The UK: Controls over Residence

tax on its business profits if it was controlled from the UK, although from 1956 to 1965 British­resident companies trading wholly abroad were exempt on their retained profits. After 1965, the British authorities used administrative powers controlling the transfer of residence abroad to try to impose limits on the volume of retained earnings in foreign subsidiaries of British TNCs. The growing international interpenetration of capital, however, eventually called into question both the unilateralism of the US approach, and the direct administrative controls of the UK.

1. The UK: Controls over Residence

We have seen in Chapter 1 that from very early on, British tax jurisdiction came to be asserted over the profits of any firm whose central management and control was in the UK. This meant that a UK company could not easily escape British tax on its foreign business merely by incorporating a subsidiary abroad. 1 However, it was possible for British­based international businesses to transfer abroad the place from which they were managed and controlled. Rising tax rates after 1909, combined with court decisions confirming the extent of the control rule, led to some company emigrations, and the Royal Commission of 1918­20 heard that this was likely to continue Evidence, para.8282. For example, the American Thread Company had been held in 1911­13 to be resident in Britain because its affairs were controlled by meetings held in England of a committee of directors representing its majority shareholder, English Sewing Cotton. Consequently, the arrangement was changed so that its affairs were managed in the USA Bradbury v English Sewing Cotton, 1923. Tax rates came down only slowly in the 1920s and rose again in the 1930s, which encouraged further emigration, not only of businesses but of individual wealth. In 1920, for example, The Times reported the sale to Chilean interests of nitrate companies, due apparently to the prospects of higher dividend payments once their trading profits were not liable to UK tax 2 March 1920, p.23a. It was considered difficult to make legitimate complaint against the transfer of central management and control from the UK to a foreign country where the substantial business of a company was actually carried on. However, there was greater concern that wealthy individuals or families could find the means to transfer 1 As discussed in Chapter 1, the Revenue considered that the same factors that tended to show that a company was controlled from and therefore resident in the UK also tended to show that its trade was sufficiently based in the UK to be taxed on its business profits directly under Case I of Schedule D; but where a company was managed completely outside the UK, with no actual exercise by the UK shareholders of their powers of control, unless the foreign company could be considered a mere sham or agent of the the UK shareholders, the latter would be liable only on its declared dividends. control of their capital abroad, while themselves remaining in Britain and retaining rights to enjoy the proceeds in a non­taxable form. 1.a The Islands In particular, attention was drawn to the increasing use of the Channel Islands and the potential of the Isle of Man for avoidance of British tax. The Inland Revenue had found, following publicity given to the case of Sir Robert Houston, that considerable numbers of large private investment companies had been formed in Jersey and Guernsey, whose shareholders and directors appeared to be mainly nominees. Although the precise nature of the evasions they concealed were not known to the Revenue, some had been traced to British residents. Apart from illegal evasion, they could be used for avoidance if British residents transferred assets to them, allowed their capital to accumulate, and enjoyed the proceeds by means not taxable in the UK, such as loans or capital repayments. Both the Channel Islands, which were originally part of the Duchy of Normandy, and the Isle of Man, which was purchased by the Crown from the Dukes of Atholl in 1765 to end its use for smuggling, are dependencies under the Crown: they are British Islands, although not part of the United Kingdom. Their special position based on royal grants is respected by the UK Parliament, which can legislate for them but does not do so without prior consultation and, normally, agreement. They have fiscal autonomy, and although the UK government represents them in international affairs and can conclude treaties on their behalf, by constitutional convention it does so only with their agreement. 1 The issue of the use of the islands for avoidance of British taxes was taken up in negotiations initiated in 1923 for a fiscal contribution towards `the expenses of Empire ¶ The island parliaments objected to annual payments, but offered a one­off contribution to the costs of the War. In 1927, Sir John Anderson, on behalf of the British government, agreed not to press the matter of fiscal payments over the Channel Islanders objections, but asked for co­ operation in dealing with the use of the Channel Islands by British subjects for tax avoidance. His letter was accompanied by an Inland Revenue Memorandum, which found its way into the local press. 