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HMRC internal manual

International Manual

Arbitrage: practical guidance - examples demonstrating the application of the arbitrage legislation: Example 8 - convertible securities

Example 8 - convertible securities

Use this link to view example 8 - convertible securities diagram

Facts: The UK Company borrows from an unconnected lender and puts the money into a non-UK company “NUK1”. That company issues a convertible security to another non-UK entity “NUK2” of an amount equal to 80% of the UK borrowing. For the purposes of this example assume that:

  • NUK1 recognises the security as equity in its accounts and is not liable to tax on the receipts from NUK2;
  • NUK2 obtains tax deductions for the payments it makes to NUK1; and
  • The UK borrowing was obtained as a consequence of the decision to route the investment in NUK2 through the UK.

Analysis: The NUK2 convertible is a security subject to conversion, and so is a hybrid instrument (F2A05/SCH3/PARA7). Therefore the scheme that includes all the transactions in the diagram is a qualifying scheme, and so Condition A is met. The tax deductions for interest paid by the UK company mean that Conditions B and D are met.

The scheme has a commercial purpose of obtaining funds for use in NUK2. However, it is necessary to consider what would have happened in the absence of this or any other arbitrage scheme. If it appears likely that NUK2 itself would have borrowed the funds on normal terms (either intra group or from a third party), then one effect of the scheme is to reduce UK tax, and it is reasonable to suppose that this was a main purpose. On this analysis, Condition C is met and so HM Revenue & Customs will issue a notice to the UK company in respect of the interest paid.

NUK1 is wholly exempt from tax in respect of receipts arising from the same series of transactions as gives rise to the tax deductions for the UK company. Rule B therefore cancels all of the deductions for interest in the UK company.

In this case, the tax advantage main purpose extends to 80% of the UK borrowing, because that is the extent to which the funds have been used to fund the arbitrage scheme. Therefore, the company may retain part of the deductions for interest by disclaiming 80% and thereby preventing the operation of Rule B.