TAXGUIDE 4/06 FINANCE BILL 2005 OPEN DAY DISCUSSIONS ON AVOIDANCE INVOLVING TAX ARBITRAGE AND AVOIDANCE INVOLVING FINANCIAL ARRANGEMENTS

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1 TAXGUIDE 4/06 FINANCE BILL 2005 OPEN DAY DISCUSSIONS ON AVOIDANCE INVOLVING TAX ARBITRAGE AND AVOIDANCE INVOLVING FINANCIAL ARRANGEMENTS Agreed note of a meeting on 6 June 2005 between HM Revenue and Customs and HM Treasury and Representative Bodies including the Tax Faculty of the Institute of Chartered Accountants in England and Wales (ICAEW) Contents Paragraph BACKGROUND 1-2 INTRODUCTORY COMMENTS 3-10 AVOIDANCE INVOLVING TAX ARBITRAGE AVOIDANCE INVOLVING FINANCIAL ARRANGEMENTS

2 FINANCE BILL 2005 OPEN DAY DISCUSSIONS ON AVOIDANCE INVOLVING TAX ARBITRAGE AND FINANCIAL ARRANGEMENTS Meeting between HMRC and HMT and Representative Bodies including the Tax Faculty of the ICAEW Monday 6 June am pm BACKGROUND 1. The Open Day meeting on 6 June 2005 between HMRC and HMT and Representative Bodies including the Tax Faculty of the ICAEW considered the clauses dealing with avoidance involving tax arbitrage and avoidance involving financial arrangements contained in Finance Bill 2005 (FB 2005) published on 25 May There was no Open Day in respect of the first Finance Bill 2005 published on 22 March 2005 of which certain measures were contained in Finance (No 2) Bill published on 6 April 2005 and enacted on 7 April 2005 as Finance Act INTRODUCTORY COMMENTS 3. The second reading of FB 2005, published on 25 May 2005, should occur on 7 June All statutory references in the present document are to the clauses in FB 2005 unless otherwise stated. 5. Comments on the draft arbitrage Guidance Notes ( the Notes ) are due by 10 June Only a short period was given for providing comments, so that the comments received could be available for the Committee Stage of the Bill. However, 10 June 2005 will not be the last stage to comment on the Notes. It is anticipated that the Notes will be finalised during July It was noted that the Standing Committee meetings on the Bill will commence in the week beginning 13 June Policy drivers 6. HMRC are concerned that financing arrangements that result in a loss of UK tax are being entered into because of tax arbitrage. The intention of the avoidance involving arbitrage and financial arrangement provisions is to limit the damage to the UK tax base and level the playing field for all taxpayers. 7. The FB 2005 is not the first time the government has acted against arbitrage; for example, in 1987 rules were introduced in relation to dual resident companies and in 1993 rules were introduced in relation to equity notes. Also, it should be noted that in 2002 the US introduced rules limiting benefits available to reverse hybrids. 2

3 8. HMRC are not seeking to be the world tax police. However, HMRC are seeking to challenge contrived schemes that involve arbitrage and have as their main purpose the avoiding of UK tax. 9. HMRC have seen figures that suggest three-quarters of direct investment between the US and UK uses an arbitrage structure. In addition, the US check the box rules have made it easier for companies to use arbitrage. Tax planning that has been disclosed to HMRC has confirmed the increased use of arbitrage. HM Treasury s view 10. HM Treasury has been working very closely with HMRC on the avoidance involving tax arbitrage and financial arrangements provisions. HM Treasury s view is that both the arbitrage and financial arrangements measures are designed to ensure the fairness of the corporate tax regime and protect the UK tax base. AVOIDANCE INVOLVING TAX ARBITRAGE 11. The operation of the arbitrage provisions were illustrated as follows: The numbers in brackets refer to the clauses in the first FB 2005 published on 22 March HMRC advised that there have been 51 amendments to the avoidance involving arbitrage provisions since the first FB 2005 which was published on 22 March However, the open day focused on just four major amendments: Disclaimer; CFC and hybrids; Matching of receipts; and Extension of grandfathering. 3