2 The Revenues proposals were comprehensive, and included measures to restrict company formation in the islands to those carrying on 1 See the Report of the Royal Commission on the Constitution 1973, Cmnd 5460, Part XI. Although the Islands pressed for a formal declaration that it would be unconstitutional for the UK to bind them internationally or legislate internally without their consent, this was resisted by the Royal Commission, which pointed out that the UK is responsible for the territories under international law and must therefore have the ultimate legal power. The Islands are not part of the European Communities and maintain their own customs regimes as well as separate tax systems. 2 The text is reproduced in Johns 1983, p.85. bona fide business there and beneficially owned by native islanders, as well as provisions to apply British income tax and super tax to persons transferring their residence there from Britain. These proposals would have entailed changes in British law to tax the income of persons who transferred their residence abroad. Furthermore, effective enforcement would require the assistance of the island authorities, both to supply information and, more importantly, to collect the taxes. Under pressure, the islands Bailiffs agreed to such measures, provided they were not unique, but were capable of applying throughout the Empire Pocock 1975, 64­67. A clause providing for reciprocal enforcement of revenue judgments within the British Empire was slipped into the Administration of Justice Bill of 1928. However, it quickly drew the attention of the business lobby, especially shipowners, who expressed the concern that it would reciprocally oblige the UK to enforce foreign taxes which might be unacceptable, such as Australian taxes on shipping cargoes. In fear of losing the whole Bill, the Law Officers dropped the clause. At this stage, the Inland Revenue saw no point in introducing controls on the transfer of residence abroad without arrangements for cooperation in assessment and collection, which seemed unlikely to be obtainable, so this proposal was not reintroduced PRO file IR407463. 1.b Family Trusts: the Vestey cases It nevertheless was considered important to take action against persons who continued to be resident in Britain, while transferring their wealth abroad in ways which allowed them to continue effectively to enjoy it. This could be done not only through low­tax jurisdictions, such as Jersey, but also by forming private companies in countries which did not tax income from abroad. The Finance Acts of 1936 and 1938 therefore enacted provisions which for half a century were a legal battleground, in which complex and sweeping legislative provisions and the ingenious devices which have been attempted to circumvent them have led to some strange interpretations by the courts, and occasional legislative amendment. The aim and scope of the provisions 1 were indicated by the sections preamble, stating that it was enacted: for the purpose of preventing the avoiding by individuals ordinarily resident in the United Kingdom of liability to income tax by means of transfer of assets by virtue or in consequence whereof, either alone or in conjunction with associated operations, income becomes payable to persons resident or domiciled out of the United Kingdom. The objective was therefore quite specific ­ to prevent a UK resident from continuing to enjoy income by transferring assets to a foreign company or trust and receiving from it loans, capital payments or other benefits. However, the terms of the provision 1 Originally Finance Act 1936 s.18, later ICTA 1970 s.478, and then ICTA 1988 ss.739­46. were widely drafted, especially the notion of `power to enjoy ¶income derived by the UK resident as a result of the asset transfer. To be fully effective against any possible circumvention, the provisions aimed to include any beneficiaries and to tax the whole of the income sheltered potentially including all the income of the transferee whether or not derived from the transferred assets, even if not actually paid over to the resident beneficiary. This gave the Revenue very broad powers, and has been denounced as a `preposterous state of affairs ¶which could only be made tolerable by its exercise of `discretion as to whom, and how and how much income to assess ¶ a discretion so wide as to amount to a `suspension of the rule of law ¶Sumption 1982, p.116, 138. Nevertheless, gaps were found in the Revenues armoury, especially by the Vestey family trusts, which gained two spectacular victories over the provisions, after occupying lawyers and courts at intervals for decades. As mentioned above Chapter 1.2, the Vestey brothers had left the UK in 1915 so that their meat business should not be taxable on its worldwide profits in the UK. William Vestey stated in his evidence to the Royal Commission that while his