The impact of COVID-19 on holding company structures and the potential development of the UK as a holding company jurisdiction
November 2020 | SPECIAL REPORT: CORPORATE TAX
Financier Worldwide Magazine
November 2020 Issue
A particular concern of UK managers of private investment funds whose structures include non-UK (Luxembourg or Channel Islands, for example) holding companies is to ensure that those holding companies are operated so as not to, inadvertently, become UK tax resident.
The restrictions on all but the most essential travel and international borders being closed with a view to containing the coronavirus (COVID-19) pandemic have created unforeseen and unparalleled complexities in this regard. It was hoped that such restrictions would be short term and limited in nature, but – more than six months on – this seems increasingly unlikely.
In this article we consider why many private investment funds invest via holding companies, the short, and potentially much longer term, challenges posed by COVID-19 on the continued use of such structures, and potential solutions including the expansion of the UK as a holding company jurisdiction.
Holding companies
Private investment funds generally incorporate holding companies between the collective investment partnerships in which their external investors participate and their portfolio company investments for non-tax reasons, including relating to external financing and administrative efficiency. However, it is important that these intermediate structures do not impose additional layers of tax cost that would reduce net returns to investors.
Investment funds typically will establish holding companies to acquire and hold investments in jurisdictions in which they already have ancillary operations. Popular jurisdictions for holding companies permit the return of profits from the sale of portfolio assets to investors in a tax-effective manner, via a combination of a low corporate income tax rate, limited local withholding taxes (or an extensive double tax treaty network making any such withholding taxes reclaimable by many investors) and corporate liquidation rules that permit capital to be returned to investors.
Certain non-UK jurisdictions may have advantages over the UK as a holding company jurisdiction in this regard. However, most of these potential local tax benefits will typically be dependent on the non-UK holding company being and remaining tax resident in its local jurisdiction and not becoming UK tax resident.
UK tax residence – “central management and control”
A non-UK holding company is UK tax resident under UK law if it is “centrally managed and controlled” in the UK. The place of central management and control is where the highest level of control of the business of the company is. This will usually be the location where board-level decisions are made, but this is ultimately a question of fact and if the reality is that control is exercised by one or more particular individuals, the company is likely to be resident where he, she or they carry out their decision making.
It is, therefore, crucial to ensure that holding companies are centrally managed and controlled where established and not in the UK by seeking to ensure that: (i) as many board meetings as possible of those companies are held outside the UK and are attended in person where possible; (ii) the board comprises a majority of locally-resident directors and a limited number of UK-based directors, if any; (iii) board meetings are where the actual decision making takes place; and (iv) any UK-based directors join that board meeting in person to the extent feasible.
HMRC response
The travel restrictions imposed in March as a response to COVID-19 made adhering to many elements of this typical approach to ensuring non-UK residence wholly or partly impractical. The concern is that any UK directors of those non-UK holding companies who participate in board meetings and take decisions in the UK could cause those companies to become UK tax resident by virtue of being centrally managed and controlled there.
In response to this, in April, HMRC published guidance specifically addressing company residence issues arising from COVID-19. The guidance provided reassurance insofar as HMRC stated that it is “very sympathetic” to the difficulties brought about by COVID-19 movement restrictions. However, at the same time, HMRC stressed that it was not introducing any specific change of approach to corporate tax residence, stating instead that existing legislation provided sufficient flexibility for businesses to temporarily adjust their business activities in response to the virus.
A short-term solution
What HMRC was likely referring to here is that occasional UK-based decision making by a non-UK resident company is unlikely to lead to it becoming UK tax resident under the “central management and control” test, with the pattern of decision making taken over the life of the company and the relative importance of the decisions taken being of the greatest significance.
This meant that, although not ideal, companies were unlikely to become UK resident just because a few board meetings were held in the UK or there was participation in overseas board meetings from the UK or because some decisions are taken in the UK in the short term while the travel restrictions were in place. Newly incorporated holding companies could perhaps not afford this luxury where their initial decisions are among the most important decisions that they will take.
The longer term outlook
In recent weeks, it has become increasingly apparent across Europe that COVID-19 is not a short-term issue but one that could impact our lives for years to come. At the time of writing, lockdowns are being reintroduced in the UK on a localised basis while a second national lockdown looks possible. International ‘air bridges’ are removed as quickly as they are introduced. This creates huge uncertainty for travel and, so, for international tax planning.