4 In addition, the main purpose test was also discussed in detail. 13. HMRC also confirmed that clause 24(6) FB 2005 has been amended so that it no longer refers to the tax advantage so achieved but to the tax advantage in question. The reason for this amendment was that Conditions A to C look at the scheme from the outset, whereas Condition D in the first FB 2005 referred to what was achieved. The change is to ensure that all the conditions in clause 24 look at the scheme from the outset. In addition, HMRC confirmed that the legislation only applies when a notice is issued by HMRC. Given the nature of the legislation, HMRC thought it appropriate to have the legislation contingent on a notice being issued and that notice will be issued centrally by the International Business Tax Group. A non-statutory clearance procedure has also been made available. Disclaimer - Clause 25(14) to (16) 14. Once HMRC has issued the taxpayer with a notice, the taxpayer can choose to disclaim a portion of the deductions that have arisen under the scheme to counteract the UK tax advantagethat is the main purpose of the scheme. The disclaimer puts more weight on the main purpose test (which is discussed in detail below). CFC and hybrid 15. Concern had been raised that paragraph 3 Schedule 3 could apply to subsidiaries which are CFCs under another country s CFC regime and the apportionment of retained profits of the overseas CFC to the UK parent company could fall within the hybrid entity definition. Paragraph 3 now contains a reference to section 747(3) ICTA 1988 in order to remove this concern. In addition paragraph 3(1)(a) and (b) have now been changed to refer to any person (so that the wording reverts to the original Budget Note.) Matching of receipts 16. The first FB 2005 did not appropriately cover the base case i.e. a payment that was only partly deductible. Changes were therefore made to clauses 27(2) and (3) to allow the payment to be split into two parts, and only the deductible part falls within the receipt rules. Grandfathering 17. The grandfathering period, which allows unconnected companies to unwind their arrangements to avoid a charge under the arbitrage provisions, has been extended to 31 August The main purpose test 18. The main purpose test, contained in Condition C, requires a comparison of what would have happened in the absence of the arbitrage i.e. the scheme without the arbitrage. 4

5 19. When making the comparison, the following factors are likely to be relevant: Would the transaction have taken place at all? (That is, was there no commercial purpose?) If it would, would the transaction have taken place in the same form (without the arbitrage)? (For example, would the transaction be wholly for equity or partly equity and debt.) Would the deductions claimed have been for the same amount? When making the comparison HMRC made an analogy with a see-saw i.e. balancing the commercial purpose with the non-commercial (or tax advantage) purpose. An example using loans 20. The first step to consider is whether there is a commercial purpose for the loan and, if so, does that commercial purpose extend to the whole loan (i.e. does the whole loan represent a real investment or does it simply replace existing equity?). 21. The second step is to consider whether the arbitrage is affecting the location of debt within the group (i.e., has debt dumping occurred). The third step is to consider whether the loan has directly or indirectly replaced equity. 22. The final step is to consider whether any of the terms and conditions of the loan are affected (e.g., is the loan long dated, but could actually be repaid within 3 years, etc.) Mixed purpose 23. A disclaimer had now been included in FB 2005, which allows companies to disclaim deductions to the extent of the arbitrage and effectively cancel the UK tax advantage which has arisen. The disclaimer would therefore switch off Rule A and Rule B. It is important to note that a UK tax advantage may arise where there is solely a commercial purpose (i.e., some deductions would have arisen under the vanilla option) and it may therefore not be necessary to disclaim all deductions claimed to prevent Rule A or Rule B applying to a scheme. 24. HMRC confirmed that the examples in the Notes have been completely reworked. HMRC also confirmed that information obtained from clearance applications may be used to provide further examples in subsequent versions of the Guidance Notes. HMRC advised that there is some difficulty in illustrating purpose in examples it is easy to illustrate whether you have a qualifying scheme or not, but purpose is a matter of judgment which requires balancing evidence. 25. Representations were made to HMRC that the facts in example two were a bit light and did not necessary support the conclusion that the purpose of the scheme outlined in that example was to achieve a UK tax advantage. A reworked example two should be available on HMRC s website on 6 June Example One concerns a loan that was made to the UK via an inbound double dip structure. The loan was used partly for real investment (e.g., to build a factory) and 5

