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International Manual

HM Revenue & Customs
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Arbitrage: legislation and principles - deductions: Deduction not matched by a taxable receipt

Section 245 TIOPA 2010 applies in certain circumstances where a payment qualifies for a tax deduction and there exists a corresponding payee who is either not taxed on the receipt, or the tax charge is reduced. Where the rule applies, it cancels the deduction that gives rise to the UK tax advantage to the extent that the payee is not effectively taxed on the receipt. The rule will only apply if all of the conditions in s245 TIOPA 2010 have been met (see INTM595040).

The exempt receipt need not be in respect of the same payment as gave rise to the UK tax deduction. For example, a UK resident company A makes a tax deductible payment to a non-resident company B, which is taxed on the receipt. B makes a matching payment to company C, whereby B obtains a tax deduction but C is not taxed on the receipt. In this example A is the payer and C is the payee for the purposes of s245 TIOPA 2010.

However, the rule will apply only if the tax deductible payment and the untaxed receipt arise out of the same transaction or series of transactions. Hence, if A makes a payment to B and B is taxed on the receipt, s245 is not triggered by a wholly unrelated but tax exempt receipt in B.

Not all exemptions or reductions of tax for the payee trigger the rule. Section 245 TIOPA 2010 applies if the tax reduction results from any of the following circumstances:

  • The income or gain is matched by a deduction or relief for the payee that arises from transactions forming part of the scheme s246 TIOPA 2010;
  • The income or gain is exempt from tax otherwise than by reason of an exemption from tax that is given by reason of the characteristics of the payee (s246 TIOPA 2010); or
  • The income or gain is exempt from tax because of an exemption from income or gains that takes the form of taxing a different person in respect of the income or gain (s246 TIOPA 2010).

A dividend that is exempt because of a participation exemption falls within the second bullet point above, because a participation exemption is given in respect of a category of income rather than to a category of payee.

Examples of where s245 TIOPA (2010) does not apply include where:

  • The payee is generally exempt from tax in respect of income that would otherwise be taxable in the jurisdiction (whether or not the exemption extends to all categories of income) and the payee’s income or gains are not taxed as the income or gains of any other person. For example the payee is resident in a tax haven;
  • The payee is liable to tax but is covered by a statutory exemption. For example, charities and pension funds are within the scope of taxation but are not liable to tax as they benefit from a statutory exemption under many tax codes; or
  • The payee has relief available to set off against the income and the relief does not arise as part of the scheme. For example, an arrangement would not be caught by the legislation if loss relief unrelated to the transactions in question was available to set off against income in computing the recipient’s taxable income or profits.

As noted in the second paragraph above, it is not necessary that the unmatched deduction is given in the UK, although there must be a UK tax advantage and a UK deduction arising from the scheme for the rule to apply. Rule B cancels part or all of the deduction giving rise to the UK tax advantage, as follows:

  • If the payee is wholly exempt from tax in respect of payments made under the scheme, the deduction is reduced to nil;
  • If relief is given against only a proportion of the receipt or a proportion is exempt in the hands of an otherwise liable taxpayer, that same proportion of the deduction is disallowed;
  • If any amount of tax credit relief arising from a scheme transaction is given against the tax liability on the whole of a payment, the whole of the corresponding amount will be disallowed.

It should be borne in mind that:

  • a partial disclaim of the deduction may cancel the tax advantage main purpose and so “switch off” the legislation altogether s243(6)(a) TIOPA 2010 - see INTM595110); and
  • where the amount of the credit or relief is small, it may be unlikely that it represents a main purpose of the scheme.

Simple example of scheme involving a hybrid entity, resulting in asymmetry of tax treatment

Use this link to view example 1 diagram

In this simple example, UK1 is a hybrid entity in that its profits and gains (subject to UK Corporation Tax as it is a UK resident company) are also taken into account by its US parent for the purposes of computing its US tax liabilities.

This is because a check-the-box election has been made to treat UK1 as a branch of its immediate parent for US tax purposes.

The result of this structure is that UK1 obtains a UK tax deduction for interest payments on a loan from its US parent, but the interest receipt in not taxed in the US because the loan between the US parent and UK1 is disregarded as it is viewed as an intra-company loan between the US company and its branch.

Simple example of a hybrid instrument

Use this link to view example 2 diagram