For many UK managers of private investment funds that use non-UK holding companies, as well as other international businesses, the current HMRC guidance is unlikely to provide long-term security of tax treatment or to be a viable long-term option. In the absence of specific measures being introduced by HMRC to prevent companies becoming unintentionally UK tax resident due to COVID-19-related travel restrictions, some UK private investment fund managers may feel compelled to explore alternative structuring solutions.
Deeper non-UK roots
One option to avoid non-UK holding companies becoming or risking becoming UK tax resident may be to further enhance the level of presence in non-UK holding company jurisdictions. For example, by appointing more locally resident directors to company boards who are sufficiently experienced and involved in the investment manager’s overall business to undertake the decision-making processes in the local jurisdiction, without significant input from UK resident directors.
Looking to the UK
Another potential approach may be to look closer to home and consider reengaging with the UK as a holding company jurisdiction. Such UK structures should be less susceptible to being undermined by COVID-19-related or other travel restrictions in the future, which may make them more attractive in the future.
Coincidentally, just as the pandemic hit the UK in March 2020, HMRC published a consultation document exploring and seeking to encourage the use of the UK as a holding company jurisdiction.
The consultation correctly identifies that in certain ways the UK is already a suitable holding company jurisdiction, benefiting from: (i) a relatively low corporate income tax rate of 19 percent; (ii) an extensive network of double tax treaties; (iii) exemptions from withholding taxes on corporate interest; (iv) no withholding tax on outbound dividends, except by real estate investment trusts (REITs); and (v) a comprehensive participation exemption on capital gains – the substantial shareholding exemption – and on receipt of dividends from portfolio companies.
However, the consultation also identifies various limitations with the UK as a holding company jurisdiction. In particular, the UK’s substantial shareholding exemption has considerably more conditions to it than do comparable European jurisdiction participation exemptions and it may be difficult to repatriate profits in a tax-effective manner from a UK holding company.
For example, the interest on loans typically used by credit funds to fund and repatriate profits through their holding structures may not be fully deductible for corporate income tax purposes in the UK as it may constitute so-called ‘results dependent’ interest. Another example is that it can be harder for venture or private equity funds to extract returns from the sale of interests in portfolio companies from UK holding companies as capital rather than income compared to other jurisdictions because of UK rules which treat the gain element on a share buyback as dividend income for certain shareholders.
Although these issues are not generally insurmountable, and many UK private investment fund managers already use UK holding company structures for appropriate investments, simplifying these profit repatriation and other rules would be likely to increase the UK’s attractiveness as a holding jurisdiction. HMRC’s consultation closed in May 2020 and the conclusions are yet to be published, so it remains to be seen whether HMRC will capitalise on potentially renewed enthusiasm for the UK as a holding company jurisdiction in this way.
The new normal
In the immediate aftermath of lockdown being imposed in the UK, there was a widespread call for HMRC to provide clarification as to how corporate residence rules would be interpreted during the pandemic. The response was clearly limited to the short term. It is now clear that COVID-19 is here to stay, and international tax planning ignoring its long-term impact is ill-advised. The continued use of non-UK holding companies by UK private investment fund managers as discussed in this article is just one example of this, although the extent to which the travel restrictions are likely to adversely affect the tax status of such companies will depend on the specific facts and the way in which they are managed.
Richard Miller is a special tax counsel and Philip Gilliland is a tax associate at Proskauer Rose (UK) LLP. Mr Miller can be contacted on +44 (0)20 7280 2028 or by email: rmiller@proskauer.com. Mr Gilliland can be contacted on +44 (0)20 7280 2236 or by email: pgilliland@proskauer.com.
© Financier Worldwide
BY
Richard Miller and Philip Gilliland
Proskauer Rose (UK) LLP
Q&A: Effective transfer pricing strategies in the COVID-19 era
Equity compensation and transfer pricing – emerging cross-border issues
Cum-ex: a game of high-stakes musical chairs
Tax liability insurance in Europe: an effective solution for tax uncertainties
The partial employment schemes in the EU and in the UK