Finance Bill 2004 introduces an “unallowable purpose” rule for manufactured payments. It applies only where the manufactured payment is made by a company. This guidance gives an overview of the new rule and sets out the circumstances in which the Revenue will, and will not, seek to apply it.
Manufactured payments are payments which arise under a contract or other arrangement for the transfer of securities that are representative of interest or dividend payments on securities. They typically arise under stock lending or repo arrangements and are intended to compensate the original holder of the securities for not receiving real interest or dividends.
The legislation that deals with manufactured payments is at Schedule 23A ICTA88. The regime applies to three categories of payments: payments that represent dividends on UK equities, those that represent dividends on overseas equities and those that represent interest. In many circumstances the payment qualifies for deduction either in computing profits for CT purposes or against total profits.
The Revenue has become aware of a number of schemes that seek to reduce corporation tax liabilities by the use of manufactured payments. A few of the schemes are described in outline in part 4 of this note. These schemes exploit different parts of the manufactured payments legislation. The new rule counters any such scheme by introducing an “unallowable purpose” test similar to that used elsewhere in the tax legislation .
This guidance note describes the rule in detail and answers questions on how it will be applied. Three initial points may be made:
Firstly, very few transactions will be affected. “Arrangements” (see 1.4 below) will not have an unallowable purpose if a company has been party to them solely for commercial reasons and entered into them on commercial terms.
Secondly, the rule is closely modelled on the unallowable purpose test that is a feature of the 1996 loan relationship regime and a similar rule introduced for derivative contracts in 2002. The principles used in the guidance that the Revenue has already published on the operation of these rules will be followed here.
Thirdly, transitional rules make proper provision for companies which are already committed to such arrangements, as described below.
A new paragraph 7A is inserted into Schedule 23A which provides for “relevant tax relief” to be restricted where that relief is attributable to manufactured payments made by a company in pursuance of arrangements having an unallowable purpose. The restriction applies only to the extent that, on a just and reasonable basis, the relief is attributable to the unallowable purpose.
Before paragraph 7A can apply the following conditions must be met:
Arrangements have an unallowable purpose at any time where the purposes for which the company is party to the arrangements or to any transaction in pursuance of them or to any related transaction (see 1.4 below) include a purpose which is not amongst the business or other commercial purposes of the company.
The business or commercial purposes of a company are defined to exclude the purpose of any part of its activities which is outside the scope of corporation tax.
Tax avoidance is an unallowable purpose if it is the main or one of the main purposes for which the company is party to the arrangements. Tax avoidance means a purpose that consists in securing a tax advantage for the manufacturer or any other person. Tax advantage takes its meaning from section 709 ICTA88.
Where the relevant conditions are met then relevant tax relief (1.5) attributable to the manufactured payment is disallowed on a just and reasonable basis. The restriction can apply only to the company that makes the payment. It follows that where that person would not otherwise receive relief for the payment, for instance because it is representative of a dividend on UK equities and the manufacturer is not within the scope of section 95 ICTA88, then the rule can have no effect.
The rule will not operate where any relief for the manufactured payment could be restricted under the existing unallowable purpose rule in the loan relationships legislation. For accounting periods starting on or after 1 April 2004, the new management expense rules contain an unallowable purpose rule. Again, the new manufactured payments rule will not apply where relief is restricted under this provision.
The “arrangements” to which the rule can apply include schemes, arrangements and understandings of any kind whether or not legally enforceable. Their scope is extended to include any transaction, a “related transaction”, that it is reasonable to assume would not have been entered into independently of the arrangements themselves. For instance, if a company acquires shares as part of any arrangements, then their later sale will be a related transaction if it is reasonable to assume that it would not have occurred independently of the arrangements under which the shares were acquired. A transaction is not prevented from being a related transaction just because the transaction is not between the parties to the arrangements.
