Disguised interest
Introduction
What is disguised interest?
Purposive drafting and the idea of principles-based legislation
Problem areas
Conclusion
Introduction
Last year's PBR announced a consultation on a principles-based approach
to financial products avoidance. This was to address the areas of
"disguised interest" and transfers of income streams. It was
revolutionary, and would address tax planning that other anti-avoidance
provisions could not reach. Principles-based legislation would embody a
principle of UK taxation, and would be accompanied by a statement of how
the legislation intends to operate by reference to that principle. It
would be clear, on a first reading, what was being addressed by the
legislation, and with what outcome in mind.
The PBR announcement was followed by publication of the consultation
document in mid-December, with draft clauses; and the consultative
process continued this year with open days in January and February
before concluding at the end of the latter month. Thereupon HMRC
withdrew to mull over the responses that they had received. After some
delay, HMRC published a technical note in July, and announced a series
of closed workshops over the summer.
This year's PBR brings the story up to date, and we have a new
consultation document. HMRC has commented on the feedback obtained to
date, and has re-shaped the draft legislation. Responses to the new
document are sought by 11 February 2009, and HMRC will hold an open day
early in the New Year to explain the proposals further.
What is disguised interest?
The debate on the principles-based approach to financial avoidance has
focused on the subject of "disguised interest". This has largely
eclipsed the sister-proposal relating to transfers of income streams.
Disguised interest avoidance schemes are depicted, in the 2007
consultation document, as those exploiting differences in tax treatment
between interest and other receipts such as dividends, and which seek to
convert taxable interest into an exempt dividend or capital gain. The
document noted that a number of legislative measures had previously been
introduced to address such avoidance, notably the shares-as-debt rules
in FA1996 ss.91A-91G, which were introduced by F(No.2)A 2005. In fact,
there has been serial legislation in this area. The Conservative
government of John Major introduced provisions relating to "guaranteed"
returns on futures and options in the FA1997, which were enacted in
March 1997. It is possible to trace features of that legislation through
the provisions relating to guaranteed returns in the derivative
contracts rules, and subsequently within the shares-as-debt rules; and
now within the current proposals relating to disguised interest.
It has not always been easy to comprehend what is meant by "disguised
interest". The 2007 consultation document spoke of this in terms of
economic equivalence. The fundamental principle was said to be "A return
designed to be economically equivalent to interest is to be taxed in the
same way as interest". This seemed to import economics as a frame of
reference. This might involve an economic analysis of the constituents
of a lending return, which might not address the concept of interest
other than in the context of the total financial return. However
(perhaps unsurprisingly) the draft legislation did not quite deliver
this. It required the return to exhibit the essential characteristics of
the common law concept of interest, which is something that the courts
have examined in fiscal and other legal contexts. (For example, it is
addressed in the non-tax case of Chevron Petroleum (U K) Ltd & Others v
B P Petroleum Development Ltd & Others (57 TC 137)). The 2007
consultation document spoke of an arrangement that was designed to
produce a return that equated, in substance, to that on an investment of
money at interest. Here, as in the predecessor legislation from which
the phrase derives, "Equated, in substance" seemed to invoke certain
quantitative and qualitative characteristics. The rate of return would
clearly be relevant. But other characteristics such as the nature of the
creditor's contractual entitlements would presumably also be relevant.
Did a return constitute consideration for the use of money over time?
What were the "creditor's" rights on a default?
The technical note issued by HMRC in the summer tied the return to the
main substantive characteristics of interest. "The object of the
proposed disguised interest legislation is to produce a clear rule
ensuring that a time value of money return is charged to corporation tax
in all circumstances where an arrangement produces that return in a form
that is not subject to tax as income, but not so as to affect cases
where an effect similar to such a return is produced essentially by
chance". Draft clauses were circulated prior to the last of the summer
workshops, and these defined the return in those terms. HMRC's
explanatory notes were also clear that time value invoked familiar case
law indicia relating to the revenue law concept of interest. The return
had to be calculated by reference to an amount: "there must be a sum of
money by reference to which the payment said to be interest is to be
ascertained" (Megarry J in Euro Hotel (Belgravia) Ltd (51 TC 293)). It
had to be determined by reference to the time value of that amount:
"payment by time for the use of money" (Rowlatt J in Bennett v Ogston
(15 TC 374)).
