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Introduction | Interest in the form of
non-taxable distributions | Foreign tax credits allowable
in respect of interest | Intra-group convertible debt:
accounting arbitrage | Disguised interest: derivative
contracts | Disguised interest: derivative contracts |
Shares as debt rules | Leases of plant and
machinery | Our view
At PBR 2007 the Government announced (as a simplification measure) a
“principles-based” legislative approach to avoidance involving financial
products. The first instance of the approach was legislation relating to
“disguised” interest. There was also a provision relating to the sale of
income streams. A consultation document that included draft clauses was
published in December 2007. An Open Day followed in the New Year. The
consultation closed at the end of February, but not before the publication
of revised draft clauses, and the convening of a second Open Day. It is
unnecessary here to detail the many concerns of the professions, commerce
and industry regarding the “principles-based” draft legislation. Most
respondents were profoundly disturbed by the timescale in which the new
approach was to be adopted. The Government has listened to these concerns.
It is not now proposed to introduce a “principles-based”, or generic,
approach until 2009.
In the absence of a generic measure dealing with financial products
avoidance, the Government has reverted to a more targeted approach.
Legislation will be introduced in the Finance Bill to block a range of
planning arrangements.
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Interest in the form of non-taxable distributions
In certain circumstances interest paid by a company is treated as a
“distribution” for tax purposes – that is, it is treated in the same way as
a dividend. Distributions of UK companies are not usually deductible by the
payer; and they are not chargeable to corporation tax in the hands of a
corporate recipient.
HMRC has become aware of arrangements under which interest payable is
structured as a distribution in circumstances where the payer, nevertheless,
is somehow able to deduct the interest for tax purposes; or is indifferent
to the availability of corporation tax relief (for example, because it has
losses). The recipient, however, receives the interest as a non-taxable
distribution. Legislation is proposed under which a company receiving
interest that is treated as a distribution is to be taxed on that interest,
if it arises in connection with tax avoidance. This will have effect for
credits relating to such income arising on or after 12 March.
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Foreign tax credits allowable in respect of interest
Under current law a company that sells an overseas debt instrument may
credit against its corporation tax liability, in respect of interest
accruing during its period of ownership, any attributable foreign tax
suffered, or to be suffered, on payment of that interest. This is the case
even if the debt is sold before the interest is actually paid, and before
any tax is suffered. The Government has decided to repeal this rule in
response to arrangements which exploit it to obtain a tax advantage – for
example where the debt is sold to a person benefiting from a nil or reduced
rate of withholding relative to the vendor. The change takes effect for
sales of debts occurring on or after 12 March.
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Intra-group convertible debt: accounting arbitrage
HMRC has become aware of arrangements that exploit a discontinuity in the
accounting treatment where convertible debt is issued by a company to
another member of its corporate group. Typically an issuing company, under
UK GAAP, will separate out the equity instrument that is “embedded” within
convertible debt. It will report this as equity, if it is to be treated as
equity in accordance with FRS25. The “host” debt would be reported as a
financial liability, and such an issuer would recognise an additional cost
of finance, for accounting purposes, that accretes the carrying value of the
financial liability to the debt’s nominal amount at maturity. The investing
company, on the other hand, may not separately identify the equity
instrument, if it has not adopted FRS26. Consequently, it would not
recognise, for accounting purposes, income corresponding to the issuer’s
additional cost of finance. This accounting asymmetry would usually be
eliminated in preparing the consolidated financial statements of the
corporate group.
Because the corporation tax regime for corporate debt largely follows the
accounting treatment, the asymmetry in accounting treatment is respected for
corporation tax purposes. However, the Government will introduce legislation
in the Finance Bill to require the holder to recognise additional credits,
for corporation tax purposes, to match the issuer’s additional debits. This
is to take effect for credits and debits arising on or after 12 March.
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Disguised interest: partnership arrangements
The Government has also responded to arrangements designed to produce
tax-free interest-equivalent returns through the use of partnerships. The
first of these relates to the acquisition of a partnership interest for the
present value of the partnership capital, where that capital is in fact to
be contributed by the vendor at some future date. The planning depends upon
the increase in the economic value of the partnership interest falling
outside the scope of corporation tax. The second arrangement produces a
return on money invested by way of partnership capital through alterations
in the profit-sharing ratio of the partners. The Finance Bill will include
provision that charges companies to corporation tax in respect of such
returns as profits from loan relationships. The proposed legislation will
take effect for returns arising on or after 12 March.
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Disguised interest: derivative contracts
A number of technical changes are proposed which will prevent the use of the
derivative contracts legislation in transactions that are designed to
produce returns in the nature of disguised interest.
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Shares as debt rules
Legislation will be introduced to stop planning that exploits or
circumnavigates the “shares as debt” rules in the corporation tax regime for
the loan relationships. This will address:
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depreciatory transactions that are intended to
create losses under the shares as debt rules;
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rates of interest that are said to be “uncommercial”,
and thus not within the rules;
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arrangements that fragment a return in the nature of
disguised interest between related companies to avoid the application of
the rules;
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transactions that are designed to conceal (by
masking) an underlying return that is in the nature of disguised
interest; and
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the use of exit strategies that do not constitute
redemption for the purposes of the shares as debt rules.
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Leases of plant and machinery
Legislation was introduced in 2004 to ensure that consideration would be
brought into account as taxable income of the seller where that person
disposed of lease receivables in circumstances where it was not brought into
account for tax purposes as income, or as a capital allowances disposal
receipt. HMRC has become aware of arrangements that avoid the application of
this rule for various technical reasons. Legislation will be included in the
Finance Bill to rectify this.
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Our view
The stay of execution in respect of a “principles-based” anti-avoidance
rule for disguised interest is a welcome response to the concerns of tax
professionals.
Given the delay in introducing such a rule, it was inevitable that a
range of targeted rules would follow addressing the specific concerns of
the moment. Like the Mounties, HMRC must always get its man (and be seen
to get its man!).
Of particular interest is the proposal to counteract the tax and
accounting treatment obtainable where a company issues convertible debt
to related companies. A “principle” underpinning the corporation tax
regime for loan relationships (and indeed large parts of the corporation
tax system in general) is the recognition of accounting measures for
taxation purposes. There is no suggestion that the accounting treatment
obtained in such arrangements is in any way abnormal or unusual. Clearly
there is a limit to the notion that tax legislation ought to be
“principles-based”.
We also note that the targeted provision relating to the sale of lease
receivables is significantly narrower than the corresponding
“principles-based” provision proposed in the consultation document. |
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