INTM550085 - Hybrids: introduction: interaction with transfer pricing legislation

In many cases where the hybrid rules in Part 6A have a potential application, the transfer pricing rules in Part 4 will also be in point. How the two sets of provisions work together is explained below.

In essence, the transfer pricing rules should be applied taking the hybrid rules fully into account as part of the process to determine the correct transfer pricing position. That is, Part 6A should be considered for both the actual and the arm’s length provisions. Part 6A should then be considered in respect of the transfer pricing outcome to see if any further restriction is necessary.

It should be noted, you cannot compare Part 4 and Part 6A and choose to apply one and not the other, nor can you choose to apply the two sets of rules in an order which produces a preferred result.

INTM550086 includes a series of examples showing the outcomes of various scenarios where different chapters of Part 6A are in point.

Applying transfer pricing

When considering whether a transfer pricing adjustment is necessary, the taxable profits arising has a result of the making of each of the actual and arm’s length provisions must be computed assuming full effect is given to Part 6A as it applies to each provision. Accordingly, whether there is any potential advantage in accordance with s.155 will be determined taking account of the impact, if any, of Part 6A.

If a potential advantage results, s147(3) and (5) will require the taxpayer’s computations to be restated as if the arm’s length provision had been made. Any counteraction under Part 6A applicable to the arm’s length provision must be taken into account when the resulting profits and losses are calculated.

In the absence of a corresponding adjustment claim, the transfer pricing rules only mandate adjustments to the tax computations of the potentially advantaged person, as defined. However, when considering the possibility and potential quantum of counteractions under Part 6A as part of the transfer pricing process, the counterparty or counterparties of the potentially advantaged person(s) under the contractual arrangement actually in place must be assumed to be party to the arm’s length provision and so paying or receiving the arm’s length amount. In relation to those chapters of Part 6A to which the ordinary income of payees is relevant, that assumption is necessary to test the potentially advantaged person’s tax outcome as if the arm’s length provision was imposed, as required by Part 4.

As an example, consider the simple case of an interest payment from a UK company to a hybrid payee. Suppose the actual interest payment is 100, but if the loan was on arm’s length terms it would be 60. When applying Part 6A to the arm’s length provision for the purposes of assessing whether there is a ‘potential advantage’ within the meaning of s155 and, consequently whether a transfer pricing adjustment is appropriate (and then in due course when giving effect to that adjustment), the payee must be assumed to be receiving 60. In consequence the payee’s amount of ordinary income for Part 6A purposes will be computed as if it had received a payment of 60.

In relation to Chapters 9 and 10, in computing the quantum of any double deduction, the payment made by the payer should be assumed to be reduced to the arm’s length amount in both jurisdictions in determining whether an adjustment under Part 4 is necessary and, if it is, quantifying the amount of any Part 6A counteraction applicable in relation to the arm’s length provision.

The entitlement of a payee to claim a corresponding adjustment is unaffected by any hybrid counteraction. In any case where the actual provision conferred an advantage on the payer (so an adjustment under Part 4 has resulted), the payee is entitled by Chapter 4 of Part 4 to make a claim to prepare its own returns as if it had received a payment of the arm’s length amount (a ‘corresponding adjustment claim’). Note however that where a corresponding adjustment claim is made, whether by a UK payee pursuant to Chapter 4 Part 4 or by an oversees payee under its own law or applicable treaty, that claim will reduce the amount of ordinary income received by that payee where relevant to the application of Part 6A.

Similarly, where the payment is one of interest, on the making of the relevant claim by the payee, s.187 provides that any withholding tax liability is computed by reference to the arm’s length payment (so, ignoring any counteraction under the hybrid rules).

Finally, in the event that any part of the payment falls to be recharacterized as a distribution under s.187A, that amount is the excess over the arm’s length amount with any hybrid counteraction irrelevant to the calculation.

Applying Part 6A

The possible application of Part 6A must also be considered independently notwithstanding the possibility that a hybrid counteraction may fall to be made via the transfer pricing process.

Part 6A Chapters 3 to 5 and 7 to 8

The overwhelming majority of cases where a hybrid counteraction is possible involve a UK resident payer.