The revised draft clauses follow this lead. A return produced for a
company by an arrangement in relation to an amount is defined as
"economically equivalent to interest" if
- it is reasonable to assume that it is a return by reference to the time value of that amount of money;
- it is at a rate reasonably comparable to a commercial rate of interest; and
- at the time that the arrangement is entered into by the company there is no practical likelihood that it will cease to be produced in accordance with the arrangement
It is clear from this that it is not necessary to address unspecified economic concepts. It is merely necessary to examine, objectively, whether there is an amount and a return on that amount; and whether that return is interest-like in that its exhibits the essential legal characteristics of interest.
Purposive drafting and the idea of principles-based legislation
The original draft legislation included a purpose statement prefacing
the operative provisions. The object of this was to aid interpretation.
However, the effectiveness of the approach seemed questionable. It was
not obvious that the courts would respect it: in fact, the relevant case
law seemed to show the contrary. Paradoxically, it seemed to make the
legislation confusing and somewhat repetitive. After strongly-worded
opposition, the idea of including such "purposive" drafting has been
abandoned (at least in relation to disguised interest).
However, the idea of the provisions being "principles-based" in nature
has been retained. In the context of disguised interest, this seems to
consist of defining the scope of the legislation in generic terms. HMRC
has defined the "principle" that it wishes to see (disguised interest
returns to be charged to corporation tax as income), and has created
legislative machinery to accomplish it. Disguised interest returns are
defined in objective terms, and not by reference to design features. It
might be possible for such a return to arise accidentally. Because the
approach is wide-ranging, it has become necessary to provide for
wide-ranging exclusions. The rules will not apply where a return would
be chargeable to corporation tax as income by some other means. For
example, if the return falls to be charged in the computation of trading
income, or under the special corporation tax regimes for derivatives,
loan relationships or intangibles, then it is excluded from the
disguised interest rules.
More significantly, the rules do not apply where an arrangement produces
a return but it is not the main purpose, or one of the main purposes of
the arrangement to secure that the return is not chargeable as income
for corporation tax purposes. This is a vitally important filter,
operating to exclude innocent transactions. There are telling echoes
here, also, of the unallowable purposes provisions within the
corporation tax regimes for loan relationships and derivatives.
Finally, an arrangement is not within the scope of the rules if the
return that is produced "involves only" relevant shares. This
strangely-worded phrase depends upon the return in question reflecting
only an increase in the fair value of the shares. The explanatory notes
to the revised clauses comment that this "...excludes from [the rules] all
straightforward share investments in 'relevant shares' where the only
economic exposure that the holding company has to the shares that it
holds is to the value of the shares". Relevant shares, for this purpose
are fully paid-up shares in group companies, not including controlled
foreign companies (CFCs), and in group and non-group CFC's. The shares
of group and non-group CFCs are relevant shares, if their chargeable
profits are subject to an apportionment in accordance with ICTA, s752 by
virtue of s.747(3), or the CFCs are within one of the exemptions
specified in ICTA, s.748(1) or (3).
The approach of defining the catchment area of the rules in wide terms,
but making this subject to wide exclusions probably succeeds in making
the rules more generic in nature. This is at the cost of increasing tax
uncertainty for business. HMRC regards this as a price worth paying, and
comments in the consultation document that "our expectation is that the
measures would not impact on compliant businesses, charities or the
public sector". HMRC's complaint has been that targeted anti-avoidance
provisions have been ineffective. Time will tell whether the disguised
interest rules will fare better. They too have their boundaries. Perhaps
we will we see planning arrangements that depend upon returns not being
in the nature of interest.
It is interesting to note that disguised interest from certain
preference shares do not fall to be treated under the disguised interest
rules. Instead, elements of the predecessor shares-as-debt provisions
are amended, and will be re-enacted. The rationale for this is not fully
explained. It is commented that non-participating or fixed-rate
preference shares that are treated for accounting purposes as a
financial liability (rather than as equity) "give rise to specific
issues". They are regarded as "quasi-loans", like repo and certain
alternative finance arrangements (for example, Islamic finance
arrangements). They are to be distinguished from arrangements yielding
disguised interest that do not create a quasi-loan. However, unlike repo,
it is not thought that these quasi-loans should be subsumed into the
loan relationships rules. Such an approach would give rise to
deep-seated transitional issues and we can safely assume that
corporation tax relief for such finance costs is not an agenda item for
the Government. The target of the disguised interest rules is confined
to disguised interest returns that do not arise from quasi-loans.
Consequently, there is a need to retain more specific, "targeted"
provisions in relation to returns from such "share" quasi-loans.
