INTM598150 - Arbitrage: practical guidance - examples demonstrating the application of the arbitrage legislation: Example 7 - CFC restructuring
Example 7 - CFC restructuring
Use this link to view example 7 - CFC restructuring diagram
Part 1
Facts: A loan is made to a treasury company in a low tax jurisdiction which is a member of a partnership. The partnership on-lends the funds to a UK business whose activity brings it within the scope of a foreign jurisdiction’s Controlled Foreign Company “CFC” rules (a non-active business). The rate of interest (x%) on the loan paid to the 3rd party lender from the low tax jurisdiction is lower than the rate paid to the partnership (x% + y%), in order that a profit arises in the low tax funding company.
The loan to the UK business is made for commercial purposes and we assume that it would have taken place without the arbitrage scheme. We assume further that the UK business would have borrowed directly from the bank in absence of the scheme and that the UK business could itself have borrowed the funds on the same terms and with the same cost efficiency as the treasury company.
The scheme has a main purpose of obtaining an advantage under the CFC regime in
Code A. The rate of interest (x%) on the loan paid to the 3rd party lender from the low tax jurisdiction is lower than the rate paid to the partnership (x% + y%), in order that a profit arises in the low tax funding company.
Analysis: Both the partnership and the treasury company are hybrid entities, so this is a qualifying scheme. Condition A is therefore met and the interest payments made by the UK business mean that Conditions B and D are met.
Under these facts, it is established that the loan would have been made even without the use of hybrid entities, whose primary role is related to foreign tax purposes. Nevertheless, since the UK business could itself have borrowed the funds on the same terms and with the same cost efficiency as the treasury company, it is further established that the group would not have caused UK Sub to pay the y% portion of the interest in absence of the hybrid entities in the scheme. The scheme has therefore increased UK tax deductions and so Condition Cis met.
Rule B applies if a UK deduction is not matched by a taxable receipt. The receipt may either be wholly untaxed, or the taxation may be reduced as a result of provision made under the scheme. If the tax charge on the receipt is reduced but not eliminated by provision made under the scheme, then a corresponding proportion of the deduction is disallowed.
Here we consider the application of Rule B to the payment of interest by the partnership to the treasury company. The treasury company’s liability to tax is reduced by the interest payments it makes to the 3rd party lender, which represent deductions arising out of a series of transactions forming part of the scheme - the borrowing and on-lending by the treasury company. Because the tax on the interest is reduced by these deductions, Rule B applies to the UK company’s payment of interest to the partnership to the extent that it is matched by the interest paid to the independent lender - this corresponds to the x% rate of interest.
The company can prevent Rule B from applying by making a disclaim of interest sufficient to counteract the UK tax advantage purpose of the scheme. As the advantage consists of the higher rate paid by the UK company compared to the amount paid to the 3rd party lender, the disclaim should be represent the difference between the two rates of interest of y%. It is likely that the company would benefit from a disclaim, since the y% margin will generally be small in comparison to the x% rate paid to the independent lender.
Part 2
Facts: The facts are the same as in Part 1 except that the treasury company was established to act as a group treasury centre that is able to access the capital markets more efficiently than would be the case if each operating company in the group borrowed individually. The y% portion of the interest charged to UK Sub reflects an arm’s-length spread to the treasury company.
Analysis: In this case, it is established that the UK Sub could not have borrowed on the same terms as the Treasury company and that the y% portion of the interest paid by the UK Sub is consistent with arms length commercial practice rather than the presence of hybrid entities in the scheme. Thus, it is considered that obtaining a UK tax deduction is not a main purpose of the scheme and condition C will not be satisfied.