HMRC internal manual

International Manual

INTM595075 - Arbitrage: legislation and principles - deductions: condition C - the main or a main purpose of achieving a UK tax advantage: Examples on the application of Condition C

Examples on the application of Condition C

Inward investment

A loan of 1000 is made by a foreign parent company to its UK subsidiary, to be used solely to finance the building of a new factory. The loan is structured through a qualifying scheme within the meaning of the legislation and is made via a hybrid entity. The UK company gets a deduction for the interest it pays under the loan but, because of the scheme, the foreign parent also gets a foreign tax deduction for the same interest.

In order to determine whether a UK tax advantage was a main purpose of the scheme, an appropriate comparison must be made. Given that in this case the loan was made for a clear non-tax purpose, i.e. the new factory, it is reasonable to suppose that the investment would have been made in the absence of the scheme. Consequently the appropriate comparison of the UK tax effect of the scheme would be where the same loan was made by the parent company but without the benefit of using a hybrid entity. If in this case the same debt finance would have been offered to a UK entity (or UK branch) on similar terms and conditions, the arbitrage legislation will not apply.

In the above example, the comparison is therefore between the actual arrangements and a “plain vanilla” loan on which the interest payments give rise to single tax deductions. If the loan would have been made in the same amount and under the same terms and conditions, the scheme does not have the obtaining of a UK tax advantage as one of its main purposes.

If, on the other hand, the facts and circumstances indicate that the existence, amount or terms and conditions of a loan have been influenced by an arbitrage opportunity in a way that increases the UK tax deduction, and that this was a main purpose of a scheme exploiting the arbitrage, condition C will have been met.

For example, if (or to the extent that) a group of companies simply converts a proportion of its UK equity into debt in a scheme that uses a hybrid entity and (in contrast to the above example) there is no purpose other than to exploit this arbitrage opportunity, a scheme exists that has the creation of a UK tax advantage as its main purpose. It should be noted that it is not necessary that the conversion of equity into debt was a direct result of the hybrid entity. Rather, the focus of the legislation is on determining whether there is a main tax purpose of the scheme.

In the paragraph above, it will usually be reasonable to suppose that none of the interest expense would have been incurred in the absence of the hybrid entity. Where, however, a loan is used partly for a tax main purpose and partly for other purposes that do not include the creation of a UK tax advantage, the company may choose to make a disclaim of the deduction relating to part of the loan that relates to the tax main purpose, in order to prevent the wider application of the legislation. This is described in INTM595110.

Outward investment

In a case involving outward investment, arbitrage may arise where an equity investment is made in such a way that interest expense is taken into account in both the UK and another jurisdiction. As with inward investment, the question to be addressed is whether the arbitrage opportunity has affected behaviour in a way that reduces the amount of UK tax, in particular by increasing net interest deductions.

It may be that in the absence of the arbitrage opportunity, the debt would have been “pushed down” to the subsidiary, either by placing the original loan in that company, or by means of a loan from the parent company to the subsidiary. In either case the subsidiary would be financed using a mixture of debt and equity, rather than solely by equity. If so, then the arbitrage opportunity will result in increased net interest expense in the UK, and so Condition C will be met. INTM598040, INTM598050, INTM598060 and INTM598070 illustrate some of the issues to be considered in outward investment cases.

Other factors

In some situations it may be relevant to consider regulatory and market constraints when determining whether a tax main purpose exists:

Example - Tier 1 capital

Banks must hold regulatory capital to meet Financial Standards Authority requirements, including Tier 1 capital that consists mainly of equity, but may include a proportion of “innovative” Tier 1 capital, consisting of subordinated debt that is treated as equity for accounting and regulatory purposes. Although the legislation may potentially apply to these hybrid instruments, the unusual features of innovative Tier 1 capital described below will often suggest that there is no main purpose of obtaining a UK tax advantage.

Firstly, the main purpose condition is less likely to be met in circumstances where the existence of arbitrage depends upon the tax status of the holder, and the issuer does not seek to influence the identity of the holder. This will be the case where these instruments are genuinely placed on a market that is:

  • open to all investors irrespective of the buyer’s tax position; and
  • accordingly, the tax position of the holder is not something that the issuer could reasonably influence (e.g. because of a secondary market).

To fulfil the market condition above, it may not be necessary for the UK bank itself to directly issue the Tier 1 capital onto the market, as long as it can be shown that the Tier 1 capital can be directly linked to an issue to the market by the group of which it is a part and the other conditions of this paragraph are satisfied.

Secondly, Tier 1 capital is exceptional in that it represents a regulatory capital requirement for which conventional debt is not permitted, which represents a non-tax purpose for the issue of the debt in the form of a hybrid instrument, and reducing the pre-tax cost of meeting that regulatory capital requirement may represent a main purpose of choosing a hybrid debt instrument rather than equity.

Where both of the above conditions are met (genuine issue to market and the existence of a clear non-tax purpose for the choice of hybrid instrument), it will be reasonable to suppose that there is not a main purpose of achieving a UK tax advantage, and so the legislation will not apply. Moreover, in many cases the recipient under the instrument will be taxed in respect of the receipt (without reduction for underlying tax), or will benefit from a general tax exemption. In such cases the legislation would not have an effect because the conditions for rule B would not be met (see INTM595030).