Note
The following predates the publication and enactment of the Finance Act 2011 which was signed in to law on the 6th February 2011.
The following hypothical facts set out the background to a proposed expansion by a person, operating an Irish based business, into the UK. It is a case study of the analysis undertaken, the likely best approach in terms of structuring the business expansion considering tax efficiency AND minimising business and commercial risk (Following the collapse of his business former Minister Ivan Yates said in an interview on Newstalk FM on Wednesday the 5th January 2011 that he would be very risk averse so minimising business risk is focussed on in this case study) arising from the suggested operating legal structure.
Background & Facts
Tasty Bites Limited (TBL), is an Irish resident company which was incorporated in 2004. Since its incorporation, the entire share capital of TBL has been owned by Vincent O’Dwyer. Vincent O’Dwyer is 40 years old and is resident and ordinarily resident in Ireland. Vincent is an accomplished business man but has limited knowledge of tax law matters.
TBL currently operates a well known chain of restaurants throughout Ireland. TBL’s strategy has been to expand aggressively and, as a result, it now has over 10 restaurants in Ireland.
In recent years, TBL has generated trading profits of over €5,000,000 per year. Despite this recent success, the company does not have any cash on hand (as any profits have been used to fund the expansion strategy). Any future expansion will have to be funded by bank borrowings.
Vincent recently asked to meet with you to discuss his plans for the business. During this meeting, Vincent explained that the company had few remaining opportunities to open new restaurants in Ireland. Therefore, he wanted to expand the business by opening a major new restaurant in London.
Vincent explained to you that opening new restaurants is expensive. The new restaurant in London will require a significant investment of €10,000,000. This would include €9,000,000 to purchase the property, equipment and furniture needed for the trade. It would also cover €300,000 for working capital requirements and €700,000 to cover any losses in the initial trading period. Vincent has negotiated with his bank so that TBL (or a subsidiary company) can borrow this amount at an interest rate of 5% per annum.
From past experience Vincent knows that new restaurants generally take some time before they become profitable. He expects that the tax adjusted profit/(loss) before interest of the new restaurant will be:
- Year 1 (€600,000)
- Year 2 (€100,000)
- Year 3 €300,000
Ideally, Vincent plans to sell the UK restaurant business after three years. He expects that he would be able to sell the business for €13,000,000 at the end of three years (including all the premises, goodwill, stock, cash, creditors etc). However, if he is not able to sell the business after three years then he will eventually want to remit any profits back to Ireland in the form of dividends.
From your initial chat with Vincent it was determined that the new restaurant could either be set up as branch of TBL or in a newly incorporated UK resident subsidiary company. Vincent has a number of options and would like you to advise him as follows in this regard:
1. Whether he should carry on the trade through a branch of TBL or,
2. In a newly incorporated UK resident subsidiary company considering in particular in respect of each option the ongoing Irish corporation tax implications, the Irish tax implications on the potential sale of the business and the Irish tax implications should he be required to remit income into Ireland if he is not in a position to sell the business in three years time; and If the new restaurant is set up in a new UK company which company (i.e. TBL or the new UK company) should borrow the money considering the respective tax and non tax advantages and disadvantages in this regard.
Summary and Key points
What are the primary issues that should be focussed on by an AITI Registered Tax Consultant when analysing the various options posed by Vincent above in considering whether the expansion should be facilitated by way of a UK branch of an existing Irish company or by way of incorporation of a UK resident subsidiary (UKnewco) of the Irish parent.
UK Branch V UKnewco – General tax treatment of losses/profits
Under general corporation tax principles the trading activities of a UK branch of an Irish limited parent company would be within the charge to UK Corporation Tax by virtue of Articles 5 and 8 of the UK/Ireland Double Taxation agreement deeming the UK branch to be a permanent establishment. Permanent establishments are generally covered by the tax laws of the country in which the permanent establishment exists and therefore Any UK profits arising to the branch would also be within the charge to Irish Corporation Tax by virtue of the fact that the profits would “belong” to an Irish resident company.
