INTM551115 - Hybrids: financial instruments (Chapter 3): conditions to be satisfied: condition D – structured arrangements

Whilst the question of whether arrangements are structured arrangements will depend on the specific facts and circumstances, the following scenarios are provided as examples of arrangements which we would not generally see as structured arrangements for the purposes of the hybrid mismatch legislation. The aim in providing these examples is to minimise any additional due diligence in relation to compliance with the hybrid mismatch rules.

These examples are intended to illustrate that, in appropriate cases, the existence of a range of prices for similar transactions, and the fact that a UK broker dealer, prime broker or agent lender has some understanding of the tax position of the underlying principals/counterparties, do not necessarily or automatically lead to the conclusion that the UK broker dealer, prime broker or lending agent is party to a structured arrangement for the purposes of Part 6A.

Stock loan pricing

• A UK broker dealer, prime broker or agent lender operates under standard market agreements with a wide range of third-party lenders and borrowers.
• A stock loan of shares issued by a French company, crossing the dividend date, would have a real gross dividend of EUR 100 which is subject to a statutory rate of EUR 30 French withholding tax at source, leaving a net French dividend equal to EUR 70.
• Lender 1: a pension fund in Country A, exempt from tax within its jurisdiction on all income, but under a double tax treaty is subject to a French withholding tax treaty rate of 15% on its French source dividend received, agrees a dividend payment rate of EUR 70 plus EUR 15 equaling a total of EUR 85, thereby putting the pension fund in the same economic position as if it had not lent the securities. In addition to agreeing its dividend pricing with the borrower, the pension fund would also agree a fee for its loan of the French equities based upon an agreed percentage value of the gross dividend value. The fee represents a cost to the borrower, and it would be pro-rated over the term of the trade into a basis point value. From its stock loan fee income, the pension fund would pay a fee to either its prime broker or its agent lender calculated on an agreed revenue share basis that would not be reflective at all of the fact that the pension fund has a tax exempt status within its home jurisdiction.
• Lender 2: an investment fund such as a non-French qualifying UCITS, entitled to a 0% French withholding tax rate on French source dividend income, ought to agree its French manufactured payment value at a rate of 100% of the gross dividend because the pricing ought to reflect what the UCITS fund will receive with regard to its real French source dividend income. As with Lender 1, the non-French UCITS fund would receive an agreed fee from the borrower for lending its French equities (the percentage rate charged would fluctuate in this instance) and would, in turn, pay either its prime broker or agent lender a fee for arranging the loan. Again, as with Lender 1, the fee which the non-French UCITS would pay to either its prime broker or its lending agent would not be reflective of the fact that it has an exempt status within its home jurisdiction.
• Lender 3: an insurance company, resident for tax purposes within a jurisdiction which has not concluded an income and capital treaty with France, would become subject to a 30% French withholding tax on its French source dividend income. The insurance company would probably lend its French stock with a dividend rate of 70 (100 – 30% French withholding tax). The insurance company may be able to elect to have its foreign source income in the form of a real or manufactured dividend income which is not subject to local corporation tax. Once again, as with the previous examples, the fee which the non-treaty insurance company would pay to either its prime broker or agent lender would not be reflective of the fact that it has a tax exempt status on the income within its home jurisdiction.

The above varying substitute payment rates are consistent with the market range of pricing for substitute payments. Furthermore, the fees charged by the lender to the borrower are subject to many variables such as the attractiveness of the stock, the lender’s treaty or non-treaty withholding tax rate and whether the stock is difficult to source. In addition, the fees paid by the lender to either its prime broker or lending agent for arranging the loan are normally agreed based upon a revenue sharing agreement, that revenue being the initial fee charged by the lender to the borrower for the borrower’s temporary use of the stock. The fee does not therefore reflect any deliberate intention to share in the benefit of any D/NI mismatch between the parties, even if the stock lending desk has some awareness of the expected tax position of (some of) its counterparties.

Ordinary course derivative

• A multinational enterprise (MNE) wishes to hedge certain exposures arising from its employee share scheme.
• The MNE enters into a cash settled share option, linked to the value of the MNE’s shares, with a third-party UK bank.
• On maturity, the UK bank pays the settlement amount to the MNE, as the MNE’s shares have risen in value. The UK bank obtains a tax deduction in the course of computing its financial trading profit.
• The MNE is exempt from tax on the return from the option, for example because it is linked to shares or because it is linked to a transaction in its own shares.
• At the time of entering into the transaction, the UK bank expects (due to a general awareness of the tax position of its counterparties) that the MNE would be exempt from tax on any return on the option, but there is no reason to suppose that this is a relevant consideration in the pricing of the transaction.
• The UK bank’s pricing of the option reflects its usual approach to pricing share options, taking account of a range of commercial factors including characteristics specific to the MNE’s shares (such as share price and volatility) and which might include the size of the transaction.