tax position in Argentina suited him admirably, he would prefer to come back to Britain to live, work and die. He also wrote to the Prime Minister, Lloyd George, in 1919, stating that if the brothers could be assured that they would pay only the same rate of tax as the American Beef Trust paid on similar business, they would immediately return. Failing to receive such assurances, they took legal advice from 1919 to 1921, as a result of which they established a family Trust in Paris. Returning to London, they leased all their properties, cattle lands and freezing works in various countries to a UK company, Union Cold Storage, stipulating that the rents should be payable to the Paris trustees. By various deeds they provided for funds from the trust income to be used for the benefit of their family members but not themselves; but the trust deed also gave them power to give directions to the Trustees as to the investment of the trust fund in any way whatever, although subject to such directions the Trustees were given unrestricted powers. Following the death of Lord William Vestey, the Inland Revenue assessed his executors and his brother Edmund for the years 1937­1941 for a total of £4m, in respect of the receipts of the Paris trust. These assessments were upheld until the case reached the House of Lords in 1949. Evershed, L.J. in the Court of Appeal considered that the power to give the Trustees directions gave the brothers effective control over the revenues produced from the assets, and that this was a benefit which amounted to a power to enjoy income Vesteys Executors v. IRC 1949, p. 69. The House of Lords disagreed, on the grounds that under English trust law the trust funds were to be applied for the benefit of the beneficiaries; the brothers power to give directions gave them no more than a right to direct the trustees to give them a loan on commercial terms, which would not amount to a payment or application of the income for their benefit as contemplated by the statute Lord Simonds, p.83, Lord Reid, p.121. In any case, the power to direct the investments was given to them jointly, while the statute referred plainly to the power to enjoy only of an individual. 1 Thirty years later the Vestey trust gained an even more decisive victory when the House of Lords confined the scope of the anti­avoidance provisions of the statute to the actual transferor and not other beneficiaries Vestey v IRC 1979. Although the position was substantially restored legislatively in 1981, 2 the liability of beneficiaries other than transferors became limited to the benefits actually received and not the entire income from the transferred assets Sumption 1982, ch.7. These provisions were aimed at private wealth rather than business income or profits. Although some arrangements might involve both, as in the cases of wealthy families such as the Vesteys, the 1949 decision by the House of Lords that the power to direct trustees as to foreign investments did not fall within the section meant that these provisions had little application to the control of foreign business. 3 Individuals such as the Vesteys could live in the UK and direct the investments of companies abroad, provided they obtained no personal benefits themselves, and provided that the actual exercise of corporate control in particular the holding of Board meetings took place abroad. 1.c Companies: Controls over Foreign Subsidiaries It was not until 1951 that powers were introduced governing the transfer abroad of control over a companys business. These powers were described as `an exceptional and no doubt temporary requirement ¶ by the Royal Commissions report in 1955 para. 641. They perhaps might have been abolished when provisions were enacted in 1956, also on the recommendation of the Royal Commission, for exemption from UK tax of the undistributed earnings of British­resident Overseas Trade Corporations. However, when this exemption was ended with the introduction of corporation tax in 1965, powers to control the manipulation of company residence became even more necessary. The original provisions remained, virtually unchanged, in the anti­ avoidance armoury until 1988, and an important vestige remains still. 4 Through the control of transfers abroad of company residence, the Revenue attempted to regulate the use by British­owned business of foreign­resident affiliated companies. The 1951 provisions required a company to obtain prior Treasury permission not only to transfer its residence abroad, but also to transfer any part of its trade or business to a non­resident; also, most importantly, permission was needed for 1 This loophole was partly blocked by Finance Act 1969 s.33. 2 Finance Act 1981 ss. 45­46, now ICTA 1988 ss. 739­741. 33 It applied rather to individuals who wished to be resident in the UK while receiving income from investments in a foreign business: e.g. Latilla v. IRC 1943. 