INTM551130 - Hybrids: financial instruments (Chapter 3): extent of the mismatch - case 1

Case 1 deals with deductions arising from a payment or quasi-payment under or in connection with a financial instrument where

• the deduction exceeds the total amount of ordinary income arising to payees, and
• all or part of that excess arises by reason of the terms or features of the financial instrument

Reason for the excess - terms

The legislation requires a consideration of whether any excess of the deduction above the ordinary income would have been less if the terms or any other feature of the financial instrument had been different. If so then, to that extent, it is a hybrid or otherwise impermissible deduction/non-inclusion mismatch.

Where Case 1 applies the impermissible mismatch is the amount of that excess which is attributable to the terms, or any feature, of the financial instrument.

There may be circumstances where only part of the excess is so attributable, with the balance arising for different reasons, and in that case only the part so attributed will satisfy this condition - see the example at INTM551380 where part of the mismatch is attributable to differences over the characterisation of a finance return but the balance is attributable to one of the parties being a share trader (and the mismatch would have arisen regardless of the instrument’s attributes).

Reason for the excess - any other feature

The addition of the phrase ‘or any other feature’ to s259CB(2) widens the scope of Case 1, bringing within it, for example, mismatches that arise by reason of the financial instrument being treated in a more beneficial manner because of the relationship between the relevant parties, see the examples at INTM551210, INTM551250, and INTM551300.

Exclusion for specified loan relationship debt relief provisions

There is an exclusion to the extent the excess arises by reason of a relevant debt relief provision or in relevant debt relief circumstances, as defined in s259CC(3) and (3A). Relevant debt relief provisions generally recognise loan relationship provisions specifically introduced to permit mismatches but following changes in accounting treatment that leave a number of the provisions redundant, relevant debt relief circumstances were added in s259NEB to s259NEF which correspond to a number of the relevant relief provisions, to ensure that excesses that arise in those circumstances do not lead to counteractions under Chapter 3. These are limited to circumstances such as genuine distress situations, where the object is not to burden further a debtor that is already genuinely struggling financially or to discourage rescue situations. See CFM35370 for more specific details.

Exclusion for an excess attributable to an interest distribution designation

An interest distribution designation means a designation made under regulation 5(2) of the Investment Trusts (Dividends) (Optional Treatment as Interest Distributions) Regulations 2009 (S.I. 2009/ 2034). So far as an excess arises due to an interest distribution designation, the excess is deemed not to arise due to the terms, or any other feature, of the instrument, and therefore that excess will not be countered by Chapter 3.

Exclusion for excess attributable to a relevant investment fund

The legislation excludes any element of the excess which arises as a result of the payee being a relevant investment fund, which is defined in s259NA. This includes certain open-ended investment companies, authorised unit trusts and certain offshore funds.

What if the mismatch arises for several reasons

Where the mismatch arises for several reasons it will be treated as arising by reason of the terms, or any other feature, of the financial instrument if it would have arisen as a result those terms or features.

However, if a mismatch arises solely because of the combination of the terms, or any other feature, with a particular fact pattern of the counterparty, and would not have arisen with any other counterparty then the mismatch cannot be attributed to specific terms or feature of the instrument.

Relevant assumptions

A hybrid mismatch within Case 1 arises where the mismatch is attributable wholly or in part to the terms or other features of the financial instrument.

S259CB(5) sets out the relevant assumptions that test whether the mismatch arises for reasons other than hybridity of the financial instrument. If there is no mismatch on making the relevant assumptions, then any actual mismatch does not result from hybridity of the financial instrument. In these circumstances the actual mismatch is not a Case 1 mismatch and falls outside the scope of Chapter 3.

The relevant assumptions are

• If the payee is not within the charge to tax as it benefits from an exclusion, exemption, immunity or relief assume that the exclusion, exemption, immunity or relief does not apply.

This assumption deals with mismatches that arise solely because the entities do not have ordinary income as a result of specific reliefs or exemptions. This will include exempted charitable corporations, certain pension funds or companies benefitting from sovereign exclusion.

• If the payment or quasi-payment is not made in connection with a business carried on by the payee in the relevant jurisdiction, then assume it is made in connection with such a business.

This assumption tests whether the mismatch is attributable to a territorial tax regime. An entity within a territorial tax regime is typically charged to tax only on receipts arising from a business carried on in that jurisdiction.

If the payee is not within the charge to tax in any territory, either as a resident or through a permanent establishment, then assume it is UK tax resident and that the payment or quasi-payment is made in connection with a business carried on in the UK. This assumption tests whether the mismatch arises because the payee is resident in a territory that has no equivalent to UK income tax or corporation tax on income.

Differences in valuation

If the mismatch is not attributable to the terms, or any other feature, of the financial instrument then it will not be within the scope of Chapter 3.

This could occur, for example, where the mismatch arises due to a difference of opinion on the value of shares to be received on the maturity of a convertible loan note. This contrasts with the situation where the mismatch arises as a result of attributing different valuations to an equity element created by inserting an option to convert before maturity, see the example at INTM551280.