This is accomplished by retaining elements of the previous
"shares-as-debt" regime, in particular FA1996, s.91D. These are amended
and to be re-enacted as Chapter 6A of the re-written corporation tax act
(shares accounted for as liabilities). There are, however, some
important developments. Whilst the operative effect of the new rules,
like their predecessors, is to treat the shares as creditor loan
relationships, and to disapply the treatment of dividends as (exempt)
distributions, their scope is much narrower. First, the rules only apply
to shares that are accounted for as a financial liability in accordance
with generally accepted accounting practice. They do not apply to "equity" shares. This is a massive difference from the current FA1996,
s.91D, which, arguably, might operate to charge as income gains in
respect of ordinary shares in certain circumstances. Secondly, the rules
do not apply where the investing company and the issuing company are
under common control. These restrictions should prevent many of the
problems associated with applying anti-avoidance rules of this nature in
group contexts. Like FA1996, s.91D, the shares must be "designed" to
produce a return which equates, in substance, to the return on an
investment of money at a commercial rate of interest, and the investing
company's purpose in acquiring the shares must be an unallowable
purpose. This contrasts with the approach of the principles-based
disguised interest rules, which do not require design features but
merely the objective existence of an interest-like return. The purposes
test and the group/ CFC exemptions are intended to carve out innocent
transactions. This is the difference between a targeted anti-avoidance
rule and a more generic (principles-based) approach.
Problem areas
A number of problem areas were discussed with HMRC during the
consultation process, and are addressed to greater or lesser extent in
the revised rules.
Underlying disguised interest
One concern was the potential of the rules to reach within commercial
arrangements to isolate a disguised interest component of some larger
return. In the draft clauses issued in the summer, the use of the adverb
"partly" in the phrase "determined wholly or partly" seemed to allow
some theoretical underlying disguised interest to be separately
identified. The revised clauses do not entirely eliminate this concern.
The phrase in question has been replaced by a reference to the objective
character of the return – "it is reasonable to assume that it is a
return by reference to the time value of that amount of money". This may
not prevent HMRC from seeking to identify a disguised interest component
of a larger composite return, where they consider that it is objectively
discernible.
Exchange gains and losses
A limitation of the clauses circulated in the summer was the treatment
of exchange differences. Where disguised interest was denominated in
foreign currency, it seemed appropriate that exchange gains and losses
should also be brought within the charge to corporation tax or allowed.
However, the previous version of the clauses did not cater for this in
any reasonable fashion. The revised clauses improve on this, but some
technical concerns remain.
Split returns
The consultation document comments on the basis of allocation where a
disguised interest return was "split" between two or more persons. The
response is that this will be on a just and reasonable basis. However,
concerns were also expressed that it was inappropriate for returns to be
addressed where these were "split" between unrelated companies. This has
not been explicitly addressed. It is possible that HMRC believes that
the purposes test and other exclusions in the legislation provide
sufficient protection. It may also be noted that, whilst the earlier
clauses addressed returns split between companies, the revised clauses
go further and address returns that are split between "persons".
Single return taxed on more than one company
The exclusions in respect of group companies and CFC's are intended to
assuage concerns that the rules might give rise to a multiplicity of
charges in respect of disguised interest, where the offending return is
held through a chain of shareholdings.
Interaction with CFC rules
There was acceptance by HMRC at an early stage that the disguised interest rules should not apply in respect of the shares of CFCs, and this has been respected. The shares of CFCs are excluded "relevant" shares, provided their chargeable profits are subject to an apportionment in accordance with ICTA, s752 by virtue of s.747(3), or they are within one of the exemptions specified in ICTA, s.748(1) or (3). As a matter of policy, the treatment of CFCs falls within the scope of the foreign profits changes.
Conclusion
The revised proposals constitute a marked improvement on the December 2007 consultation document. The confusing and unnecessary apparatus of purposive drafting has been usefully abandoned - at least in respect of the proposals relating to disguised interest. The clauses are generic in nature and potentially wide-ranging but they are constrained by significant and wide-ranging exclusions - notably in respect of group shares and the purposes test. The consultation is set to run through to February next year, with a view to including provisions in next year's Finance Bill. It is proposed that the new rules should take effect for arrangements commencing on or after 1 April 2009, although there are also transitional proposals for arrangements within the shares-as-debt rules before that date. It does not seem at all likely that the initiative will be abandoned. It is therefore imperative that remaining matters of concern are identified and communicated in the coming months.