Finance Bill 2009 introduced new legislation in respect of exemptions from UK corporation tax for dividends

How will these new rules work and is there any action which needs to be taken now?

What are the current rules?

A UK resident company is taxable on dividends received from overseas subsidiaries, with a credit available in most cases for tax paid by the subsidiary. Dividends received from UK subsidiaries are not taxable.

What are the proposed changes to the rules?

From 1 July 2009, a new regime will apply to dividends from both overseas and UK subsidiaries. Dividends will be exempt if they satisfy the conditions outlined below, but will be taxable if they do not. However, please note that the rules are complex and below is a broad outline of key issues.

Small groups
A 'small' group for these purposes is one which has fewer than 50 employees, and either turnover below €10m or a balance sheet total below €10m. Certain investment funds will not be considered 'small' even if they satisfy these conditions, for instance, open ended investment companies, authorised unit trusts, insurance companies and friendly societies.

For small groups, a dividend will be exempt if:

• The payer is resident in the UK or a 'qualifying territory'
• Broadly, it is not a payment of interest which is treated as a dividend for tax purposes
• It is not tax deductible by the payer
• It is not paid as part of a scheme, the main purpose of which is to secure a tax advantage

A 'qualifying territory' is one with which the UK has a double tax agreement which includes a non-discrimination article.

Large groups
For groups which are not small, a dividend will be exempt if:

• It falls within an 'exempt class' - as listed below
• Broadly, it is not a payment of interest which is treated as a dividend for tax purposes
• It is not tax deductible by the payer

There are also anti-avoidance rules which prevent the exemption from being available in certain cases. These are complex rules, full details of which can be found in the Finance Bill 2009.

What are the exempt classes of dividends for large groups?

The following dividends listed below will considered to be exempt from corporation tax from1 July 2009.

• Dividends from 'controlled companies'. The definition of 'control' is the same as the definition in the controlled foreign company (CFC) rules, and includes 51% subsidiaries as well as joint venture companies where both joint venture partners hold at least 40% of the shares. It is anticipated that most dividends from subsidiaries will fall within this exempt class.

• Dividends paid in respect of non-redeemable ordinary shares. The definition of ordinary shares is very narrow, and only includes shares which do not carry any preferential rights. The definition of non-redeemable is also very narrow, and if either the issuer or the shareholder can call for redemption, the share will be redeemable.

• Portfolio dividends ie where the shareholder is entitled to less than 10% of the ordinary share capital, profits available for distribution and assets available for distribution on a winding up.

• Motive test. A dividend will be exempt if it has been paid out of profits which have not been diverted from the UK, or where the diversion of profits was not one of the main purposes of the transaction which gave rise to the profits. Most dividends from UK subsidiaries should satisfy this motive test if they do not fall within one of the other exempt classes.

• Shares treated as loans. Where shares are treated as loans under the loan relationship rules, the dividends will be taxed as interest, and will therefore not be taxable dividends in their own right.

Is there any action which should be taken in advance of 1 July 2009?

A number of planning opportunities arise as a result of the new regime, including:

• If dividends are not likely to be exempt after 1 July 2009 they should be paid now if excess underlying tax has arisen on other dividends. Under current rules, this excess underlying tax will reduce the UK corporation tax on other dividends, but this will not be possible after 1 July 2009.

• All existing and new joint venture or minority shareholding arrangements should be reviewed to ensure that dividends will fall within one of the exempt classes. Dividends will only be exempt under the first exempt class if a shareholder has control of the paying company. The conditions for the other exempt classes may be more difficult to satisfy.

• Small companies should as far as possible not receive dividends from subsidiaries in non-qualifying territories. Such dividends should be deferred until the company has ceased to be small, at which point the dividend may fall within one of the exempt classes.

• Where loans have been made from subsidiaries to holding or parent companies, which are affected by the new debt cap rules, an exempt dividend could be paid to reduce or eliminate the loans. For more details see our previous tax story on the debt cap.

Is it worth considering an election for a dividend exemption not apply?

It is possible to make an election for the exemption not to apply to a particular dividend. Such an election may be beneficial where a reduced rate of withholding tax under a double taxation agreement is only available if the dividend is subject to tax in the UK. Although the dividend would then be taxable in the UK, management expenses or other deductions may be available to reduce the amount which is taxable.

In addition, an election may be necessary as in order to pay an Acceptable Distribution Policy (ADP) dividend because for controlled foreign company (CFC) purposes a dividend must be taxable.

Nick Farr, Tax Partner at Grant Thornton says: "The extension of dividend exemptions to foreign dividends has been a welcome change to UK tax legislation. However, if companies do not fully understand the rules they may not be able to use them to their full advantage."

Please contact us if you would like further advice on any of the above.