On the basis that the transaction is a normal commercial transaction that has not been designed by the parties to obtain a D/NI mismatch and has not been priced to share the benefit of any mismatch or to reflect that a mismatch is expected, it is reasonable to suppose that this is not a structured arrangement for the purposes of the hybrid mismatch legislation. It follows that the UK bank would not need to carry out any additional due diligence review.

Securities issued to customers

Not all securities issued to customers which aim to deliver a particular tax treatment for the customer will give rise to arrangements within the definition of structured arrangements.

For example, Excluded Indexed Securities (EIS) within the terms of s433 ITTOIA 2005 are not usually considered to be structured arrangements. These can be debt securities which provide a return linked to an underlying asset or index – such as the FTSE 100. The securities are designed to meet the requirements of the UK’s EIS rules, so that a UK resident individual is subject to capital gains tax on their return from investing in the security – entirely in line with the policy objective of the EIS regime. The payments a bank makes under such securities will be deductible from financial trading profits.

In addition, there is an expectation that instruments such as UK EIS

• are priced in the same way as other similar instruments entered into with third parties; and,
• there is no certainty the instrument will produce a gain for the investor

The issue of securities that meet the conditions of s433 ITTOIA 2005 will not give rise to structured arrangements where

• they are designed with an intention of meeting those conditions in order to deliver the policy aim underlying the introduction of the EIS legislation, and
• they are issued in the normal course of commercial banking business

Directly comparable securities issued in other jurisdictions, and which would satisfy the conditions set out in the preceding paragraph had they been subject to s433 ITTOIA 2005, will be treated in the same way.

We take the same approach in relation to ISAs and similar statutory financial products.

In considering this guidance, it may be helpful to also consider the anti-avoidance provisions in Chapter 13 of the legislation, see INTM561500.

Hedge accounting

A third-party client may enter into a transaction with a bank if the client has a specific intention that it will obtain a hedging accounting treatment. For example, a corporate group issues a convertible bond to investors. If the corporate group wishes to hedge the associated risk of conversion, it may enter into an equity derivative with a bank. Obtaining hedging accounting may mean that the corporate group requires specific features in the derivative, which the bank would take care to provide. A consequence of hedging accounting treatment may be a hedging tax treatment, which may result in a situation where any deduction for the bank is not matched by an inclusion for the client.

Where the underlying instrument does not result in a hybrid mismatch, then any associated hedging would not be considered to be a structured arrangement, on the basis that the arrangement is not designed to secure a tax mismatch and the pricing is not affected by the tax treatment of the parties.

Where, however, the hedging instrument may itself be a hybrid financial instrument, it would be necessary to consider all of the facts to determine whether there is a structured arrangement.

Islamic financing

Islamic finance transactions may involve sales and purchases of assets, such as commodities (for example, a gold purchase), and may not be taxed on the same basis as in the UK. Income/expenditure arising in overseas jurisdictions may therefore not correspond to that brought into account for tax purposes in the UK, perhaps because the transaction is on capital account or because income/expenditure is considered to arise at maturity. These transactions are designed to achieve a particular characterisation for the purposes of the relevant Islamic GAAP or financing requirements, which in turn may have tax consequences.

For example, in a UK bank, the fee income and interest on a loan/gold purchase would be accounted for across the period of the loan under IFRS, whereas under an Islamic GAAP system, interest is not allowed and would be rolled up into the loan. This would create either non-inclusion or a timing mismatch between the UK deduction and the taxable period for the counterparty in the Islamic country. The Islamic counterparty usually has no influence on the accounting treatment.

Such sharia compliant financing instruments are not usually considered to be structured arrangements as

• the arrangement is not designed to secure a tax mismatch, and
• the arrangement is priced in the same way as other similar instruments entered into with third parties

However, if the parties use such instruments to produce a mismatch outcome that is not intended by the legislation and is contrary to the policy intention, the possibility that the financing arrangements are structured arrangements would need to be considered.