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HMRC internal manual

International Manual

Arbitrage: practical guidance - examples demonstrating the application of the arbitrage legislation: Example 2 Part 1 - outward investment

Example 2 Part 1 - outward investment

Use this link to view Example 2 Part 1 - outward investment diagram

This example looks at the use of hybrids in outward investment.

Facts: Two UK resident subsidiaries of a UK parent form a partnership. The UK parent borrows on the market and on-lends to the partnership. The partnership uses the funds to establish a new overseas subsidiary, which is wholly equity funded and has no debt at all. For the purposes of this part of the example we assume that the funds were applied and retained for commercial purposes in the subsidiary.

Under Code A, the partnership is regarded as a taxable person and so deductions are given for the interest paid by the partnership to the parent in two jurisdictions.


Condition A: Is there a qualifying scheme involving UK Parent?

In this example, there is a scheme which includes: (1) the loan between the UK Parent and the partnership; (2) the formation of the partnership by the two UK subsidiaries; (3) the investment by the partnership into the overseas subsidiary; and (4) the setting up of a form of partnership which allows that overseas subsidiary to recognise the partnership as a person. The UK Subsidiaries are clearly a party to that scheme. The scheme is a qualifying one because it includes the partnership which is recognised as a taxable person under Code A but whose profits and gains are recognised as those of the UK subsidiaries for UK tax purposes. Condition A is therefore satisfied.

Condition B: Do the UK Subsidiaries get a deduction or set off for UK tax purposes under the scheme?

Yes, in this example it is the deduction for the loan interest paid via their partnership to their parent. For the purposes of this example assume that the amount is not minimal, and so Condition D is also met.

Condition C: Is it one of the main purposes of the scheme to achieve a UK tax advantage?

The question to be addressed for the purpose of Condition C is whether the same transactions would have taken place in the absence of the arbitrage scheme.

In this case, the scheme achieves a commercial purpose of making a foreign investment and furthering the group’s trade. It is therefore assumed that the foreign investment would have been made in the absence of the arbitrage, but the question that arises is how far the underlying borrowing would have been “pushed down” the chain.

The group’s policy is generally to “push down” at least 50% of centrally borrowed funds to the entity requiring the funds and there are no commercial reasons for the group not to follow this policy in this case (i.e. the foreign subsidiary is carrying on normal operations and is not carrying on particularly risky activities such as blue-sky research that would normally require substantial equity funding). The group’s normal debt /equity policy therefore represents the “plain vanilla” alternative for the purposes of Condition C which would provide for a smaller net tax deduction.

In other situations there might be commercial reasons for structuring the investment wholly as equity, for example, if the subsidiary had no borrowing capacity because, say, it had made substantial losses and was carrying a balance sheet deficit. The existence of such a strong commercial purpose for funding in the form of equity would mean that it was reasonable to suppose that there was not a tax main purpose for the scheme and would demonstrate that the investment would have been wholly in the form of equity in the “plain vanilla” case.

In the absence of commercial reasons for not “pushing down” the underlying borrowing in accordance with normal group policy, it would be reasonable to assume that the creation of a UK tax advantage was one of the main purposes of the scheme, and so Condition C is satisfied.

Rule A will apply because the deduction available to the UK subsidiaries is also available to the partnership under the Code A. All of the subsidiaries’ deductions will be disallowed.

However, the companies may disclaim sufficient deduction to cancel the effect of the scheme in relation to the tax advantage main purpose. The facts suggest that, even without the arbitrage opportunity, only half of the underlying borrowing would have been “pushed down” to Overseas Subsidiary. Therefore a disclaim of 50% of the interest paid by the partnership will cancel the reduction in UK tax created by the scheme and so counteract the UK tax advantage main purpose. This prevents the operation of Rule A.