The UK’s new rules governing tax avoidance through international arbitrage are expected to be enacted later this month. International arbitrage refers to arrangements using either a hybrid entity or a hybrid instrument to obtain a UK tax advantage. Tax advantage includes merely getting relief from UK tax. Hybrid entities include "check-the-box companies" which may get tax deductions in more than one jurisdiction. The rules, which are explained more fully below, will have retrospective effect from 16 March 2005, although certain schemes between unconnected parties will not be caught provided they are dismantled by 31 August 2005.
Despite the Government’s insistence that the rules would only affect "highly contrived" schemes, the rules are drafted broadly and could potentially catch long-established and previously unobjectionable structures used by US groups to finance their UK operations.
Although the legislation is not final, its general shape is now clear, and it should be treated as already being effective given its retrospectivity. All multinational groups with interests in the UK should consider the application of this new legislation in the light of their particular corporate structure.
The new legislation will apply only if HM Revenue & Customs (HMRC) serves a notice on the relevant company, requiring it to take the legislation into account in preparing or amending its self-assessment tax return. There will be no right of appeal against the issue of a notice as such. However, the company may disagree with HMRC’s view of the application of the legislation and submit its tax return on a different basis. If HMRC subsequently seeks to amend the return, the company can challenge such an assessment through the normal appeal procedures. Alternatively, a taxpayer can disclaim a deduction in order to take itself out of the ambit of the legislation.
Conditions of Application
The legislation applies to two types of situation, known as "deductions cases" and "receipts cases". The deductions cases are likely to be more commonly encountered in practice. These are where the tax advantage derives either from two deductions given in respect of the same expense or where a deduction is given but there is no corresponding pick-up of the receipt elsewhere within the structure.
A notice will be issued under the legislation if the following four conditions are met:
- The transaction giving rise to the deduction is part of a scheme involving the use of a hybrid entity or instrument (a "qualifying scheme")
- The company is able to claim a deduction as a result of the scheme
- A main purpose of the scheme is to achieve a UK tax advantage for the company
- The amount of the UK tax advantage is more than minimal
To qualify under the legislation, the scheme must involve either a hybrid entity or a hybrid instrument. A hybrid entity is defined as an entity treated as a person under the tax law of any territory but whose profits or gains are also treated as arising to a person other than itself under the law of any territory.
Clearly US "check-the-box" entities can be within the rules, whether they are UK companies treated as branches in the US, or UK partnerships or limited partnerships treated as separate entities for US purposes.
HMRC guidance indicates that a company with a permanent establishment in another territory will not be a hybrid entity. Nor will a controlled foreign company (CFC) be viewed as a hybrid entity, even though the effect of CFC rules is to attribute a CFC’s profits to another person.
The legislation recognises various types of hybrid instruments. In broad terms, they are:
- Instruments where an election can be made to vary the instrument’s tax treatment
- Shares that carry a reasonable expectation of conversion into debt and vice versa
- Debt treated as equity in accordance with generally accepted accounting practice
- Shares other than ordinary shares carrying the usual rights to distributions and assets on a winding-up, but only where the shareholder is connected to the company
- Securities where the rights to income or gains are split between connected persons
UK Tax Advantage
The legislation can only apply where a company obtains a UK tax advantage as a result of the qualifying scheme.
The Government takes the view that in determining whether a UK tax advantage was a main purpose of the scheme, it is necessary to compare the position with a hypothetical situation based on equivalent arrangements that did not make use of hybrid entities or instruments and which also did not have a main purpose of achieving a UK tax advantage. To accompany the guidance, HMRC has issued worked examples showing the factors they regard as indicating that a main purpose of the scheme was to achieve a UK tax advantage. The rules will not apply to certain innovative Tier 1 capital of banks issued to meet regulatory requirements. If the hybrid arises as a result of clear non-tax reasons and the deductions would not have been less in the absence of the arbitrage, the rules will not apply.
The legislation does not provide for there to be a comparator, still less define its characteristics, so the status of this guidance must be questionable.
Minimal Tax Advantage
The legislation provides that a tax advantage must be more than minimal before a notice can be issued by HMRC. This threshold is not defined in the legislation, but HMRC has indicated that it will not seek to apply the legislation where the deduction claimed is £50,000 or less.
A notice may be triggered broadly where a scheme involves the receipt of a payment that constitutes a capital contribution which is not subject to UK tax and is deductible for the paying party (either for UK or foreign tax purposes). These provisions are, in the opinion of HMRC, relatively narrow in application and are targeted at arrangements such as deferred subscription agreements.
Calls for a statutory clearance mechanism have been rejected by the Government. HMRC has, however, undertaken to provide an informal advance clearance mechanism in respect of the rules and "will consider itself bound" by any ruling.
The legislation that has emerged potentially affects planning techniques that have not hitherto been seen as particularly aggressive, and certainly many that have been accepted and widely used for many years. It introduces a tax charge which is dependent, in part, on the tax rules of other territories, and it introduces a comparative test for determining whether a main purpose of achieving a UK tax advantage exists without specifying what an appropriate comparator should be. The result, at least in the short term, seems likely to be considerable uncertainty as to how broad the effects of this legislation are.
Potentially affected groups should consider the impact of these rules on their group structures now. Whilst the guidance from HMRC states that legislation is not intended to catch all "check-the-box" structures, the burden of proof is likely to be on the taxpayer to establish a justification for the structure which does not relate to the avoidance of UK tax.
The main practical upshot of the legislation for the future is that companies looking to establish hybrid structures should consider carefully their reasons for entering into them. Assuming there are good non-tax reasons for doing so, these should be minuted accordingly in case the structure’s commerciality needs to be justified to HMRC.