6 partly replaced existing equity. It was assumed that the terms and conditions of the loan were not affected by the arbitrage. 27. HMRC confirmed that a commercial purpose is persuasive in determining whether the sole or main purpose of a transaction is not to achieve a UK tax advantage. However, in this example, the thinning out (i.e., the portion of the loan that represents replaced equity) lacks a commercial purpose, so Condition C is met. It would be possible for the company to disclaim the portion of the interest deduction that is attributable to the replaced equity and this disclaimer would prevent the whole loan falling foul of the arbitrage provisions. 28. Questions that may be asked when making the comparison to determine whether a UK tax advantage has arisen in Example Two include: Why was the debt separated from the investment i.e. why wasn t it located close to the investment? What is the group s usual policy? Has the investment been changed because of the arbitrage opportunity? What would have happened if there was no double dip? Would the same deductions have arisen in the UK or would the deductions have been lower? Avoidance involving tax arbitrage Question and Answer session Q1. Would a company seeking a thin capitalisation clearance also be able to simultaneously seek an arbitrage clearance (i.e., only submit one clearance application that covered both thin capitalisation and arbitrage)? 29. HMRC confirmed that companies would be able to simultaneously seek thin capitalisation and arbitrage clearances. However, taxpayers are not obliged to seek clearance on both issues should they not want to do so. HMRC also confirmed that the time frame for providing a thin capitalisation clearance and an arbitrage clearance may differ. HMRC are intending on providing arbitrage clearance within 28 days of receipt of an application. 30. It was noted that timing of the clearances could be a critical factor from a commercial point of view. 31. It was not clear from HMRC s answer whether the same individual in HMRC will deal with both clearances. This would obviously be preferable from the taxpayer s perspective. Q2. Condition C requires a comparison to be made in absence of a scheme (not a qualifying scheme). However, we could have a tax advantage that has arisen but is not part of a qualifying scheme and does not fall foul of any other provision e.g. paragraph 13. Should a subsequent element be introduced and the scheme now fall foul of the arbitrage provisions, will the scheme be compared against a plain vanilla structure or the scheme that existed before the subsequent element was introduced? 6

7 32. HMRC have not made this point clear in the Guidance Notes and it would be helpful if they did. 33. HMRC confirmed that assuming the existing scheme meets all the other tests and had been in place for several years, the introduction of a subsequent element is unlikely to cause the scheme to fall foul of Condition C. 34. However, the legislation is concerned with the purpose of the scheme and not just the purpose of the tax advantage which may have arisen. Q3. Inbound debt example Would debt of a foreign parent that was pushed down to e.g. a UK subsidiary to ensure appropriate interest cover fall foul of the arbitrage provisions? 35. HMRC confirmed that the level of parent debt is not relevant. What is relevant is whether the UK company holds debt solely for a commercial purpose (e.g., what were the funds pushed down used for?) and whether the debt was just put into the UK for tax reasons. This example could potentially give rise to a mixed purpose. In addition, it may be necessary to make a comparison by taking out the arbitrage and see what the gearing would have been. Q4. HMRC was asked to clarify if a UK company had to borrow to pay dividends whether the borrowing would fall foul of the arbitrage provisions? (E.g., if UK check the box entity borrowed funds to pay a dividend to the US, would clearance be needed?) 36. HMRC said the terms of the loan would be relevant (e.g., for a loan to fund a dividend HMRC would expect that loan to be short term and not for, say, a 10 year term). Consideration would also be given to the size of the dividend. HMRC would also look to see whether the loan was to cover a normal dividend payment and where the money was to go. Q5. Would HMRC please confirm whether the disclaimer would give rise to horse trading like e.g. section 765 ICTA 1988? 37. No clear answer was given to this question. HMRC reiterated that as this is a selfassessment regime, when a notice was issued, it was the company s responsibility to disclaim. To do this, the company had to use its own judgement. There was also the normal appeal route and joint referral point that could be applied. Q6. If Rule A and Rule B could not apply to a scheme (i.e., the scheme does not give rise to a double deduction or receipt not brought into account) could HMRC please confirm that the legislation does not bite? 38. Yes if Rule A or Rule B does not apply, the legislation does not have any effect. Q7. If the legislation is passed by mid-july, should we expect our inboxes to be full with notices when we return from our summer holiday? 7