It is projected that the UK trade would give rise to losses in the first 2 years with profits accruing from year 3 so the question arises as to whether the losses would be available for offset against the profits of the Irish parent (in the event that a UK subsidiary is utilised from the outset). On the basis that the shareholding held in UKnewco by the Irish parent company satisfies group relief rules as set out in Irish Tax law (Section 420 Taxes Consolidation Act 1997 as amended) the UK loss may be available for surrender to the Irish parent so as to reduce the Corporation Tax of the Irish parent. The ECJ case of Marks and Spencer V David Halsey (HM Inspector of Taxes) Case C446/03- AG Opinion facilitates cross border group relief in certain circumstances plus Section 420C TCA 1997 as inserted by Section 48 Finance Act 2007 also provides for relief from Irish tax for certain foreign losses incurred by foreign subsidiaries.
Where the UK expansion is facilitated by way of a UK branch the losses in the first 2 years would be treated as arising to the Irish limited company in law in any event and therefore would reduce the taxable profit in the Irish company. Therefore, in the first 2 years, irrespective of whether a UK limited company or a UK branch is used the same tax outcome is achieved.
Planning for a sale of the UK business in year 3
The question of how a sale of the business in year 3 can be facilitated should be addressed, as much as possible from the outset. The taxation of the sale is considered below for a branch structure or a UKnewco subsidiary structure.
1. UK branch of existing Irish Ltd company
It is stated that Vincent’s objective is to sell the business 3 years after commencement. Therefore this needs to be planned for in the initial planning phase by the AITI Registered Taxation Consultant (Associate of the Irish Taxation Institute). In the event that the assets (property and equipment) acquired for the purposes UK business are acquired by the existing Irish limited company this means that a sale of the UK business by the Irish limited company would be exposed to Irish Corporation Tax on Capital Gains. In addition, given that one of the assets is a UK commercial building this means that UK Capital Gains Tax would need to be considered as, if there is a similar legislative provision under UK law to Section 29 Taxes Consolidation Act 1997 – Specified assets for CGT purposes, it is certain that UK Capital Gains Tax would apply. Double Taxation relief would be available for the UK Tax paid against the Irish Tax.
Furthermore, any plant and machinery acquired by the Irish limited company would have been subject to Capital Allowance claims in the first 3 years and as such their disposal (assuming it was a straight forward asset sale to an unconnected purchaser without any pre-conditions) would trigger balancing allowance/balancing charge (additional allowances granted or previously granted tax allowances clawed back triggering a tax liability) considerations.
However, it would not be uncommon in this type of scenario for an intending purchaser to impose pre-conditions on the sale, such as, for example that the vendor engages in a pre sale reorganisation of the business. Typically this might involve hiving the business (the assets used to conduct the UK business) into a UKnewco and this would have tax consequences as follows:
A. The transfer of the plant and machinery (on which capital allowances have been claimed) would constitute a disposal and ordinarily this would trigger a balancing allowance/charge adjustment. However, the UKnewco (incorporated as part of a pre-sale re-org) would be commonly controlled and therefore it would be possible to transfer the plant and machinery equipment from the Irish limited company to the UKnewco at tax written down values (original cost – net of any grants – minus allowances claimed). What this means is that the transfer of the machinery would not trigger a tax cost.
B. The transfer of the UK building from the Irish limited company to a UKnewco (common control) prior to a sale of the UKnewco shares to the unconnected purchaser would not benefit from Irish Group Capital Gains Tax relief by virtue of Section 617(1)(c) Taxes Consolidation Act 1997 meaning that the transfer of the UK building to the UK newco would be within the charge to Irish Capital Gains Tax. UK CGT as mentioned above would apply to the “disposal” of the building by the Irish limited company to the UK newco. The flat rate of UK Capital Gains Tax for companies is 28% meaning that no additional Irish Capital Gains Tax would apply where the Irish rate at the date of disposal is less than the comparable UK Rate. The rate of Irish CGT as at 06/01/2011 is 25%.