4 ICTA 1970 s.482; what remains is now ICTA 1988 s.765. a company to cause or permit any non­resident company over which it had control to issue any shares or debentures, or for it to transfer any shares or debentures to a non­ resident company. Since `debenture ¶ has been given a very wide meaning by the courts, encompassing any specific debt acknowledged in written terms, this last requirement was very sweeping, especially when considered in conjunction with the necessary Bank of England approval under the Exchange Control Act 1947. However, these very broad requirements were limited by general exemptions granted by means of General Consents five in all. The administration of applications for special consent was carried out by a department headed by a Chief Inspector Company Residence. Applications, except in straightforward cases, were referred to an outside Advisory Panel, sitting in private although allowing the attendance of the applicants representatives, whose task was to weigh the advantages to the applicant against the prospective loss of revenue and foreign exchange, and to recommend to the Chancellor whether it would be in the national interest for permission to be granted Simon 1983­, para.D4.119. These powers were used to try to regulate the form taken by the foreign operations of British­based company groups or TNCs for tax purposes and negotiate an acceptable rate of taxable remittances. Foreign­owned companies were given a general exemption, if set up in the UK after 1951 to carry on business. General exemption was also given for the issuing of shares or debentures by a company formed after 1951 in a Commonwealth country for the purpose of starting and carrying on a new industrial activity there GC No.4; as well as for the issue of shares by a non­resident company directly to a UK resident company GC No.2. Plainly, the major concern of the Revenue was to control the use of intermediary non­resident companies by British­owned TNCs to avoid UK tax on retained foreign profits. Applications for consent could be granted subject to conditions or undertakings; and it appears that a common condition was to require the repatriation as dividends of a specified proportion of the profits accumulated overseas, such as 50­60 see Simon 1983­, para.D 4.112; Ashton 1981, 119. The administrative and discretionary nature of the procedure gave some scope for flexibility in negotiating the proportion of overseas earnings to be taxable as investment income in the UK according to the circumstances of the company; although equally, the secrecy of the procedure may create doubts as to whether that discretion was exercised either properly or fairly. In addition, the requirement of consent was designed to prevent the use of transfers of residence purely for tax avoidance. However, the technicalities of the section offered significant avoidance opportunities: for example an `off­the­shelf ¶ company which had no trade or business could start a UK branch and later become non­resident without consent; and such a company could also be set up by a directly­owned non­ resident subsidiary of a UK company Dewhurst 1984. The criminal sanctions imposed by the section required a significant element of intent, so that company directors or their advisors could not be convicted without evidence to disprove that they honestly believed no breach was involved. In fact, it seems that no prosecution was brought in the near four decades of life of the provision Dewhurst 1984; and the Keith committee expressed surprise at finding a criminal sanction for a tax avoidance provision, and recommended that the penalty be made a civil one UK, Keith Committee 1983, p.158. The requirement of consent for transfer of residence abroad was therefore essentially an administrative measure which provided the basis for private, indeed secretive, negotiations between the Revenue and British­owned TNCs. This apparently satisfied both parties. Whether for this or other reasons, the issues of national or international equity of British taxation of the returns from foreign direct investment did not arouse any significant public or political debate for more than two decades after 1955. 1.d Modification of the Residence Rule A variety of factors from the mid­1970s led to measures intended to bring British principles of taxation of foreign investment earnings more into line with those of other countries. These factors included the re­emergence of the international debate on taxation of international investments, focussing on matters such as the transfer pricing policies of TNCs to be dealt with in Chapter 8. A major factor was the policy of liberalization of controls on international capital movements initiated by the Thatcher governments ending of all exchange controls in 1979. The abolition of exchange controls could not easily be reconciled with the continuation of the requirement of prior permission for the transfer of company residence abroad, and for raising capital through a foreign subsidiary. At the same time, membership of the European Communities made it legally doubtful whether the Treasury could withhold permission for a company to transfer its residence to another EC country, even if this might be a step towards transfer outside the EC altogether. 