8 39. No. HMRC do not see the legislation applying to the vast majority of cases. The revenue target for the provisions is 200m and HMRC are judged on how accurately this revenue target is achieved and not on how much revenue was raised. 40. Further comment from HMRC would be useful on this point. It does not appear to be consistent with HMRC s comment that three-quarters of direct investment between the UK and US uses arbitrage. [ HMRC comment: But for the arbitrage provisions to apply all 4 conditions (for deductions cases) have to apply and HMRC s view is that this will only be so in the minority of arbitrage cases.] If a provision falls foul of the arbitrage provisions, would HMRC accept e.g. recapitalisation of a loan rather than using the disclaimer? 41. HMRC confirmed that the disclaimer is a virtual unwind and if you actually unwind you will have the same effect for the purpose of the arbitrage rules, but a complete unwind may, obviously, have other tax or commercial consequences. Q8. Will the first question asked by inspectors be Should I send you a notice under the arbitrage provisions? 42. The relevant in-house tax manager would need to be comfortable that they have a defence or that they have obtained clearance. HMRC comments would be helpful on the level of disclosure expected in tax returns to avoid the risk of discovery procedures although it was acknowledged that arbitrage formed a major component of much international planning. Q9. Do the arbitrage provisions amount to an international GAAR? 43. No. The focus of the legislation is on particular transactions or arrangements. The legislation does not introduce an international general anti-avoidance provision. AVOIDANCE INVOLVING FINANCIAL ARRANGEMENTS Reaction to Schedule 13 of the first FB 2005 (now Schedule 7) 44. HMRC started with a quote from CIOT: Schedule 13 counters various avoidance schemes and does so, but for one glaring exemption, with properly targeted legislation. In general, the drafting is a good illustration of how effective the disclosure regime can be when coupled with appropriate anti-avoidance [provisions]. 45. HMRC then went on to talk about changes to the original Finance Bill that have been made as a result of representations. Rent factoring 46. Paragraph 1 was amended so that there is no disallowance of rent representing interest expense. Degrouping charge for LR and DC 8

9 47. The legislation was amended to allow debits on a derivative contract where there is a credit on a loan relationship which the derivative contract is hedging, and on a loan relationship where there is a derivative contract which hedges it. The charge under the legislation is disapplied where the degrouping arises on a demerger. Background to sections 91A and 91B 48. Section 91A is to be enacted as a result of transactions disclosed under the disclosure regime. Sections 91C and 91E were designed to prevent variations on shares that fell within section 91A and might arguably have been better placed with section 91A (in which case section 91D could have been dealt with separately). Sections 91A and 91B representations 49. The following representations were made to HMRC in respect of sections 91A and 91B and some amendments were made to those provisions: Representation: Response: Representation: Response: Representation: Response: Representation: Response: Representation: That the legislation be amended to allow debits (in addition to credits) to be brought into account in respect of a share deemed to be a loan relationship. The legislation has been amended to allow debits and credits to be brought into account (except when value shifting occurs). That the amortised cost basis of accounting should be available to determine how debits and credits are to be brought into account in respect of the shares deemed to be loan relationships. The amortised cost basis would not be made available because HRMC are not convinced that it would not be abused. That the double charge that arises in respect of repos be removed. HMRC stated that no double charge arises in respect of repos, although no justification was given for this view. That the notional gain or loss that arose on 16 March 2005 for shares held on Budget Day is not taxable or does not crystallise. Section 91G now provides that the notional gain or loss that arose on 16 March 2005 for shares held on Budget Day is not taxable or does not crystallise provided that the shares cease to be subject to section 91A or 91B on or before 31 December That reference to treated as interest be removed. Response: The reference to treated as interest has been removed. The reference was only needed to ensure the DTR rules worked correctly. A new sub-section in section 807A ICTA 1988 will be introduced to ensure DTR works appropriately. 9

10 Representation: That section 91F be amended to ensure that it applies prospectively. Response: Section 91F has been amended to ensure it applies prospectively. Interest like return 50. A comparison was made between the latest Bill and the original Bill in respect of the interest like return provisions. Section 103(3A) FA 1996 has been introduced to ensure a commercial rate of interest is required (which is defined as being reasonably comparable to the rate a company would obtain by placing funds on deposit). It is important to note that what is required is that the interest rate be reasonably comparable the section does not require the rate to be exactly the same. The intent is to exclude interest rates that might be available but are clearly not commercial e.g. of a few basic points only. Condition Two amendments have been made to Condition 1: Condition 1 now requires that the return on the investment of money represent a commercial rate of interest (and does not deviate to a substantial extent from that rate of increase); and Condition 1 now contains an exclusion for non-income producing assets. 52. Exclusion of issuing companies that hold only income producing assets is intended to prevent companies that hold shares in e.g. a 91B company from also falling within section 91B. The list of income producing assets may be added to by HM Treasury. Any additions to the list can apply from the start of the period in which the relevant regulation comes into effect. 53. HMRC were of the view that normal group finance companies are unlikely to fall within Condition 1 because those companies are trading companies and the fair value of their shares is therefore unlikely to increase at a commercial rate of interest. Condition Redeemable preference shares in tres partes divisa est (like Caesar s Gaul): Always good e.g., portfolio holdings by persons independent of the issuer or shares mirroring public issues. Always bad e.g., shares that circumvent section 95 ICTA 1988 (warned in 1997 by the Paymaster General). Middle All others, which are good subject to the unallowable purpose test. 55. Public qualifying issue exemption there is an automatic let out for shares issued by a company as part of an issue of shares to independent persons and less than 10 percent of the shares in that issue are held by the investing company or persons connected with that company. 10

