INTM610180 - Exception Conditions: Tax Mismatch: Hybrid and Transparent Entities/ Reasonable to Conclude/ UK Resident Non-Domiciled Individuals

Hybrid and Transparent Entities

Paragraph 6(6) Schedule 4 Finance Act 2019 describes how the tax mismatch test should apply where the overseas party is a tax-transparent or hybrid entity – such as an overseas partnership.

This paragraph provides an explanation of how the resulting increase in relevant taxes payable by the overseas party is calculated in circumstances where the income of the overseas party is charged under the law of a country or territory outside the UK as the income of a person or persons other than the overseas party (“other persons”).

In these circumstances any reference to the overseas party’s liability to any tax includes reference to the liabilities to tax of the other persons who are charged to tax on the income; references to any tax being payable by the overseas party include tax being payable by the other persons; and references to loss relief obtained by the overseas party include a reference to loss relief obtained by the other persons.

It also provides that paragraph 6(4) (the treatment of withholding tax) applies to any other persons as it applies to the overseas party.

Example 18 – Tax Transparent Entity

If the overseas party was a United States (US) limited liability company (LLC) it could be charged to tax in the US as if it was fiscally transparent. However, for the purposes of UK tax, US LLCs are regarded as taxable entities and not fiscally transparent. In these circumstances paragraph 6(6) would apply to treat the US LLC as fiscally transparent for the purposes of applying the tax mismatch test, thus ensuring that account is taken of tax paid by the members of the overseas party.

For example, A is a UK resident company with Profit Fragmentation Arrangements under which it transfers £10,000 of value to O US LLC. O US LLC is owned by US resident individuals (B and C). O US LLC is a transparent entity for US tax purposes such that B and C pay tax on the profits generated by O.

B pays tax on £5,000 of the value transferred to O US LLC at 28% (£1,400). C also pays tax on £5,000 of value transferred to O US LLC at 39.6% (£1,980). In considering O US LLC’s liability to tax account should be taken of the £1,400 and £1,980 paid by B and C. O US LLC is therefore treated as having paid £3,380 on the £10,000 transferred.

Thus when considering the tax mismatch condition the increase in relevant taxes to be paid by the overseas party would be £3,380 and not zero.

Reasonable to Conclude

It will not always be possible for the resident party to obtain sufficient information about the overseas party to discern the increase in relevant taxes payable by the overseas party when carrying out the tax mismatch test.

If it is reasonable to conclude that the reduction in relevant tax payable by the resident party does not exceed the increase in relevant tax payable by the overseas party, or that the 80% payment test is met then it is reasonable to conclude there is not a tax mismatch.

The expression “reasonable to conclude” shows that this is an objective test, which is to be applied by taking into account all the relevant circumstances and asking what, in the light of those circumstances, a reasonable conclusion would be.

UK Resident Non-Domiciled Individuals

If the resident party is a non-domiciled individual with foreign source income that is not connected to a UK business activity, then, if that individual is chargeable on the remittance basis for a tax year the foreign source income is not chargeable to income tax or corporation tax. In such a case, any transfer of value from the foreign source will not derive from the profits of a business chargeable to UK tax, so any arrangements will not be Profit Fragmentation Arrangements.

If the resident party is an individual who has settled an offshore trust, which has as a matter of fact protected foreign source income to which the trust protections described below apply and that is not connected to a UK business activity, then the income would not be an amount taken into account by the resident party in computing the amount of UK tax payable.

The ‘trust protections’ are the changes made by Finance Act 2017 to remove overseas trusts settled by non-UK domiciled settlors from a charge under S624 Income Tax Trading and Other Income Act 2005 (“ITTOIA 05”), S720 ITA 2007 and S727 ITA 2007 in respect of certain trust income and the income of any underlying companies and instead bring them within the scope of S731 ITA 2007 or S643A ITTOIA 05 so that they are assessed on the benefits they receive from the trust and its underlying entities.

This means that any genuine foreign source income will not be affected by the Profit Fragmentation legislation as the Tax Mismatch exception test will apply.

For more details regarding the interaction between the Profit Fragmentation legislation and the transfer of assets abroad rules see INTM610250 and INTM610260.

Example 19 – Remittance Basis – Foreign Source Income

Judy is a UK resident non-domiciled individual who claims the remittance basis.

Judy spends every other weekend carrying out a trade in Switzerland through a Swiss company leading executive team building excursions in the Alps. This activity takes place solely in Switzerland and all the activities are carried out by Judy in Switzerland.

The Profit Fragmentation legislation will not apply to the income derived from her team building company in Switzerland as this is foreign source income not derived from the profits of a business chargeable to UK income tax.