INTM551140 - Hybrids: financial instruments (Chapter 3): extent of the mismatch - case 2

Case 2 deals with ordinary income arising from a payment or quasi-payment under or in connection with a financial instrument where

  • the income is under-taxed, and
  • the under-taxed amount is wholly or partly attributable to the terms or features of the financial instrument

A similar exclusion in relation to excesses attributable to a relevant investment fund applies as for Case 1 and is outlined in INTM551130. Likewise, INTM551130 also considers the interpretation of the term ‘or any other feature’.

If there is more than one reason why an amount is under-taxed, and one of those reasons includes the effect of the terms or any other feature of the financial instrument, then the amount will be treated as under-taxed by reason of the terms, or any other feature, of the financial instrument.

Where Case 2 applies, the amount of the impermissible mismatch is calculated by applying the following formula to each under-taxed amount

  • UTA multiplied by (FMR minus R) divided by FMR

Where

  • UTA is the under-taxed amount
  • FMR is the payee’s full marginal tax rate for the permitted taxable period, as a percentage
  • R is the highest rate at which tax is charged on the profits that are under-taxed, as a percentage, taking into account the effect of any credit for underlying tax on a just and reasonable basis

For the purposes of establishing the under-taxed amount ignore withholding tax.

The full marginal tax rate is the highest rate that could be charged on the taxable profits of that payee on finance related income. It does not include a higher tax rate that may be imposed under the Diverted Profits Tax.

The ‘under-taxed amount’ is the relevant proportion of ordinary income that is subject to tax at a rate lower than the ‘full marginal tax rate’.

The highest rate at which tax is charged recognises income and capital taxes corresponding to the charge that would be imposed under the UK’s income tax, capital gains tax or corporation tax regime.

Illustration of calculation

Consider a payee that would ordinarily be subject to tax at 40% on their finance income but who treats the relevant receipt as proceeds from a capital asset, which is eligible for a lower tax rate and other relief. After taking into account the relevant deductions and reliefs, available to be offset under that capital gains taxation regime (including, where relevant, taper, indexation or other such reliefs), they are effectively subject to tax at a rate of 10%, then

  • ‘UTA’ is the relevant gross proceeds amount
  • ‘FMR’ is 40%, and
  • ‘R’ is 10%

Effectively only 25% of the receipt has been fully included as ordinary income, and 75% is therefore treated by the rules as not included.

There are examples illustrating this point further at INTM551220, INTM551310 and INTM551380.