it extended the control rules to cover individual cells of a PCC.

Incorporated and unincorporated cells are defined by S371VE TIOPA 2010.

So, in determining whether an individual cell should be taken to be a CFC for the purposes of the legislation, the control rules will be applied to an individual cell as if it were a non-UK resident company to determine whether it is controlled by a UK person or persons under the legal and economic control tests.

It will be interesting to see how newly enacted CFC legislation in jurisdictions will develop. Much of the new legislation presumably will not catch PCC companies yet (or other methods which break control), but no doubt as loopholes are exposed in these countries, legislation will be tightened as countries seek to strengthen their tax bases.

If you have any concerns around beneficial ownership, please contact me, Des Hanna:

Des Hanna

International Director

M: +44 (0)7941 655 579 or

E: des.hanna@uk.Andersen.com


Des Hanna

Des is International Tax Director at Andersen LLP and has over 20 years of experience advising on UK and International Tax Issues. He has worked in practice, industry, and banking and spent seven years in HMRC’s head office working on contentious cross border cases involving many areas of domestic UK international tax legislation.

Email: Des Hanna