C. If the UK newco shares were under the ownership of the Irish co (after incorporation) for a certain period of time it would be possible for the disposal of the UKnewco shares to the purchaser by the Irish limited company to be free from Irish Tax on any gain on disposal of the shares by virtue of Section 626B Taxes Consolidation Act 1997. This is known as the “participation exemption”.
There is a practical disadvantage to this structure that more than likely makes this option unworkable from a commercial perspective and that is the timeframes for which shareholding relationships need to be maintained in order to qualify for the exemption outlined at point c above. Given these timeframes it is likely that a prospective purchaser would walk away from the deal altogether. This means that the structure is not suitable for facilitating the expansion into the UK from the outset.
2. UK resident (UK incorporated) subsidiary of Irish parent
The alternative structure posed by Vincent is whether a UK subsidiary company should be used to facilitate the expansion from the outset and if this option is favoured should the Irish or UK subsidiary borrow the funds to finance the expansion.
A UK incorporated, UK resident subsidiary would be within the charge to UK Corporation Tax with the rate being 28%.
A. Availability of losses
A UK incorporated, UK resident subsidiary would be within the charge to UK Corporation Tax with the rate being 28% (as at the date of original publication which is the 12th January 2011).
It is suggested by Vincent that the business would incur losses in the first 2 years. Notwithstanding Section 420(c) Taxes Consolidation Act 1997 (inserted by S48(1)(b) Finance Act 2007) and the Marks and Spencer case decided in 2005 by the ECJ and the Advocate General ref C-446/03, which granted cross border loss relief in certain circumstances, losses in the first two years are unlikely to be available for surrender by the UK subsidiary.
There is a commercial mechanism whereby the selling Irish parent company can recover the cash equivalent of the tax that would have been saved if the losses from the UK subsidiary had been available legally for surrender to the Irish company in the first 2 years. This can be handled at the time of sale.
B. Should the borrowing be made by the Irish parent or the UK subsidiary
The question of which company (the Irish or the UK subsidiary) should borrow the money has been raised. Under either system of tax laws interest on borrowings used for trading purposes are deductible in arriving at taxable profits for Corporation Tax purposes.
It would be open to the Irish company to borrow the funds required and provide them to the UK newco either by direct share capital injection or by way of onward loan to the subsidiary and qualify for relief from Irish taxation in accordance with Section 247 Taxes Consolidation Act 1997. Company Law would have to be considered in connection with this, specifically Section 60 Companies Act 1963 and in this context specific legal advice should be sought if this is seriously considered by Vincent.
As mentioned above the interest paid by the UK company on borrowings either from the Irish parent or on borrowings directly from a bank is deductible under UK tax law in arriving at taxable trading profits for UK Corporation Tax purposes at the rate of 28%. Therefore, non tax reasons should play a part in considering which company should actually incur the borrowings.
The current climate has seen many liquidations, receiverships, and examinerships for a variety of reasons including and not limited to both insolvencies and liquidity reasons. Furthermore, we have seen one company in a group bring down a connected company and this can be down to many reasons including cross lending. The dependence of the lending company (the parent in this case) on the repayments from the borrower in the group (UK newco in this case) gives rise to commercial risks for the parent lender in the event of the UK business ceasing and as such if the Irish parent incurred the borrowings from the bank in the first instance the Irish parent would be at risk of going bust also.
Therefore, while the Irish parent can borrow, and lend on/invest by way of share capital injection into the UK company, and qualify for Irish Tax relief on the borrowings the commercial considerations of insulating the Irish company (an existing trade) from being brought down by the UK company in such circumstances make an overriding case for the UK company borrowing directly.
Furthermore, as the tax rate in the UK (at the date of publication of 12th January 2011) is 28% it is more effective for the UK company to borrow and also having the borrowing directly in the UK company in sterling acts as a hedge against exchange rate risk.
C. Taxation treatment of dividends received by Irish parent in the event of the UK business not being sold in Yr 3
In the event that the business isn’t sold in 3 years and Dividends are remitted to the Irish parent what are the taxation consequences for the Irish company?