1 To block this potential loophole, the Finance Act of 1988 s.105 provided that a company transferring its residence abroad without Treasury consent should be deemed to have disposed of and immediately reacquired its assets, thus rendering it liable to Capital Gains tax. With this provision in place, the requirement of consent for transfer of company residence abroad could be ended. However, permission is still needed for the issue of shares or debentures by a foreign subsidiary which, as we have seen, is used to control the use of foreign subsidiary structures by British TNCs. 2 1 Although the Revenue eventually won the test case in 1988 in the European Court of Justice: Reg. v. H.M. Treasury CIR ex parte Daily Mail and General Trust PLC 1988. 2 This remains in ICTA 1988 s.765. However, the liberalization of capital movements within the EC means that transactions falling within EEC Directive 88361 are exempt from this requirement, although they must be reported to the Inland Revenue within six months: Movement of Capital Required Information Regulations, S.I. 1990671. More broadly, however, it was clear that the residence rule was increasingly hard to operate, especially without the discretion given by the procedure for requesting consent. The traditional test of residence, based on the place where the effective investment decisions were taken, was limited to `oversight and passive management ¶ This was generally taken to mean the place where the key Board meetings were held: it could therefore be easy to manipulate, since on this narrow view it would be easy to exclude foreign subsidiaries from the British tax net merely by holding Board meetings abroad. More seriously, this could also be done for companies with substantial business in the UK, thus avoiding liability to advance corporation tax, as well as corporation tax on overseas business and investment income and realized capital gains. Conversely, Board meetings could be held in the UK if it was advantageous to import the losses of unprofitable subsidiaries via the group relief provisions. On the other hand, a broad approach to residence, which would not rely only on the location of Board meetings, might not be upheld in the courts. Although it would suit the Revenue to include in principle all unremitted income of foreign subsidiaries, this could widen the net too far, including for example foreign subsidiaries of non­British TNCs with regional headquarters in the UK. The position was further complicated by tax treaties, since in cases where a company is treated as resident by both treaty partners, the treaty definition of residence applies. However, Britains treaties have followed two models: the older model in the postwar treaties defined residence as where the business was CPDQDJHGDQGFRQWUROOHG¶, while later treaties used the test in the OECD model, of CSODFHRIHIIHFWLYHPDQDJHPHQW¶. Although for a while the UK view was that the two terms were synonymous, the Revenue subsequently accepted that in the light of interpretations in other OECD countries, a difference existed. 1 Proposals were therefore put forward in 1981 to enact for the first time into British law a statutory definition of company residence. The preferred criterion of the Revenue was the place where `the management of the companys business as a whole was conducted ¶ Not surprisingly, this was attacked as too vague and broad. A Working Party set up by the Institute for Fiscal Studies found some of the criticisms of the proposals unfounded, and supported the arguments for a statutory definition; but it found that the best approach was to build upon the principle of `effective management ¶Institute for Fiscal Studies 1982. As a stopgap, the Revenue issued a Statement of Practice 683 to define the test. It also pressed ahead with its related proposals to tax the deemed foreign income of Controlled Foreign Corporations CFCs, enacted in 1984, thus bringing the UK broadly into line with most other OECD countries see Chapter 7 below.. Finally, the Finance Act 1988 provided s.66 that any company incorporated in the UK is deemed resident there for tax purposes. 2 1 See OECD 1977 p.57; Statement of Practice 683, reissued as amended as SP 190. 2 With transitional provisions for a company which became non­resident with Treasury consent, Schedule 7. However, the test of central management and control has not yet been replaced, and could therefore still be applied to British­controlled companies registered abroad. This residual provision modified for treaty countries, as mentioned above, as well as the requirement of approval for the issue of debentures by foreign subsidiaries, remain as a fall­back for the Revenue: thus, for example, foreign companies formed for investment in UK real estate may be treated as UK resident Yerbury 1991, p. 33. However, taxation of unrepatriated earnings from foreign investment is now dealt with primarily under the CFC provisions discussed in Chapter 7 below.

2. The US: Tax Deferral on Retained Foreign Earnings