Since the release of the draft clauses of the Finance Bill 2016 in December last year, the “anti-hybrid” rules have been subject to important updates as they have passed through the Parliamentary process. This article provides a high-level overview of the rules, which are now substantively enacted, and flags some key updates since the initial draft legislation.
The new Part 6A TIOPA 2010, “Hybrid and Other Mismatches”, seeks to implement the OECD’s recommendations in BEPS Action Point 2 report, “Neutralising the Effects of Hybrid Mismatch Arrangements”. The rules are broad and aim to counteract the mismatch arrangements identified in the OECD’s report involving hybrid instruments, hybrid transfers and/or hybrid entities.
A “hybrid” arrangement exists where, broadly, two jurisdictions take differing views of the same arrangement or entity, and consequently apply different tax treatment. A simple example would be where State A regards a funding instrument as debt (allowing relief for returns on the instrument), while State B regards that same instrument as equity (applying a tax treatment, e.g. a dividend exemption, to the same returns).
The rules are targeted at structures or instruments exploiting these classification differences between jurisdictions to achieve one of the following outcomes:
It is important to note that a tax avoidance motive is not in general a condition for the rules to operate. This is a key difference to the UK’s existing anti-arbitrage rules which these provisions replace. The fact that there may be valid commercial reasons driving a specific arrangement does not in itself prevent the application of the rules which operate mechanically. This means that it is insufficient in an M&A context to consider the existence of any “tax planning structures”, as the rules are capable of catching unintended mismatches and may even bite in some cases where “mismatch” does not in reality deliver any economic benefit.
It is expected that the new UK rules will be effective for payments (or “quasi-payments” – broadly accruals) made on or after 1 January 2017. There will be no grandfathering of existing arrangements, and many groups are in the process of taking steps to identify potential exposures.
Hybrid acquisition vehicles
An important example of the type of situation which can be caught by the rules is where a US group establishes a UK entity to undertake an acquisition. In corporate acquisition structures, it is common for the UK acquisition vehicle to be treated as transparent for US tax purposes by virtue of the US “check the box” regime. Treating the UK company in this way can mean that interest costs on funding provided to it to enable it to make the acquisition will technically give rise to either a “deduction/non-inclusion” mismatch (where funding is provided by the US parent) or a “double deduction” mismatch (where funding is provided other than by the US parent). Structures which seek to derive an economic benefit from this are unsurprisingly clearly within the intended scope of the rules, which would typically seek to counteract any benefit by denying UK tax relief for the funding costs.
In many cases, however, there is no economic benefit intended or obtained. The transparent nature of the acquisition vehicle can result in income being taxable in both the UK and the US. The UK legislation is intended to reflect this, so that deductions are not restricted when relief is given against “dual inclusion income” of this kind, but the exception is narrowly drawn and it is not unusual to come across cases where deductions are denied notwithstanding the lack of any economic advantage.
In the past some groups sought to circumvent the application of anti-hybrid rules by funding investments in the jurisdictions concerned using vanilla debt and then sheltering the corresponding receipts through a structure intended to create a hybrid mismatch in a different jurisdiction with less stringent rules. Arrangements such as this, designed to effectively import the benefit of a mismatch arrangement, are targeted by the “imported mismatch” provisions of the new regime.
The new rules also go further than the existing anti-arbitrage rules in this respect, in that they can restrict deductions in the UK even when there is no direct hybrid arrangement in the UK. The rules provide that relief can also be restricted where the hybrid arrangement is part of a series of arrangements which gives rise to a deductible payment (or accrual) in the UK and which also involve a mismatch arrangement not currently counteracted by the other jurisdictions involved.
Going forward it will therefore be insufficient for UK companies to focus narrowly on the arrangements they are directly party to in order to determine the deductibility of payments made. Wherever relief may, prima facie, be claimed, it will be crucial to ascertain the tax treatment given to the corresponding receipt and whether the arrangement under which the payment is made is itself part of a larger over-arching series of arrangements. If it is, then it will potentially become necessary to understand the tax treatment of all the payments made under that over-arching series of arrangements to conclude on the UK position. This can rapidly become a fairly complex exercise, especially where there are multiple parties in multiple jurisdictions, but one which the self-assessment nature of the regime requires to be undertaken.
Numerous amendments have been made to the draft legislation since it was originally published. Among the most important are the following.
Application of the rules to permanent establishments
The extension of the scope of the regime to arrangements involving permanent establishments significantly increased its potential impact. The extended scope reflects the fact that a permanent establishment will often be taxed locally as if it were a standalone entity but as part of the larger entity in the head office jurisdiction, creating similar potential for mismatches as hybrid entities. The amendments therefore apply many of the rules originally targeted at hybrid entities to permanent establishments. The main impact of this is on loss-making permanent establishments, with increased restrictions on using the loss in the UK and the risk that any loss may be forfeited altogether in certain circumstances, although all groups with permanent establishments will now need to assess the potential impact of the rules.
Restriction of “permitted reasons” exclusions
The original draft legislation followed the OECD in targeting mismatches caused by hybridity. It therefore identified various “permitted reasons” which might cause a mismatch to arise (e.g. the receipt corresponding to a deductible payment was received by a tax exempt entity) and broadly excluded mismatches attributable to these from counteraction.
Subsequent amendments to the legislation have significantly tightened these rules. In particular, rather than it being sufficient to show that a mismatch does arise for a permitted reason, it is now effectively necessary to show that it does not arise from hybridity. This is achieved by requiring an assessment of whether a mismatch could still arise if the relevant “permitted reasons” did not apply (e.g. if a tax-exempt payee ceased to be tax exempt).
This creates a risk of a UK disallowance in cases where, e.g. the UK is funded using a hybrid financial instrument, even though the same mismatch would have arisen (and not been counteracted) had the UK been funded with vanilla debt.
A further amendment provides that where a payee is (i) a hybrid entity, (ii) that is not subject to tax in any jurisdiction, and (iii) whose income is not brought into tax through the application of Controlled Foreign Company legislation (or equivalent) at investor level then any mismatch would potentially be within the scope of the rules. Although targeted at “reverse hybrids” this provision should be considered, in particular, where a structure includes “checked-open” entities in no-tax jurisdictions or checked-open US LLCs which are also potentially caught.
Introduction of an anti-avoidance provision
The rules now include a broadly drafted anti-avoidance provision, primarily aimed at arrangements intended to circumvent the new regime. An important carve out protects those arrangements where the non-application of anti-hybrid rules is in line with the “principles and policy objectives” behind the regime, but in the absence of any clear guidance from HMRC the extent of this exclusion can be expected to be an area of debate.
In an M&A context, the new rules are potentially relevant when considering the tax position of the target, the funding of the acquisition itself, and the suitability of the ongoing post-acquisition structure. In many cases the analysis will require a greater awareness of the bigger picture in which the transaction itself is an element.
Whilst the anti-hybrids legislation is now substantively enacted, it is not yet certain how HMRC will seek to apply the rules in practice. It is anticipated that HMRC will publish guidance ahead of the rules coming into effect on 1 January 2017 and it will be important to assess any potential impacts from this when it becomes available.