Hybrid and other mismatch rules - example of private equity funding

Hybrid and other mismatch rules - example of private..

Article six in our series on the new hybrid rules looks at how they apply to situations involving private equity funding.

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Our series of articles looking at the practical implications of the anti-hybrid and other mismatch rules continues this week with a look at how the rules apply to a situation involving private equity funding. Following the introduction of these rules on 1 January 2017, if a UK company has borrowed from an overseas group company, the whole funding chain should be checked to ensure that there is no mismatch, otherwise the anti-hybrid rules might apply to either deny or defer a deduction in the UK.  Similar rules apply where the UK company is paying for goods or services provided by overseas group companies.  The example below illustrates how the rules can apply where there is a mismatch in the chain of transactions outside the UK, whether in the form of financing or payments for goods/services, which can result in a disallowance in the UK.

Background

  • A UK subsidiary has borrowed on interest bearing terms from its Luxembourg parent company.  The interest expense is deductible in the UK as recognised in the accounts and the corresponding income is recognised in the accounts of the Luxembourg parent company and taxed at the standard rate.
  • As a result, there is no mismatch in the treatment of the loan interest between the UK and Luxembourg. 
  • The Luxembourg parent company is financed by preferred equity certificates (PECs) issued to its shareholders who are private equity investors.  In Luxembourg, the PECs are accounted for as debt and the coupon recognised in the accounts is tax deductible.  As a result, the Luxembourg parent company is effectively taxed on a small margin.

Why does this matter?

  • If there is a mismatch in the treatment of the coupon on the PECs in Luxembourg and for the private equity investors, the UK company may be required to self-assess a disallowance of the interest expense on its borrowing from the Luxembourg parent company.
  • This assessment will require a good understanding of the tax treatment of each private equity investor, to determine whether there is a mismatch and its nature; perhaps the mismatch is only one of timing if the investor is a US company which is taxed on a receipts basis or non-taxation if the income is received in a tax haven or benefits from a tax exemption regime.
  • The amount which has been disallowed may, in certain circumstances, be offset against income of the UK subsidiary only in future periods.  However, as a practical matter, the UK subsidiary may have little or no taxable income. 
  • It is also necessary to consider the interaction with the new corporate interest restriction regime which applies from 1 April 2017.  If there is expected to be a disallowance under these interest restriction rules, it might be considered sensible to first allocate this to the shareholder debt to avoid the compliance burden of applying the anti-hybrid rules.  This compliance burden may be significant given that the tax treatment in the various investors needs to be considered, particularly where the investors are in the form of partnerships as it may be difficult to obtain information on the tax status of the partners.
  • The interaction of the anti-hybrid and corporate restriction rules is not straightforward because both sets of rules provide for disallowed interest to potentially be deductible in later periods in certain circumstances. 

Businesses should act now to ensure that they fully understand the tax treatment of their global transactions, and to establish what the impact of the new rules on them may be. If you have any questions, then please get in touch with your usual KPMG contact or one of the named contacts below.

This article is the sixth in a series on the application of the UK’s new hybrid and other mismatch rules. The previous articles in this series cover the following:

 

For further information please contact :

Rob Norris

Mark Eaton

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