Relevant tax relief is any of the following:
a) any deduction in computing profits or gains for the purposes
of corporation tax (including any deduction to which a financial
trader might otherwise be entitled under section 95 ICTA88);
b) any deduction against total profits;
c) any debit brought into account under the loan relationship
provisions;
d) the surrender of any amount by way of group relief.
The basic rule is that the clause applies to all manufactured payments made on or after 2 July 2004 (“commencement date”), the date the clause was tabled. But this is subject to the transitional rules described below.
The rules distinguish between old and new arrangements. “Old arrangements” means arrangements some part of which was entered into or acted upon before commencement date. “New arrangements” means any arrangements that are not old arrangements.
The unallowable purpose rule will apply fully to all new arrangements. The transitional rules will be relevant only to old arrangements where the manufactured payment is made on or after Royal Assent. This means that companies that were committed to any arrangements which might have been subject to the rule will have a short window up to Royal Assent of the Finance Bill to unwind those arrangements without the new unallowable purpose rule applying.
Where manufactured payments in pursuance of old arrangements are paid after the date of Royal Assent, there is a further provision restricting the extent to which the unallowable purpose rule can apply. In determining relevant tax relief may be restricted, it is necessary to establish whether any income or capital gain from the arrangements arose to or accrued to the company before commencement date and was within the charge to corporation tax (whether or not covered by losses brought forward). Relevant tax relief is not denied to the extent that the manufactured payment represents, on such just and reasonable apportionments as may be necessary, the income or gains.
Where no income or capital gain accrued or arose under the arrangements prior to 2 July 2004 or, where it did, none of the income or gains was within the charge to CT, then tax relief for the manufactured payment can be disallowed in full, if that is the correct result using the main just and reasonable apportionment test.
Q1. Will this affect normal commercial stock lending and repo transactions?
No. Very few transactions will be affected. Provided that companies are entering into transactions for genuine commercial activities or making investments on normal commercial terms then the rule will not apply.
Q2. Will companies be unwittingly caught by the rule?
No. As was noted when the original loan relationship unallowable purpose test was introduced, companies that enter into arrangements with the primary aim of avoiding tax will invariably be aware of the fact. As the examples in part 4 of this note show, the arrangements at which the rule is aimed typically involve “funny” shares, abnormal dividends or contrived structures that are intended to produce a tax result which is more favourable than would be given if the economic substance of the transaction were followed. Often, this will be reflected by a deduction in the tax computation not featuring in the accounts.
Q3. Will this rule be applied in the same way as the loan relationship and derivative contract unallowable purpose tests?
Yes. In determining whether arrangements have an unallowable purpose the Revenue will follow its existing guidance in CT12670+, CFM6210+ and CFM13610+.
Q4. What is to stop an individual inspector applying the rule in an inconsistent and inappropriate way?
In any case where the unallowable purpose rule may apply, inspectors are required to refer to the Revenue’s Special Investigations Section. Companies who disagree with the Revenue’s view will have the right of appeal to the Commissioners and the Courts.
Q5. Will deemed manufactured payments be subject to the rule in the same way as real ones?
Yes. The test is whether the arrangements have an unallowable purpose. The rule will operate in the same way for deemed and for real payments.
Q6. Will the rule affect normal transactions where the pricing reflects the tax status of the counterparty, e.g. the pricing of a stock loan involving a pension fund that reflects its tax-exempt status?
No. The guidance given by the Economic Secretary when the loan relationship unallowable purpose test was introduced is still applicable:
Where a company is choosing between different ways of arranging its commercial affairs it is acceptable for it to choose the course that gives a favourable tax outcome. Where the rule will come into play is where tax avoidance is the main, or one of the main, objects of the exercise.
Q7. Will arrangements that give rise to manufactured payments paid to non-UK recipients be treated differently from those that involve only domestic counterparties?
No. The fact that a company makes manufactured payments to companies outside the UK tax net will not by itself be relevant to whether the new rule applies.
Q8. Is there a clearance procedure?
