Arbitrage: practical guidance: case identification and working of enquiries: factors to consider in identifying potential arbitrage cases
The following are factors to consider when looking at a scheme to which the arbitrage legislation may be applicable:
Whether debt has been pushed down into overseas subsidiaries
Where an overseas subsidiary is used as an acquisition vehicle or where there are foreign subsidiaries of a UK company at whose level debt is taken on with respect to a third party acquisition, it is reasonable to assume that the normal commercial position would be for the debt to have been placed in the overseas subsidiary. If debt is held in the UK parent company instead, this may be an indicator that one of the main reasons for the funding structure is to obtain a UK deduction for the interest payments. It is necessary to consider whether debt has been placed where it is for commercial reasons or for UK tax purposes. It may be that the use of a hybrid entity or instrument has encouraged the UK company to seek to maximise its UK deductions in a situation where, in the absence of a qualifying scheme, the UK deductions might otherwise have been less.
In a situation where debt is placed in the UK rather than pushed down to an overseas subsidiary (as would ordinarily have happened in the absence of the qualifying scheme), then the amount of interest deduction which is claimed in the UK, rather than in the country of residence of the overseas subsidiary, may be a suitable measure of the amount of UK tax advantage attributable to one of the qualifying scheme’s main purposes. In some instances, the foreign jurisdiction of the overseas subsidiary may have thin cap rules (or similar) which might prevent push down of the debt in part or in its entirety. This may be one of many factors to consider when ascertaining whether the scheme has a main purpose (although it may be likely that this fact will have been anticipated in the overall financing arrangements).
What terms apply with respect to repayment of debt principal?
With many commercial loan relationships, it is usual for repayment of the loan principal to be made throughout the term of the loan. It may also be commercial (depending on the circumstances) to repay the loan in full at the end of the term, or perhaps to refinance it in full or in part. It will be a question of fact how repayment of debt has been agreed.
A potential risk area could be where a company enters into a loan relationship which is part of a qualifying scheme and that it takes on debt on terms without repaying loan principal, when ordinarily it would have repaid debt during the period of the term of the loan. In this situation, it is possible that the company is artificially maintaining debt in the UK with a view to maximising its UK deductions because of the existence of a qualifying scheme, and that the scheme may thus have a main purpose of achieving a UK tax advantage.
It may be (all else being equal) that the amount of UK deductions achieved by the scheme, over and above the amount of UK deductions which would ordinarily have been claimed by the company in a loan relationship involving repayment of loan principal during the term of the loan, might represent the amount of UK tax advantage arising from the scheme.
What levels of leverage exist in the worldwide group?
Occasionally it may be claimed that the increase in the amount of debt in the UK (and the resulting increase in UK deductions) is attributable to a commercial purpose of having the same leverage throughout the worldwide group.
It is necessary to consider precisely what commercial advantages arise from this situation and whether this is likely to be the actual driver for releveraging the UK group.
What mixture of debt and equity funding would be used by the group ordinarily to fund acquisition vehicles when making third party acquisitions (particularly in the absence of schemes involving hybrid entities)?
It may prove useful to consider how third party acquisitions have ordinarily been funded by the group when hybrid entities and instruments have not been a factor. If the mix of debt and equity used in third party acquisitions differs between funding structures involving a hybrid entity or instrument compared to funding structures without, it may be reasonable to assume that the difference results from a purpose of seeking to achieve a UK tax advantage.
In the case of an internal reorganisation, whether intra-group debt has been increased as a result of the scheme
Some schemes will be in respect of internal reorganisations, where no new assets are acquired by the group as a whole, but increased debt is placed in the UK. As a result of the use of a qualifying scheme using a hybrid entity or instrument, a tax deduction for interest payments might be claimed in the UK while the matching receipt remains untaxed.
It may be that there are commercial reasons for the group to undergo reorganisation. Equally, it may be that a main purpose of the scheme is to achieve a UK tax advantage.
It will be necessary to establish whether the company has a genuine commercial need for the debt or whether the debt is merely there to maximise UK tax deductions.
If it is established that the scheme has a main purpose of achieving a UK tax advantage, it may be in this scenario that none of the UK tax deductions arising on the increased debt in the UK should be allowed. Alternatively, it may be that there is commercial need for some debt (but not necessarily all of it), and that only some of the UK deductions should be disallowed (or disclaimed by the company).