REV BN 18: Avoidance Through Arbitrage

Who is likely to be affected?

1. Legislation is introduced with effect from today to counter tax avoidance using arbitrage schemes that involve hybrid entities or hybrid instruments.

2. The legislation potentially applies to any person subject to corporation tax but, as it is targeted against highly contrived avoidance structures, it will not apply to most companies nor to the majority of transactions undertaken by companies.

3. In general it will apply where an arbitrage scheme using a hybrid entity or instrument results in:

• A double deduction for the same expense
• A UK deduction for the payer in circumstances where the recipient is not taxed on the receipt because, for example, a tax credit has eliminated liability to tax
• Amounts being received by a company in a way that would not otherwise be taxable in the UK.

The hybrid entity or instrument will usually have been used deliberately to achieve one of these results.

4. The legislation will not normally apply if the recipient of the payment is a pension fund or other exempt body or if the recipient is not taxed on any of their profits. It will also not apply in the case of a permanent establishment solely because its expenses and receipts are recognised in two countries.

General description of the measure

5. Arbitrage is the exploitation of differences between or within national tax codes. This can result, for example, in a tax deduction being given by both the UK and another country for the same expense (a double dip) or a deduction being given for a payment when tax on the corresponding receipt has been avoided.

6. The legislation will apply to companies that use schemes involving certain types of hybrid entities or instruments (as detailed below) for tax avoidance purposes, but only if the Inland Revenue issues a notice directing that the legislation applies. If a notice is issued, a company must make or amend its self-assessment taking into account the legislation. The legislation will deny relief for deductions forming part of an arbitrage scheme and certain receipts will become taxable.

7. The Inland Revenue will give assistance under the established Code of Practice 10 procedures on the application of the legislation to specific cases. Detailed draft guidance on the application of the legislation is also available on the Inland Revenue's website from today.

Operative date

8. Legislation will apply to deductions and receipts arising or accruing on or after Budget Day. However, in order to allow companies to unwind arrangements with third parties, the legislation will not apply to schemes involving deductions that:

• do not involve connected parties, and
• are in place on or before 16 March 2005 and are terminated by 1 July 2005.

Proposed Provisions

9. The new legislation will apply in two situations. These are where:

• deductions are claimed by or allowed to a company in computing their profits or gains for corporation tax purposes; or
• amounts are received by a company in a way that would not otherwise be taxable.

The legislation deals with each situation separately.

Deductions

10. There are four conditions that will need to be satisfied before the Inland Revenue can issue a notice directing that the legislation should apply. These are:

• the company is a party to a scheme that involves a hybrid entity or a hybrid instrument (a 'qualifying scheme');
• the qualifying scheme results in a UK tax advantage;
• the main purpose, or one of the main purposes, in adopting the qualifying scheme was the obtaining of the UK tax advantage; and
• the amount of the UK tax advantage is not minimal.

11. A hybrid entity is an entity that is recognised as a taxable person under one tax code, but whose profits, gains or losses are also within the scope of the same or another tax code for one or more other persons. This may be because, for example, two countries treat the same entity differently in their respective tax codes with one, say, treating it as a company taxable on its own income and the otherseeing it as a partnership with its partners taxable themselves on their shares of its income.

12. Hybrid entities do not include a permanent establishment the income of which is treated under a different tax code as the profits or gains of the same person i.e. the company of which it is a part.

13. A hybrid instrument is, for the purposes of the legislation, an instrument that contains one or more characteristics specified in the legislation. There are two sets of characteristics. The first applies to schemes involving instruments between any parties and the second applies only to schemes involving instruments between connected parties.

14. For all schemes, an instrument is a hybrid instrument when it has one or more of the following characteristics:

• the tax treatment of the instrument in the hands of the payer or recipient can be varied by an election;
• it is a share with a reasonable expectation of being converted into a security or a security with a reasonable expectation of being converted into a share;
• the UK gives a deduction for payments arising from or accruing under the instrument and the instrument is recognised as equity under generally accepted accounting practices.

15. In addition to the above characteristics, for those schemes involving instruments between connected parties, an instrument is a hybrid instrument if it has one or more of the following characteristics:

• it involves shares other than ordinary share capital
• it involves an instrument that splits income from its underlying principal and connected parties hold the split rights.

16. A UK tax advantage includes the types of tax advantage listed in Section 709(1) ICTA1988.

17. Where the legislation applies, a deduction for corporation tax purposes will be denied if and to the extent that:

• more than one deduction or an amount otherwise allowed for tax purposes is available for the same expense, whether in the UK or elsewhere, and the income accruing or arising under the scheme is only taxed once; or
• a deduction is available to the payer but the person receiving or entitled to receive payments is not liable to tax under that transaction or would be liable but for a deduction or relief derived from the scheme.

Receipts

18. The legislation applies more narrowly to receipts that seek to benefit from arbitrage. If the Inland Revenue issues a notice directing that the legislation should apply, there are four conditions that have to be satisfied:

• a company has entered into a scheme under which it receives an amount on which it is not liable to tax;
• that amount may to any extent be deducted from or allowed against taxable income of the person making the payment;
• the mismatch in tax treatment is a reasonable expectation of the parties to the provision; and
• the payment constitutes a contribution to the capital of the company (a 'qualifying payment').

19. Where all these conditions are satisfied, the amount received by the company will be treated as income chargeable to tax, unless it is already the subject of a charge to tax.

Notices

20. When the conditions for the application of the legislation are triggered, the Inland Revenue will issue a notice directing that the legislation should apply and indicating its view of the adjustment that should be made in the company's selfassessment.Notices will not be issued without the approval of the Inland Revenue's Head Office. The company must then either self assess (or amend an existing selfassessment) on that basis, or on such other basis as it sees fit, if it believes that the
legislation should apply in a different way.

21. Where a company does not agree with the Inland Revenue's view of the application of the legislation and therefore self assesses on a different basis, the issue will be resolved in the normal way through a self-assessment enquiry and the appeals procedures. An appeal can challenge whether the conditions required to trigger the legislation were met or what the effect of applying the legislation should be.

22. Even after the end of the enquiry period the Inland Revenue may still issue a notice. This will apply either where the failure to issue a notice was due to the fraudulent or negligent conduct of the taxpayer or certain other associated persons, or where the Inland Revenue could not reasonably have been expected to realise that a notice should have been issued based on the information available to it.

Penalties

23. No penalty is due if a notice was not issued before a return was made as insuch circumstances the return cannot be incorrect. Once a notice has been issued directing that the legislation applies, penalties can arise if the taxpayer fraudulently or negligently fails to take account of the legislation. No penalty would arise, however, where the taxpayer takes a reasonable view that the legislation did not apply and accordingly takes no account of it in their return.

Further advice

24. Additional detailed draft guidance on the application of the legislation and definitions of all the terms used above is available today on the Inland Revenue's web-site. The Inland Revenue would welcome comments on the draft guidance including areas where additional guidance would help.

25. The Inland Revenue will consider requests for advice about the legislation in specific cases, in accordance with established procedures set out in the Inland Revenue's Code of Practice 10. Where possible, we will confirm that no notice will be issued in respect of the disclosed transactions.

26. Comments on guidance and requests for advice should be sent to:

Andrew Hoar or Ken Almand
Revenue Policy (International)
3rd Floor (Central)
1 Parliament Street
London
SW1A 2BQ

Andrew Hoar
020 7147 2719

Ken Almand
020 7147 2650