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HMRC internal manual

International Manual

Controlled Foreign Companies: The CFC Charge Gateway Chapter 9 - Exemptions for profits from Qualifying Loan Relationships: Interaction of Chapter 9 Exemption with the Arbitrage Rules

It is likely that groups will use structures involving hybrid instruments or hybrid entities in conjunction with a finance company in order to minimise tax in the jurisdiction of the finance company (including overseas withholding taxes). This is so that the overall effective rate of the tax on the finance income (both UK and foreign) is minimised. The existence of a hybrid entity or instrument in a structure should not of itself affect the availability of the Chapter 9 finance company exemptions. However a group will still need to consider whether the arbitrage rules will apply and in particular will need to consider what the comparator is for determining whether there is a UK tax advantage under TIOPA10/S234.

In the diagram in the link below, the Dutch Co-Op structure is a common shelter for intra-group loan receivables, relying on the arbitrage between the UK and Dutch tax rules. There is a lot of flexibility in setting up a co-op and there are three different types under which the members have different levels of liability.

Use this link to view the example diagram

UK 1 and UK 2 are the members of a Dutch Co-Op. UK 1 makes a loan to the Dutch Co-Op, which in turn subscribes for shares in a Dutch Company. That company uses the money from issuing the shares to make a loan to Ultimate Debtor.

The Co-Op is regarded as an opaque entity for Dutch tax purposes and forms part of the Dutch fiscal consolidation (it becomes the tax liable entity for the profits and losses of the group). In the Netherlands it is claimed that the use of the Co-Op means that in the Fiscal Consolidation the interest income arising to the Dutch BV Finco on the loan to Ultimate Debtor will be offset against the interest expenses on the loan issued by the Dutch Co-Op. So from a Dutch perspective the Netherlands is flat for tax purposes. The interest received from the loan to Ultimate Debtor is matched by the interest paid by the Dutch Co-Op to UK 1.

Under UK tax law, the Dutch Co-op is likely to be treated as a partnership meaning it is transparent. If it is a partnership it is not taxed in its own right, its profits and losses are attributed to the UK corporate partners. UK 1 will include in its calculation of its corporation tax profits the loan relationship credits on the loan it has made to the Dutch Co-Op. UK 1 and UK 2 will include in their calculations of their corporation tax profits the interest deductions of the Dutch Co-Op as they are treated as loan relationship debits. The debits are allocated between UK 1 and UK 2in accordance with the profit sharing arrangements of the Co-Op. So from a UK perspective the UK is flat for tax purposes. The interest receipt from the loan to the Dutch Co-Op is matched by the interest deductions allocated to the two UK corporate partners.

Overall the group obtains a deduction for the interest paid by Ultimate Debtor, but that interest is not effectively taxed. The interest receipt is effectively sheltered from tax by using the Dutch Co-Op, which is a hybrid entity, being treated as transparent for UK tax purposes and opaque for Dutch tax purposes.

Dutch BV Finco is a CFC. Its assumed taxable total profits will likely consist almost exclusively of the interest received from Ultimate Debtor. The fact that the Dutch Co-Op ;is a hybrid entity will not in itself affect any claim under Chapter 9 for the profits of Dutch BV Finco to be either partially or fully exempt.

However the use of a hybrid entity means that the arbitrage rule (see Part 6 TIOPA) will potentially apply in respect of the loan relationship debits attributed to UK 1 and UK 2. In applying those rules the fact that there is a CFC structure does not necessarily mean that there is a UK tax advantage or that for the purpose of the hybrid arrangement is to obtain a UK tax advantage. For example, if the hybrid structure is only being used to minimise Dutch tax there is unlikely to be a tax advantage.