Structured finance arrangements
Avoidance by factoring of business income or receipts etc
1 The Government has announced that legislation, effective from 6 June 2006, will be introduced at Report stage of the Finance (No. 2) Bill to prevent avoidance of tax by the factoring of taxable receipts or the creation of tax-deductible expenses in return for a lump sum that is not taxed as income.
2 A draft Schedule with Explanatory Notes (PDF 253K) has been published. This is done now to enable interested parties to comment, particularly on the scope of the Schedule. See paragraphs 12 to 16 below for further information about the consultation.
3 The draft legislation deals with arrangements which, in economic terms and for accounting purposes, are secured loans, but where the legal form is that of a transfer of an asset subject to arrangements under which the transferor will, if the asset (including a right to income) does not waste to nil, reacquire control of it once payments have been made that equate in substance to the amount needed to repay the consideration for the transfer together with interest.
4 UK tax law has taken two distinct approaches to such arrangements. Where the asset transferred consists of shares or securities the arrangement will normally amount to a repo and in such a case the economic substance and the accounting treatment are, in general, followed with the repo price incorporating an interest element. A similar approach is taken to certain "alternative finance" arrangements.
5 On the other hand, where the asset transferred is an interest in land including a right to rents, whether from land or from plant and machinery, the approach taken in sections 43A to 43G and section 785A Income and Corporation Tax Act 1988 ("ICTA") is to treat the transfer as a realisation of income rather than capital gain.
6 Avoidance schemes have come to light which involve a person who holds an asset from which income or taxable receipts (such as trade receipts) could arise disposing of that asset for a lump sum. The sum equates in substance to the receipt of loan finance with the receipts foregone representing repayment of that loan plus interest. It is claimed that the income or receipts are not taxable (or the expense is tax deductible), while the lump sum either gives rise to a capital gain or is not taxable at all.
7 The transaction would be accounted as a loan in accordance with its economic substance (whether in consolidated accounts or individual accounts), but the tax effect the borrower seeks is the obtaining of tax relief not only for the ‘finance charge’ but also the principal of the loan.
8 The Government considers that such arrangements should be taxed in accordance with their economic substance rather than their legal form and that it should not matter what the nature of the transferred asset is. But in deciding how to tax such transfers the Government was faced with a choice of going down either the repo route or the rent-factoring route. It considers that the better route is the repo route since that more faithfully reflects the economic substance and accounting treatment of the transactions. It is also somewhat less harsh than the approach taken by the rent-factoring legislation.
9 The legislation will ensure if the arrangement, called a structure finance arrangement in the draft legislation, is accounted for as a loan then the borrower is taxed as if it had entered into a normal loan at interest. Thus the factored income or receipts will still be treated as arising to the borrower, because the substance is that they are merely security for the loan. Accordingly the transfer which is in substance by way of security will be disregarded for the purposes of tax on chargeable gains. In the type of scheme where expenses are generated they will not be allowed for tax purposes. In both cases, a deduction will be allowed for any finance charge shown in the accounts.
10 The effect is to tax the borrower in the same way as if it had taken out a loan of the amount of the lump sum received. The tax treatment of the lender will not be affected. As with the changes to the treatment of finance leases in the Finance (No. 2) Bill, the tax principle being observed here is that financing transactions which have the same economic and accounting effect should have the same tax effect, and that the choice of method of financing should not be influenced by tax considerations.
11 Because the legislation applies to the same type of transactions as that to which the rent factoring legislation in sections 43A to 43G ICTA applies, that legislation will be subsumed and repealed.
12 There is a power in the draft legislation to exclude transactions in addition to repos and alternative finance arrangements: but the Government would prefer to know whether there are transactions which ought to be excluded from the legislation before the amendments incorporating the legislation are tabled at Report Stage.
13 It is therefore interested in knowing whether there are further exclusions that ought to be included in draft section 774E ICTA which do not fall within the exclusion for amounts treated wholly as income in section 774E(1) or the exclusions for repo and alternative finance arrangements in 774E(4) and 774E(5).
14 In particular the Government is anxious to know whether any types of finance lease and transactions including leases and lease-backs or sales and lease-backs or any kinds of securitisation arrangements, ought to be excluded.
15 Any representations in relation to particular types of arrangement should explain why it is considered not appropriate to bring those arrangements within the scope of this legislation, whether because those transactions are already taxed in accordance with their economic substance and accounting treatment, or there are good reasons why they should not be.
16 Any representations on these and any other matters to do with the draft legislation should be sent to Richard Rogers whose e-mail address is Richard Rogers and who can be contacted on 020 7147 2625.
17 It is intended to hold an "Open Day" in relation to these clauses on 20th June. Any firm or organisation wishing to attend should send the name of 1 delegate plus 1 back up (if there are sufficient spaces) to Richard Rogers at the above address.