11 56. Shares that mirror a public issue exemption Section 91D contains an automatic let out from Condition 2 for shares issues that mirror a public issues (but this automatic let out only extends down two tiers). This amendment was introduced to assist those regulated by the FSA. Condition Condition 3 now requires a scheme or arrangement and also now includes associated transactions. The definition of an associated transaction includes a contract of insurance or indemnity. Avoidance involving financial arrangements - Question and answer session Q1. Clarification requested on the meaning of a commercial rate of interest The example given was where a UK company lends funds to a US subsidiary and earns interest calculated by reference to e.g. the US Treasury rate plus a spread 58. HMRC confirmed that the commercial rate of interest requires an interest rate that a company could obtain by placing money on deposit with the actual counterparty the section does not specify with whom the funds are to be deposited. 59. Supplementary It would be helpful if HMRC could clarify whether they intend the comparison to be deposit rates only and whether or not they recognise any fundamental difference between loan rates (either secured or unsecured) and deposit rates that would not be encouraged within the reasonably comparable criterion. HMRC might consider clarifying how the meaning differs from arm s length given the reference to appropriate counter-party? Q2. A number of examples were given of continued problems with the legislation where multiple charges may arise when there are tiers of companies. 60. Consider the following diagram and the examples that follow: Example One: Assuming that the underling assets of Company C consist solely of cash on deposit and Company B has no activities other than holding shares in Company C. Although Company B is not caught by 11

12 section 91B in relation to its investment in Company C, Company A is caught in relation to its investment in Company B. Response: HMRC s response was that they did not consider many corporations would be in these situations and, if they were, the simple solution would be to remove Company B. HMRC would need to be persuaded to extend the exemption afforded to Company B to Company A. Example Two: Company A holds ordinary shares in Company B. Company B holds preference shares in Company C. Company C is a trading company. The shares issued by Company B to Company A could increase at a commercial rate of interest by virtue of the preference shares. Response: It is a question of fact whether the shares issued by Company B to Company A would also increase at a commercial rate of interest and therefore caught by section 91B. Example Three: If Company C is a CFC, then Company A and could potentially suffer a section 91B charge as well as an apportionment under the CFC rules. A double charge will therefore result. Response: This is a double counting issue, similar to the above. Q3. Would shares in a company with a finance leasing business be caught by Condition One? 61. HMRC is of the view that shares in a finance leasing company would not be caught by Condition One because the value of those shares are not likely to increase at a commercial rate of interest as the company is a trading company with risks and expenses. 62. The essence of Condition One is there is a risk free return arising that increases the value of the shares. Q4. Money on deposit clearly includes money on deposit with a bank, but does it also include money on deposit with a US affiliate? 63. Yes. Q5. How has HMRC rationalised the mark to market requirement and the overriding of DTR with EU law? 64. HMRC s view is that there is no effect on the entitlement to DTR and that the legislation does not give rise to a restriction on the free movement of capital. If anything, the override of section 208 ICTA 1988 would give rise to discrimination against UK resident companies. Q6. Given that we are three months into the legislation and there is still considerable uncertainty about the application of the legislation, will HMRC reconsider the application date? 12

13 65. No. Ministers are adamant about the application date. The Finance Bill in its current format should have removed most or all of the uncertainty. Q7. HMRC were asked the policy rationale behind legislation against a relatively common transaction for cash rich plcs that does not seem to be offensive in principle. What commonly happens is that a cash rich plc will subscribe for a special class of preference shares issued by a tax exhausted counterparty. The issuer receives no tax deduction, so why is HMRC concerned with whether or not the subscriber is taxed on its return? 66. HMRC stated that this transaction involves an arbitrage of tax characteristics, which is objectionable in principle and should be taxed. Q8. If the preference shares are not connected with lending, would section 95 ICTA 1988 apply to the shares? 67. No. Q9. In response to a question about the commencement date, HMRC clarified the commencement date of the legislation is 16 March HMRC were asked to clarify the intended commencement date given that 91A and 91B apply for the accounting period of the company and 91C does not appear to fully interact. HMRC confirmed that the loan relationship treatment of a share could only commence from 16 March IKY