Dividends from a foreign subsidiary would be treated as taxable under Schedule F in the hands of the Irish parent. Normally, up to the date of passing of the 2008 Finance Act, foreign dividends received by an Irish company were taxed at the 25% rate with double taxation relief granted for foreign tax suffered. Following the passing of the 2008 Finance Act it is possible for dividends received by an Irish company from companies resident in certain countries to be taxed under Irish tax laws at the same rate that would apply to the paying company if it were tax resident in Ireland. Section 21B Taxes Consolidation Act 1997 as inserted by Section 43(1)(b) Finance Act 2008 refers.
Dividends in the hands of closely held companies in Ireland (companies controlled by 5 or fewer participators – generally a shareholder but the definition of participator is far wider than simply being a shareholder – are regarded as being “close companies”) are also subject to an additional Irish tax, known as a surcharge tax on undistributed investment type income, if undistributed within a fixed timeframe. However, in the case of dividends received from certain “subsidiary” companies, it is possible to legally avoid this additional surcharge tax even where these dividends are not paid to shareholders by way of dividend. This is provided for in paragraph (b) of the definition of “investment income” that is included in Section 434(1) Taxes Consolidation Act 1997.
D. UK Tax Consequences of Dividends to the Irish parent
Most jurisdictions operate withholding tax on dividend payments. Dividends may be taxed in both territories – with credit relief available. Credit is also available for any dividend withholding tax stopped by the UK subsidiary. Article 4 of the UK/Ireland Double Taxation agreement refers. Specific advice should be sought from a UK tax advisor on the application of Dividend Withholding Tax by the UK company. It is the understanding of the author that there is no withholding tax on dividends paid by companies based in UK, for both local and foreign investors.
On a final note UK company law will govern the ability of the company to pay dividends to the Irish parent given that it is expected the company will make losses in years 1 and 2.
E. Disposal of shares in the UK Company (set up from the start) by the Irish company
While it is highlighted above that there is a relief from Irish Capital Gains Tax for the Irish company disposing of the UK shares in the UK subsidiary there is a risk that UK Capital Gains Tax could apply where the shares are covered by similar UK laws to the Irish Law of Section 29 Taxes Consolidation Act. Specific UK tax advice should be obtained in this regard.
Conclusions
In the case at hand the following can be summarised:
A UK subsidiary is the most appropriate structure to use for the expansion into UK for the following reasons:
- Under Corporation Tax rules the trading activities of the UK business will be under the UK regime regardless of being a branch of the Irish Company or if its under a UK company structure.
- The transfer of business assets to a new UK company prior to a sale in the future by the Irish company would trigger Capital Gains Tax exposures both in Ireland and the UK. If the property is purchased in a UK company from the outset this will be avoided assuming the shares of that company are what are sold in the future.
- The sale of shares in the UK company formed from the outset will be free from Irish Capital Gains Tax where careful planning is engaged in from the start but UK Capital Gains Tax on the same disposal may apply.
- By separating the UK business from the Irish business, and by ensuring the UK Company takes on the borrowing in its name (without any recourse to the Irish company) the Irish company is insulated from being toppled in the event of the UK company failing. In the current climate where many group structures have collapsed due to cross dependencies (Liam Carroll Zoe Group for example) minimisation of business risk, combined with tax efficiency appropriate to that risk is of utmost importance to clients.
The following assumptions can be made about UK advice received:
- The tax rate in the UK is 28% and the taxable profits would be calculated in the same way under UK law as under Irish law.
- The interest on the loan would be deductable for UK tax purposes if the restaurant was set up as a branch of TBL or if the money was borrowed by the new UK resident subsidiary company.
- Any trading losses should be available for offset against profits of the subsidiary company in the same accounting period or carried forward indefinitely for offset against income arising from the same trade.
- Capital allowances would be available on any plant and machinery purchased for the restaurant.
This is a guest article by Mark McCutcheon who is an AITI Registered Tax consultant. This post was originally posted on The Irish Tax news Blog and has been reproduced with permission.
Tags: FDI, International corporate structure, UK Accounting firms, UK Inward Investment
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