The summer has seen a number of examples of HMRC acting to limit tax avoidance involving accounting (and, therefore, tax) derecognition of credits arising on a company’s loan relationships and derivative contracts. For accounting purposes, where a loan relationship or derivative contract is derecognised it is treated as having been disposed of, with no income (and therefore no taxable income) arising from that loan or derivative being shown in the accounts of the company concerned. The legislation governing loan relationships and derivative contracts in CTA 2009 already contains provisions to counter tax avoidance on such a derecognition of a loan or derivative taking place for accounting purposes. Legislation was introduced to extend these anti-avoidance provisions in Section 8 and Schedule 5 of Finance (No.2) Act 2010 (“F(No.2)A 2010”) to prevent a number of arrangements involving accounting derecognition which HMRC considered offensive and which had been disclosed to HMRC. These measures were supplemented by the publication of a Technical Paper by HMRC on 6 July 2010 which sets out the background to HMRC’s concerns regarding tax planning which focuses on the accounting derecognition of a loan or derivative and which also considers the introduction of a general anti-avoidance rule in this area to prevent “persistent” avoidance.
The Technical Paper published by HMRC on 6 July 2010 sets out the background to the changes in Finance (No.2) Act 2010 in greater detail. The Technical Paper also notes the continuing concern of HMRC, regarding further disclosures under the Disclosure of Tax Avoidance Schemes legislation in FA 2004 (et seq.) which have been perceived by HMRC as indicating that corporation tax avoidance schemes involving derecognition continue to be developed. The Technical Paper cites two arrangements which are viewed by HMRC as instances of unacceptable tax planning, being:
(a) derecognition where a company (company “A”) with a loan asset has entered into an agreement with another entity under which, in return for additional shares or an increased interest in that entity, company A undertakes to make payments equal to the amounts it receives (interest and principal) which transfer the benefit of that loan to the other entity; and
(b) where a company (company “B”) with a loan asset derecognises that loan in an accounting period because it is contractually committed to issue securities to a connected company in the following accounting period that will form part of company B’s capital in that following period.
Legislation has now been enacted under Finance (No.2) Act 2010, Sch. 5 addressing the two examples given by HMRC of unacceptable tax planning on derecognition. The legislation includes new conditions to be added to CTA 2009, s. 311 (as CTA 2009, s.311(4B)) where a company acquires or varies a “relevant interest” in another company, or a partnership or a trust. “Relevant interest” is defined as meaning an interest in the other company’s shares or other capital, or an entitlement to the partnership’s profits or capital, or an interest in the trust’s property. The legislation also provides that the current rules in CTA 2009, s. 311 are extended so that they apply where derecognition is triggered by an event that occurs in a later accounting period to that in which the accounting derecognition takes place. These changes have effect from 22 June 2010. Equivalent provisions, introduced as CTA 2009, s.599A(5A), have been introduced for derivative contracts.
As a result of HMRC’s view that tax avoidance involving derecognition schemes is “persistent”, with “repeated manifestations” of such schemes, the Technical Paper also includes a proposal from HMRC that it will consult on recasting the loan relationship provisions in CTA 2009, s. 311 and the equivalent derivative contract provisions in CTA 2009, s.599A and 599B so that the legislation operates as a general rule that derecognition in the accounts is not followed for the purposes of the loan relationships and derivative contracts rules in Parts 5 to 7 of CTA 2009. HMRC has proposed that CTA 2009, ss. 311 and 599A would be amended by repealing the “conditions” in which derecognition in the accounts is not observed for tax purposes, and replacing them with a general rule that a creditor loan relationship or derivative contract is always fully recognised for tax purposes if amounts are derecognised in accounts as a result of “arrangements”. HMRC intends that the term “arrangements” would take the meaning commonly used in such legislation to include any arrangements, scheme or understanding of any kind, whether or not legally enforceable, involving a single transaction or two or more transactions. HMRC have commented in the Technical Paper that “recasting” the rule in this way will result in its application to a wider range of circumstances than is currently the case, and should obviate the need to insert new conditions each time further examples of tax avoidance involving derecognition arise.
A significant concern with the proposals made in the Technical Paper is that the definition of “arrangements” is very wide and would encompass a number of circumstances where tax avoidance is not a motivating factor. There is, however, no “filter” mechanism (such as a “main purpose” or “main intention” test) under which transactions which are not predicated on the avoidance of tax can be excluded from the effects of the proposed rule. While HMRC note in the Technical Paper that changes to the proposed general rule would be made to prevent “unfair” tax results, no details are given and, the inclusion in the legislation of a “main purpose” test is not suggested. Another concern with HMRC’s proposals regarding a general antiavoidance rule regarding accounting derecognition is that the interaction of such provisions with other legislative discussions and initiatives, such as proposals for group mismatch scheme legislation and the possibility of the introduction a general anti-avoidance rule, remains uncertain. The Technical Note contemplates draft legislation being included in Finance Bill 2011.