In these cases, chapters 3 to 5 and 7 to 8 of Part 6A will seek to identify a ‘relevant deduction’, being the amount of the deduction, which would be available to the payer if the hybrids rules were disregarded. This will then be compared to the ordinary income of the payee or payees under the arrangement in question. If the relevant deduction exceeds the total ordinary income, the difference is the basis of any counteraction.

In computing the ‘relevant deduction’, the transfer pricing legislation (and any other tax legislation) must be assumed to apply but ignoring any possible hybrid counteractions to either the actual or arm’s length provision. The relevant deduction which is to be compared to the payees’ ordinary income will therefore be reduced to the arm’s length level if the actual payment exceeds that amount.

When the comparison is made with the ordinary income of the payee(s) under the relevant chapter of Part 6A, the payee(s) should be assumed to be receiving their actual payments (unless they are claiming corresponding adjustments). At this point, the mechanical provisions of Part 6A are being applied to compare the relevant deduction as already determined with the ordinary income. Any reduced level of assumed payment delivered by the notional application of transfer pricing in the computation of the relevant deduction should, in the absence of corresponding adjustments, not be applied to the computation of the ordinary income of the payee(s).

Counteractions are applied in the form of a limitation on the deduction that may be taken by the payer. They are not in the form of a disallowance (or restriction) of a set amount of deduction, to be imposed come what may.

(For example, see s.259CD: ‘the relevant deduction that may be deducted from the payer’s income for the payment period is reduced by an amount equal to the [mismatch]’.)

In a non-transfer pricing related case (that is, a case in which either there is insufficient connection between the parties for Part 4 to be activated, or where the parties are as a matter of fact transacting on arm’s length terms), despite its strict form as described above, the counteraction is in effect a simple disallowance. The actual potential deduction available prior to consideration of the possible impact of Part 6A will inevitably be the same as the relevant deduction for Part 6A computational purposes. So, the limitation on that deduction operates exactly as a simple disallowance would.

In a transfer pricing case, this will not be so. The actual potential deduction available in a case to which both sets of rules apply will be reduced to the extent needed to give effect to Part 6A via the transfer pricing adjustment, as set out above. When Part 6A is considered in its own right, the ‘relevant deduction’ is not a real element in the tax computation process – it is no more than a computational step on the way to determining whether a counteraction is necessary. If a hybrid counteraction is to be appropriate, the ‘relevant deduction’ will inevitably be larger than the deduction due to be claimed after application of the transfer pricing code.

In Part 4, the legislation specifically mandates the calculation of profits and losses on the basis of arm’s length payments, and so enables (and requires) the grant of a deduction at a lower level than would otherwise be the case. Part 6A does not operate in this way.

Part 6A merely says that as far as it is concerned, the total deduction cannot exceed a given amount. This is the amount of the deduction which would have been available absent the hybrid’s rules, less any counteraction. Where Part 4 has applied and Part 6A counteractions have been incorporated within its outcome, the resulting available deduction will inevitably be less than the limit imposed by Part 6A when it is considered in its own right. Part 6A will therefore have no impact beyond that taken into account in the Part 4 calculation. To reemphasise, there is nothing in Part 6A mandating the recalculation of profits and losses to deliver the relevant deduction and then adjust it: there is only a computational mechanic to determine the maximum available deduction in circumstances to which Part 6A applies.

Put another way: if the relevant deduction is not being sought because, when the rest of the legislation including Part 4 is applied, a lower amount is all that can be claimed, Part 6A cannot increase the available relief.

There is nothing in its language granting relief: it only operates to reduce relief that is otherwise available. This operation of the law is consistent with s.259A(5), which states that Part 6A counteracts mismatches that would otherwise arise by making certain adjustments for CT purposes. Where a transfer pricing adjustment taking account of Part 6A has been made, there is no mismatch otherwise arising to which a separate application of Part 6A should apply.

In any payer case where a transfer pricing adjustment and a hybrids counteraction are necessary, the hybrid counteraction delivered by the independent consideration of Part 6A will inevitably not limit the relief which can be claimed to a lower level than that already imposed via the transfer pricing adjustment. Part 6A will therefore have no additional effect over and above that which it has delivered as part of the application of the transfer pricing rules.

The proper application of the transfer pricing rules will therefore, where appropriate, give rise to a counteraction under the hybrids rules as part of the transfer pricing process.