No. But in accordance with its existing Code of Practice 10, the Revenue will give its view on the application of the law to a particular proposed transaction if the full facts and circumstances are provided and it is clear the transaction was not designed to avoid tax.
Q9. Will any additional documentation be required to satisfy the Revenue that arrangements do not have an unallowable purpose?
No. Companies should already keep the appropriate documentation for self-assessment purposes.
In all the examples that follow the manufactured payments are made on or after Royal Assent. The examples are without prejudice to technical challenges that may be possible using other legislation or case law. In particular, some of the schemes may already be capable of challenge using the loan relationship or management expense unallowable purpose rules.
1. A tax avoiding company (Company A) acquires overseas shares (of a special purpose vehicle set up to facilitate the arrangements), which have a value of £500m, from their original owner under a stock loan.
2. The shares are due to pay a dividend of £450m, after which they will be worth £50m. Company A immediately sells the shares for their market value of £500m. Under the terms of the stock loan, Company A pays a manufactured overseas dividend (“MOD”) of £450m to the original lender of the shares at the time the dividend is paid to their new holder. After that payment, Company A buys the shares back for £50m. This results in a capital gain on the shares of £450m (500m – 50m), but there is no tax to pay because of other agreed CG losses.
3. Company A then returns the shares to the original owner under the stock loan. Company A is commercially flat because it has made a capital gain of £450m balanced by paying a MOD of the same amount.
4. The £450m MOD payment is claimed for tax relief against Company A’s total profits either as a management expense or a charge on income.
5. The end tax result is that Company A makes a capital gain of £450m and claims relief of £450m for the MOD against total profits. Since the capital gain is covered by CG losses, there is a net reduction in taxable profits of £450m even though the transaction has no commercial purpose or effect at all.
Company A is party to the arrangements only for a tax avoidance purpose: it has sought to obtain an immediately effective tax deduction of £450m at the cost of £450m possibly worthless capital losses. On the facts given the Revenue would seek to restrict relief for the whole of the manufactured payment.
If the scheme were an old arrangement and the gain had accrued before commencement day then the unallowable purpose rule would not apply. Had the gain arisen after commencement day then the rule would apply as if it were a new arrangement.
1. A non-resident company (Company A) acquires overseas shares under a repo which does not make provision for manufactured payments for £500m. The shares then pay a dividend of £300m to Company A, after which they are worth £200m. The dividend is not taxable because the company is not UK resident (foreign dividends are taxed on a receipts basis).
2. Just before the repo is due to unwind, Company A is acquired by UK avoider who arranges for it to become UK tax resident. The repo is then completed by Company A selling the shares back to their original owner for £200m (£500m sale price adjusted for the £300m dividend foregone by original owner).
3. Again, all parties are commercially flat. But the effect of the repo tax legislation is that Company A is deemed to pay a MOD of £300m on the day the repo unwinds, which is after it has become UK resident. There is no loss on the shares as the repurchase price is increased by the amount of the deemed MOD payment (and thus no interest deemed by section 730A ICTA88).
4. The MOD is treated as a management expense or charge on income and full relief is claimed against total profits of Company A. The £300m dividend is not taxable at all because the company was not UK resident at the time it was received.
5. Company A therefore claims tax relief of £300m on the MOD (tax saving £90m) but is not taxable on the equivalent dividend received.
Company A is party to the arrangements only for a tax avoidance purpose. On the facts given, the Revenue would seek to disallow relief for the whole of the manufactured payment. This would be true whether the scheme was a new arrangement or old arrangement, but in the latter case only where all income from the arrangements had been outside the charge to corporation tax.
1. Company A, a financial trader, wishes to borrow £150m. Instead of doing so it acquires UK shares from a bank or other lender for £300m. The shares have a value of £450m, the difference of £150m being in substance a loan (and accounted for as such).
2. The shares are shares in a special purpose entity that will pay a dividend of £165m in 3 years’ time, and thereafter a fixed dividend of 3 % per annum. The agreement under which Company A acquired the shares requires it to make what it terms a manufactured payment of £165m to the bank at the same time as payment of the real dividend. In substance, this represents repayment of the loan plus interest. No further “manufactured payments” will be made by Company A.
