Multinational Top-up Tax and Domestic Top-up Tax

MTT45160 - Particular entities and adjustments: Investment entities: Tax transparency election

By election, an investment entity may be treated as a transparent entity for MTT purposes. This election is set out in section 213 of Finance (No.2) Act 2023.

The election is intended to deal with situations where a member of the group (‘the owner’) has ownership interests in an investment entity and is taxed on the change in the fair value of these interests, such that the profits of the investment entity are effectively taxed upon the owner as they accrue.

If this tax was not taken into account, then the group could be required to pay a top up tax on the investment entity’s profits, even when these have been fully taxed at the owner level.

The election addresses this issue by treating the investment entity as fiscally transparent, both in the jurisdiction of the investment entity and in the jurisdiction of the owner. This allows the underlying profits of the investment entity to be treated as profits of the owner for the purposes of multinational top up tax and domestic top up tax, thereby ensuring that the profits and the tax on those profits are matched in the effective tax rate calculations.

The election is made where a member of a group holds an ownership interest (either direct or indirect) in an investment entity that is a member of the same group. This means that an investment entity might be treated as transparent only to a certain extent as a result of the election.  If the investment entity is owned by multiple members, and it is desired for the investment entity to be treated as transparent for each of those members, an election must be made in respect of each owner.

A tax transparency election is a long term election. See MTT52200 for guidance on elections.

Conditions

A tax transparency election can be made where:

• an ownership interest in an investment entity is held by a member of the same group,
• the ownership interest gives rise to a share of profits,
• a taxable distribution method election has not been made in respect of the ownership interest, and
• either:
• the owner is subject to tax in the territory which it is located on increases in the fair value of the ownership interest, and the applicable rate of tax is at least 15%, or
• the owner is a regulated mutual insurance entity.

The last requirement looks at the tax treatment of the owner in respect of the ownership interests in the investment entity. The ‘subject to tax’ test cannot be met on the basis that the owner’s territory applies a QDMTT.

The tax in the owner territory can be applied to the change in fair value of the ownership interest itself, or the underlying investments held by the investment entity, provided that all fair value increases are effectively taxed.

If the owner is a regulated mutual insurance entity, the election can be made even if the owner is not subject to tax on the investment entity profit on a mark to market basis. This is because the income of the investment entity will entirely belong to the policyholders, so the mutual will have no net income in respect of the investment income.

Example 1

A life insurance company owns 100% of an Open-ended Investment Company (“OEIC”). The insurance company is subject to tax on the changes in fair value of the OEIC under section 212 TCGA 1992 at a rate above 15%.

The conditions to make an election are met.

Example 2

A life insurance company A owns 60% of a fund. Another group company, B, owns the remaining 40%. Company B has made a taxable distribution method election for its ownership interest. Company A is subject to tax in its location on increases in the fair value of its ownership interests in the fund at 20%.

The conditions for A to make an election have been met.

Effect of an election

Where the election applies to an ownership interest, the following treatment applies in regard to that ownership interest, for the purpose of determining the adjusted profits and covered tax balance of the investment entity:

• the investment entity is to be treated as a flow-through entity,
• the investment entity is to be treated as being regarded as tax transparent in the territory of the owner, and
• the owner is treated as having direct ownership interest in the investment entity.

Where the investment entity itself would have had amounts of adjusted profit or covered taxes allocated to it (ignoring the tax transparency election), those amounts are to be so allocated to the investment entity and then reallocated to the owner in accordance with the election.

Some investment structures will comprise of several investment entities in an ownership chain. The changes in value of the lower-tier investment entities are generally reflected in the fair value of the “top” investment entity. Generally, tax will be suffered by the owner in respect of changes in fair value of the chain of investment entities.

The election is designed with the intention to treat the investment entity’s profits as the profits of the indirect owner, so an indirect owner’s ownership interest in the investment entity is deemed to be a directly held interest.

Absent this provision, where the ownership interest is indirect, the profits would not be allocated to the indirect owner if the indirect owner’s territory regarded any intermediate entities between it and the investment entity as fiscally opaque.

See MTT41400+ for guidance on flow-through entities.

Example

A group member owns 100% of Fund 1, which owns 100% of Fund 2. Fund 2 has £100 of income for the period. The member makes a tax transparency election in respect of its indirect ownership interest in Fund 2. The member is treated as if it had direct ownership of Fund 2. The member treats Fund 2 as a tax transparent flow-through entity and includes £100 of Fund 2’s income in its underlying profits.

Determining the direct ownership interest held by an owner

When determining the direct ownership interest held by an owner in an investment entity:

• section 246(1)(b) is not to be applied, and
• only ownership interests giving rise to a share of profits are to be considered.

See MTT17040 for guidance on calculating percentage direct and indirect ownership interests.

Regulated mutual insurance entity

An entity is a regulated mutual insurance entity if:

• it is regulated or authorised to carry on insurance business, and
• it is wholly owned by persons with which it has entered into insurance contracts.

