INTM598090 - Arbitrage: practical guidance - examples demonstrating the application of the arbitrage legislation: Example 3 Part 2 - subordinated debt

Example 3 Part 2 - subordinated debt

Facts: A UK subsidiary of a foreign-parented group issues long-dated subordinated debt to its parent company. There are no regulatory requirements imposed that require debt to be issued in this form. The debt is treated as equity for accounting purposes and also by Code A. The parent company therefore benefits from underlying tax relief against the tax due on amounts paid on the instrument (treated as dividends under Code A).

The funds raised by the issue of the debt are applied for a commercial purpose in the issuing company’s trade, such as purchase of new business premises.

Analysis: Here the facts are different than in Part 1. Although there is a commercial purpose for issuing debt, the issuer lacks any material commercial purpose for the issue of long-dated and subordinated debt. Following this analysis, it is considered that the main (only) purpose for paying the higher interest rate required on such an instrument is the tax advantage represented by the tax deductions for interest payments.

This is reinforced by the fact that the issuer and the holder of the instrument act together as members of the same group to secure the arbitrage benefit from the hybrid instrument.

Under these facts, it is considered likely that there is a main purpose of obtaining a UK tax advantage and so Condition C will be met.

Let us assume that Conditions B and D are satisfied, and so the deductions legislation applies.

Rule B applies because relief is available against the whole of the receipt in the foreign jurisdiction, and the effect of the rule is to cancel the whole of the interest deduction. Importantly, however, this is subject to the issuing company’s right to disclaim part of the deduction arising from the scheme (F2A05/S24(14) to F2A05/S24(16)) in order to prevent the operation of Rule B.

In this case, there is a genuine commercial purpose for the debt, so it is reasonable to suppose that, in the absence of the benefit from the arbitrage, the company would have borrowed to meet its funding requirement. However, the borrowing cost would be at a commercial rate applicable to “plain vanilla” debt issued on normal terms, rather than the higher interest cost of the subordinated debt.

Therefore, the issuing company may disclaim the part of its interest deduction resulting from the higher interest rate on the subordinated debt, so that the remaining part represents a market rate for normal debt that lacks the hybrid characteristics that make this a qualifying scheme.