3. After acquiring the shares in the special purpose entity, Company A immediately disposes of them for £450m under a long–term repo transaction under which it will not receive payments representative of dividends on the shares. Instead it will repurchase the shares in 30 years for £285m. It is therefore left with £150m cash this being the amount it originally wished to borrow. After 3 years it makes a manufactured payment of £165m on which it claims tax relief in full under section 95 ICTA88.
4. The result is that company A claims tax relief on £165m. It would not be deemed to receive an equivalent manufactured dividend for 30 years; there is no assurance the company will still be UK resident at this time. In substance it receives a loan of £150m but claims tax relief for repayment of principal plus interest.
One of Company A’s main purposes in being party to the arrangements is a tax avoidance one. The Revenue will seek to restrict relief in respect of the manufactured payment.
Had this been an old arrangement the Revenue would still seek to restrict relief in respect of the payment provided no income had arisen to the company before commencement day. On the other hand, had Company A received an initial dividend before commencement day (and been within the charge to CT in respect of it), but had only made the corresponding manufactured payment after the Royal Assent then the rule would not apply to that part of the manufactured payment. This ensures that the company is protected against disallowance of later manufactured payments where income within the charge to CT has arisen from the arrangements prior to commencement.
1. This scheme is intended to give company A a deduction for what in substance is a distribution of profits. The scheme is promoted by a financial trader that hopes to receive relief for manufactured payments by securing a tax advantage for another person.
2. Company A wants to raise money in the market by issuing £100m of 4.5%. It issues the shares to company B for £100m. At this stage Company B is a wholly owned subsidiary of a financial trader unconnected to Company A.
3. Company B immediately stock loans the shares to the financial trader, who sells the shares into the market for £100m.
4. The financial trader provides company B with £100m cash collateral as security for the return of the shares. The stock loan is intended to be permanent. Company B will pay interest on the collateral equal to the dividends on the preference shares, i.e. 4.5% per annum, and receive manufactured payments from financial trader of the same amount.
5. Company A purchases the Company B shares from the financial trader for £100m so that Company B is now a subsidiary of Company A. Company B lends the £100m cash collateral to Company A, effectively completing the cash injection into Company A.
6. Company A pays dividends on its preference shares for which it receives no deduction. At the same time, Company B receives equivalent manufactured payments from the financial trader on which it is not taxable since section 208 applies ICTA88. Although Company A obtains no deduction for the dividends paid, Company B is entitled to a deduction for the equivalent amount payable as interest on the cash collateral. The group has therefore effectively converted non-deductible dividends into tax deductible interest.
The financial trader will seek a deduction under section 95 ICTA88 for the manufactured payments that it makes under the stock loan. One of its main purposes in being party to the arrangements is to secure a tax advantage for another person: it has devised the arrangements and carefully engineered them to allow the group to which Company A belongs to obtain a deduction it would not otherwise obtain. The Revenue would seek to restrict relief in respect of the manufactured payments.
A detailed description of repos and stock loans is beyond the scope of this note. But very broadly:
A repo is a sale of securities, with an agreement to buy them back at a later date for a price agreed at the outset. Repo is commonly usually used as a form of secured lending.
Stock loans involve a transfer of securities otherwise than by sale, with an agreement for return of equivalent securities. The ‘borrower’ provides collateral up to or slightly above, the value of the securities. Stock loans are used to enhance liquidity in the financial markets.
Detailed guidance on repos and stock lending and on the tax rules is in the Revenue’s Inspector’s Manual at IM 4300 and 4313. Detailed guidance on manufactured payments and the circumstances under which they can arise (including transactions that do not involve repos or stock loans) is at IM4330+.
Enquiries:
Richard Rogers 020 7438 6563
E mail: Richard.Rogers@ir.gsi.gov.uk