Determining a gain or loss after the revocation of a tax transparency election

In the first year following the revocation of a tax transparency election (the 'revocation period'), any gains or losses made by the investment entity on the disposal of an asset or liability are to be determined by reference to the fair value of the asset or liability on the first day of that period.

In any subsequent period for which the election does not apply, any gains or losses made by the investment entity on the disposal of an asset or liability are to be determined:

• where the investment entity accounts for its assets on a realisation basis, by reference to the fair value of the asset or liability on the first day of the revocation period, or
• where the investment entity accounts for its assets on a fair value basis, by reference to the fair value of the asset or liability at the end of the accounting period that precedes the period of disposal.

Treatment of minority interests

Where profits of the investment entity are attributable to minority shareholders, any top-up amounts of the investment entity will not be brought into charge by the same proportion. This is achieved through two alternate mechanisms.

Where the tax transparency election has been made in relation to all of the ownership interests of an investment entity which are held by the group, any underlying profits which relate to ownership interests held by minority shareholders will be excluded from the underlying profits of the investment entity through the operation of section 168(9) of the Act.

Where the tax transparency election has been made in relation to some of the ownership interests held by members of the group, but not others, the underlying profits which relate to minority shareholders will remain at the level of the investment entity. However, where the investment entity has a top-up amount to be allocated to responsible members under section 201 of the Act (see MTT05140), the adjusted profits which relate to the minority shareholders’ interests will not be allocated to the responsible member, and so will not be brought into charge.

This is achieved through the operation of step 2 in section 201(1), in which the profits attributable to ownership interests to which the tax transparency election relates are disregarded. This corresponds to the effect of the election, which excludes amounts from the adjusted profits of the investment entity.

Sections 168 and 201 were amended by FA25. This guidance reflects the current version of the legislation. Consult FA25 for legislation applicable to prior periods if the retrospection election does not apply (see MTT09490).

Interaction between tax transparency election and excluded equity gains and losses

The election will result in the investment entity being treated as a transparent flow-through entity, such that its underlying profits will be allocated to the owner.

Under many accounting standards, the movement in the fair value of the ownership interests held in the investment entity will be recognised in the owner’s profit and loss account. In such cases, the profits of the investment entity will already be reflected in the owner’s underlying profits.

However, an election will not result in amounts being double counted in the member’s adjusted profits. This is because the amounts that are already included in the owner’s profit and loss account will be excluded from the member’s underlying profits under section 142(2)(c) as they are a fair value movement in respect of a non-portfolio shareholding. While tax paid by the owner will technically be in respect of the profits excluded under section 142(2)(c) rather than the underlying profits of the investment entity that are allocated to it, section 175(2)(a) does not apply as the purpose of the transparency election is to align the tax and the profit.

Example

UPE owns 100% of the ownership interests of Member 1 and Member 2. Members 1 and 2 own 90% and 10%, respectively, of the ownership interests in Fund, an investment entity.

Fund earns 100 of net income in Year 1, pays no tax and makes no distributions.

An election under section 213 is made on behalf of member 1 and member 2.

Accordingly, member 1 and member 2 include their share of Fund’s income, 90 and 10, respectively, in the computation of their adjusted profits.

Member 1 controls Fund and thus would consolidate its profit or loss even if Member 2 was an unrelated company. Member 1 applies the election and includes 90 of income in its underlying profits. No further adjustment is required. 

Member 2 is required to apply fair value accounting to its interest in the Fund. It recognises a fair value gain of 10 in its accounts. Member 2 applies the election and includes 10 of income in accordance with the Fund being a tax transparent flow-through entity. Member 2 removes the fair value gain of 10 from its underlying profits under section 142, so that there is no double-counting of the 10 income.  

In addition, the election allows the owner to apply the Substance-based Income Exclusion with respect to its share of the income of the investment entity. In many cases, the MNE Group’s Eligible Payroll Expenses and Eligible Tangible Assets related to managing the investment entity’s activities will not arise in the investment entity itself, but instead will be those of the owners.

Subsections 8 to 11 provides rules for revocation of the election. If the election is revoked, gains or losses from the disposition of an asset or liability held by the investment entity shall be determined based on the fair value of the assets or liabilities.

If the investment entity’s income is determined using a realisation method, the gains or losses should be determined based on the fair value of the assets and liabilities on the first day of the revocation period. 

If, on the other hand, the investment entity’s income is determined using a fair value method for the related assets, then that method will re-value the assets at regular intervals and include the gains or losses in the financial accounts. The gains and losses should be determined based on the fair value of the asset or liability as accounted for at the end of the previous accounting period.

The election is to be made by the filing member in respect of each owner. Each owner must be named on the election. For each owner, the election must identify each investment entity for which the election is being made.

The election should be made in accordance with the other requirements under Section 1 of Schedule 15 (long term elections).