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HMRC internal manual

International Manual

Arbitrage: legislation and principles - deductions: condition C - the main or a main purpose of achieving a UK tax advantage: Use of hybrids

Use of hybrids

The deductions rules apply if and only if all of the four conditions A-D set out in s233 TIOPA 2010 are met.

Hybrid entities and instruments can be used without a main purpose of achieving a UK tax advantage. There may be a variety of reasons why an overseas parent of a UK group may wish to have entities treated as “hybrids” in a funding structure; for example to achieve deferral of income under the overseas parent jurisdiction’s Controlled Foreign Company rules. This will not automatically mean that the entity is caught by the legislation, as there needs to be a main purpose of obtaining a UK tax advantage. If there is no such purpose, condition C is not satisfied and the legislation will not apply.

An important question to be asked in considering the purpose of a scheme is - what are the purposes of including the hybrid in the funding structure? Do they contribute to a main purpose of creating of a UK tax advantage, for example by characterising a transaction as debt where otherwise it would have taken the form of equity or would not have taken place at all? Or has using the hybrid created an overseas tax advantage but no UK tax advantage? These questions will depend on the facts and circumstances of particular cases, but this guidance and the attached examples at INTM598010- INTM598170 attempt to assist in answering these questions.

Where the sole purpose of introducing a hybrid entity or hybrid instrument is to obtain an overseas tax advantage, Condition C will not be satisfied, as there is no UK tax advantage main purpose. It is important to emphasise that the legislation does not apply simply because adopting a qualifying scheme gains a tax advantage under another country’s tax code and a UK tax deduction is not matched by taxable income elsewhere. The legislation applies only if there is also a main purpose to achieve a UK tax advantage.

For example, the tax rules of some countries may allow for certain benefits (e.g. under their Controlled Foreign Company regimes or equivalents) when interest is paid to an entity that is treated as a foreign company under those countries’ tax laws. In such a case, if the entity is also treated as a partnership under UK tax rules (and is therefore a hybrid entity), questions may arise as to whether the legislation should apply. If, however, it can be shown that the UK tax consequences are unaffected by the scheme including the hybrid entity, as the sole purpose of the hybrid entity is to ensure qualification for an overseas shareholder tax benefit, Condition C will not be satisfied and the legislation will not apply. Conversely, if the scheme including the hybrid achieves both a shareholder tax benefit and also adversely affects the UK, the legislation will apply if there is a main purpose of obtaining a UK tax advantage. See INTM598150.

There should, in principle, be no difference here between qualifying schemes involving hybrid entities or hybrid instruments. The test will be the same in each case. A group that has used - and wishes to continue to use - hybrid instruments directly to fund UK or overseas operations will have to address the questions whether achieving a UK tax advantage is a main purpose, whether there is a main non-tax purpose (e.g. regulatory capital) for funding that is more expensive than simple debt and whether the additional cost inherent in the cost of funding through a hybrid instrument (e.g. longer term or subordinated debt at a higher interest cost) is wholly justified by the non-tax benefits sought. See INTM598080 and INTM598090.

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Main purpose - obtaining a UK tax advantage

If a deduction arises out of a transaction that is part of a qualifying scheme, condition C of s233(4) TIOPQ 2010 asks whether the main purpose or one of the main purposes of the scheme (referred to as “a main purpose” in this guidance) is to achieve a UK tax advantage. The purpose of a scheme is determined by the purposes of the scheme’s participants in entering into the scheme. If any participant has as a main purpose to achieve a UK tax advantage that will constitute a main purpose of the scheme.

The existence of a UK tax deduction is not enough in itself to show that a scheme has a main purpose of obtaining a UK tax advantage. A tax advantage main purpose implies that in the absence of the scheme, tax deductions arising from the scheme would not have arisen at all, or would have been of a lesser amount. Hence it will be relevant to draw a comparison in order to consider whether, in the absence of the hybrid entity or instrument:

  • the transaction giving rise to the deduction would have taken place at all;
  • if so, whether it would have been of the same amount; and
  • would it have been made under the same terms and conditions.

For example, if the scheme involves a loan and the deductions are for interest payments, it will be necessary to consider whether the size, nature, or very existence of the loan has been altered by the arbitrage scheme in a way that increases UK tax deductions. The comparison should be based on equivalent arrangements that did not make use of any hybrid entities or instruments.

It may be that the same transactions could have taken place within the context of another scheme that also had a main purpose of achieving a UK tax advantage but by means other than the use of arbitrage. Such a scheme will not represent a suitable comparison for determining whether a tax advantage main purpose exists.

In making the comparison, HM Revenue and Customs will consider the actual arrangements as structured under the scheme and the arrangements that would have occurred in the absence of the hybrid entity or instrument. In making this comparison, it is important to remove only the arbitrage element created by the hybrid entity or instrument and not to alter other features in the arrangements. The comparison should not be drawn on the basis of an assumption that real investment activity funded by the scheme would not have taken place without the arbitrage. The examples in INTM595075 provide further illustrations of how this comparison should be made.

A scheme achieves a UK tax advantage for a person if in consequence of the scheme the person is in a position to obtain or has obtained a relief or increased relief (or tax credit) from income tax or corporation tax, a repayment or increased repayment of income tax or corporation tax or the avoidance or reduction of a charge to income tax or corporation tax (which may be effected by receipts accruing in such a way that the recipient does not pay or bear tax on them, or a deduction in computing profits or gains).