Introduction

The financial crisis of 2008 led OECD Members States' governments to consider how best to protect their tax bases from being depleted by tax avoidance strategies. This led the OECD Member States to establish the Base Erosion and Profit Shifting (BEPS) initiative under which Member States would seek to co-ordinate their tax policies on an unprecedented global basis to combat tax avoidance. The UK has been at the forefront of implementing BEPS initiatives into domestic law with a view to protecting its tax base and (perhaps) to fund headline cuts in the corporate rate. The Finance Act 2015 saw the beginning of this trend with the introduction of a diverted profit tax designed (amongst other things) to combat arrangements which prevented there from being a UK taxable presence. Budget 2016 has continued this trend by confirming pre-announced plans to combat hybrids and to introduce an interest cap. These measures are designed to generate significant revenues for the UK exchequer. For example, the anti-hybrids rules are projected by the Treasury to generate £200 million of revenue in 2020-21 with the interest cap being projected to generate £885 million in 2020-21.

Hybrids

The anti-hybrids rules are scheduled to take effect from 1 January 2017.

At their simplest, hybrids are financial instruments and legal entities which are viewed differently by the different jurisdictions. For example, one jurisdiction may treat an instrument as debt and another jurisdiction might treat it as equity thereby creating a favourable tax outcome where a tax deduction is created but there is no corresponding taxable receipt. Looking at legal entities, different jurisdictions may treat entities in different ways thereby creating arbitrage opportunities.

In practice, entity based opportunities are often created as a result of the US "check the box" rules. By way of illustration, say that a US parent "checks open" a UK local holding company which it debt funds with the UK local holding company holding a UK operating company subsidiary. The UK holding company can group relief the interest cost down to the UK operating company. However, in the US, as a consequence of the "check open" election the US parent company is not subject to tax on the interest payable to it.

The anti-hybrid rules are designed to clamp down on arbitrages such as these. Further they are extra territorial in scope. For example, say that a UK operating company borrows funds from a group company in jurisdiction Y and there is no arbitrage between these two companies. However if, say, there is a hybrid mismatch between the group company in jurisdiction Y and a group company in jurisdiction X then potentially the UK can take remedial action on the funding transaction between the UK operating company and the group company in jurisdiction Y.

The Interest Cap

This rule is intended to take effect from 1 April 2017.

Subject to a de minimis exemption of £2 million, a UK group will be subject to an interest cap on its borrowings. If the interest expense exceeds 30% of the UK group's EBITDA then the surplus interest will not be treated as being corporation tax deductible.

There will be a relaxation of this rule if the UK group is a sub-group of a worldwide group and the worldwide group's external interest cost exceeds 30% of EBITDA. In these circumstances the UK sub-group will be able to support tax deductible borrowings up to the group ratio.

No draft legislation has been produced at the time of writing and it will be interesting to see how this proposal affects geared sectors of the economy, such as private equity.