Note: For the reasons set out above, it is not the case that where the percentage disallowance under Part 6A is less than that under Part 4, it can be disregarded (or vice versa). The only exception to this will be in relation to a specific fact pattern to which Chapter 3 or Chapter 4 of Part 6A could apply (discussed below).

Part 6A Chapter 6

Part 4 will not have any impact on a counteraction under Chapter 6, since by its nature Chapter 6 only applies to value transfers between a permanent establishment and its ‘parent’ in its jurisdiction of incorporation.

Part 6A Chapters 9 and 10

The interaction of Parts 4 and 6A is simpler in the context of Chapters 9 and 10 than in the cases of Chapters 3 to 5 and 7 to 8. In these Chapters, there is no need to assess a payee’s ordinary income: the hybrid benefit targeted by the rules is a double deduction.

Both Chapters 9 and 10 require it to be reasonable to suppose that absent the operation of Chapter 9 or 10 as appropriate, a deduction will arise in respect of a payment or quasi-payment both the UK and another jurisdiction. If that is the case, counteraction follows in the form of the UK deduction being restricted to use against dual inclusion income.

The UK deduction to which a payment would give rise absent the operation of the relevant chapter of Part 6A will be the deduction post-adjustment under Part 4, ignoring Part 6A. Accordingly, the counteraction under Part 6A will apply to the arm’s length payment, where Part 4 has mandated the payer’s profits and losses to be calculated on the arm’s length basis. This will therefore create the same outcome as applying Part 4, which will have required counteractions under Part 6A to have been applied in determining the outcome of each of the actual and arm’s length provisions.

When applying each of Part 4 and Part 6A, the assumption should be made that the arm’s length payment is being made for the purposes of determining the overseas deduction as well as the UK one, as this is a necessary step in quantifying any double deduction.

Part 6A Chapter 11

The operation of Chapter 11 is different from that described above. This Chapter requires the identification of a ‘mismatch payment’ between entities, which is funded by a payment made by a UK entity the deductibility of which is potentially subject to counteraction.

The counteraction under Chapter 11 is based on the ‘relevant mismatch’, which is, broadly, the amount which would have been subject to counteraction had one of the parties to the mismatch payment been resident in the UK. While the definitions of the amounts required to compute the relevant mismatch must be taken from Part 6A, the quantum of the relevant mismatch must be determined according to the local law applicable to the payer of the mismatch payment.

However, Finance Act 2021 introduced s259KF into Chapter 11 which is relevant to cases that are also within Part 4 of TIOPA 2010. If there has been a reduction in the deduction allowed for the imported mismatch payment under s147(3) or (5) of TIOPA, then if there are no other payments funding the relevant mismatch, s259KF applies a proportionate reduction to the calculation of the relevant mismatch, and so to the counteraction under Chapter 11.

Where the payer, P, of an imported mismatch payment is required to reduce the deduction claimed in calculating taxable profits or losses under s147(3) or (5) TIOPA 2010 (tax calculations based on arm’s length, not actual, provision), s259KF provides for the relevant mismatch to be determined as if the mismatch payment were reduced by the same proportion.

For example, if company A makes a payment (the imported mismatch payment) of 100 to company B, and company B makes a payment of 100 (the mismatch payment) that creates a relevant mismatch of 100, assuming no other payments were made that were relevant to the mismatch, company A would ordinarily impose a counteraction of 100. However, if the payment made by A was reduced on an arm’s length basis to 50, then under s259KE, we assume that the mismatch payment from Company B is also reduced to 50, and therefore the counteraction is similarly reduced.

As with other changes to Chapter 11 in Finance Act 2021 s259KF applies to payments made after 10 June 2021, the date of Royal Assent of the Finance Act 2021, or in the case of quasi-payments, to payment periods beginning after that date.

Part 6A Chapters 3 and 4: Particular point to note

In the cases of Chapters 3 and 4, the imposition or otherwise of a hybrid counteraction turns on the nature of the provision between the parties, not the nature of the parties themselves. Accordingly, if the facts are such that it can be demonstrated that the actual provision was not at arm’s length, and that the arm’s length provision would not have contained the features which brought Chapter 3 or 4 into play, then the transfer pricing and hybrids rules will not apply cumulatively. Effectively, whichever would deliver the greater disallowance looked at in isolation will prevail. See example INTM550086: hybrid financial instrument background 3 and 4.

A series of examples to illustrate the above follows.