Tax Arbitrage is defined as “trading that takes advantage of a difference in tax rates or systems as the basis for profit”. Multi national groups are often able to exploit asymmetries between different tax regimes and achieve a reduction in its worldwide tax liability. An asymmetry arises typically where an entity or a transaction is regarded differently by two tax regimes resulting in a tax advantage.
For example, Company A is based in the UK and may be paying tax deductible interest to its parent Company B resident in say the Netherlands. However, due to how the transaction is structured the receipt is treated as a non-taxable dividend in the Netherlands. For the Group as a whole this is highly advantageous as they have achieved a tax deduction without a corresponding taxable receipt.
In 2005 the UK Government introduced anti-avoidance legislation attacking tax arbitrage.
Hybrids
The legislation attacks asymmetries arising from various uses of hybrids. A hybrid entity is defined as an entity that is recognised as a person under the tax code of any territory (not limited to the UK) and whose income or expenses are also treated under the same or a different tax code as the income or expenses of another person. Examples of hybrid entities include a limited partnership and a UK company on which its US parent has “checked the box”.
Knowledge of how any cross border structure works outside the UK is therefore critical in understanding whether a structure is affected by these rules.
How the Rules Work
The anti-avoidance rules are targeted against contrived arrangements that are intended to avoid UK tax via the use of these hybrids. If the rules apply they seek to deny any UK tax advantage (i.e. tax deduction) achieved by the scheme. The legislation applies only if HMRC issues a notice directing a company to make or amend its tax return to take into account the legislation.
If a company considers that the legislation does not apply it is entitled to submit its return on that basis although there is, of course, an element of uncertainty under this approach.
The main thrust of the rules deal with the denying of a tax deduction. The rules that impose a taxable receipt are far more limited in scope. The rules seek to deny deductions if, and only if, all the following conditions are met:
- The transaction giving rise to the deduction is part of a scheme involving the use of a hybrid
- The scheme has certain characteristics that allow the hybrid to create either a double deduction or a deduction not matched by a taxable receipt
- The main purpose, or one of the main purposes, of the scheme is to obtain a UK tax advantage
- The UK tax advantage is more than £50,000 in tax deduction
The definition of ‘scheme’ is widely drawn and includes funding structures. Any UK company setting up an entry overseas or any overseas company intending to do business in the UK needs to consider whether the structure used breaches these rules.