Key Taxation Aspects
On Monday 24 November 2008, the Chancellor of the Exchequer delivered an anxiously awaited Pre-Budget Report which was dominated by commentary on the state of the UK economy and proposals to provide a fiscal stimulus through increased public spending and tax reductions. Beyond the rhetoric and headlines generated by this central theme, there are a number of UK tax changes that are expected to be relevant to Cadwalader’s clients and friends. Among these changes may be some good news for certain companies receiving foreign dividends and those holding collateral under defaulted stock loans. On the other hand, there may well be bad news for companies hoping for a simpler tax system, with increased uncertainty arising from the proposed introduction of new legislation seeking to tax “disguised interest” and transfers of income streams. Please see our “Speed Read” section below which summarises the key points and the corresponding lengthier commentaries which follow.
1 SPEED READ SUMMARY OF KEY POINTS
1.1 Foreign Profits Consultation and Controlled Foreign Companies (“CFCs”): legislation to be introduced in Finance Bill 2009 exempting foreign dividends of subsidiaries of UK tax resident companies from UK tax together with associated measures to protect the UK tax base from erosion. Ongoing consultation on a revised CFC regime (precipitated by adverse ECJ judgments on the UK’s current CFC regime) decoupled and deferred until Finance Bill 2010.
1.2 Principles Based Avoidance: Revised draft legislation published. Introduction deferred again from February 2009 and now tentatively re-scheduled for Finance Bill 2009. The original overarching statutory “principle” appears now to be reduced to more traditional legislative language, but the question of whether any “principle” remains embedded in the legislation is less clear.
1.3 Funds: Proposed relaxations for Qualified Investor Schemes to allow substantial investor participation. Anti-avoidance measures to prevent abuse of the real estate investment trust (“REIT”) regime through tax motivated separations of property owning groups. Interesting proposal for “increased legislative certainty” on trading and investment distinction regarding activities of Authorised Investment Funds (“AIFs”)
1.4 Additional points including: SDLT avoidance on residential property transfers; proposals for extension of SDLT relief for sukuk bond issuances; relaxation of tax rules on certain stock lending transactions where stock loan goes into default; releases of trade debts between connected companies; changes of accounting practice and certain forex gains and losses.
2 FOREIGN PROFITS CONSULTATION AND CFCS
2.1 In an open letter, the Treasury wrote on 24 November 2008 to the Confederation of British Industry and The Hundred Group announcing, in effect, that it is decoupling the “foreign profits” element of the consultation from the proposed replacement of the CFC rules. The Government’s intention is now to bring forward legislation exempting foreign dividends of subsidiaries of UK tax resident companies together with associated measures to protect the UK tax base from erosion.
2.2 These measures will include:
(a) a limit on interest relief where the debt of the UK tax resident group companies exceeds that of the world-wide group;
(b) an extension of the “unallowable purpose” rule at paragraph 13 of Schedule 9 FA 1996 to disallow loan relationship credits and debits arising as a result of schemes and arrangements involving loan relationships;
(c) a targeted anti-avoidance rule to protect against avoidance activity seeking to exploit the new dividend exemption;
(d) the repeal of the “acceptable distribution policy” exemption from the CFC rules at section 748(1)(a) ICTA (this is consequential to the foreign dividend exemption, as the acceptable distribution policy exemption is predicated on the dividends repatriated being subject to tax in the UK which will not now be the case once the foreign dividend exemption is in place);
(e) the repeal of the “exempt activities” exemption from the CFC rules (section 748(1)(b) ICTA); and
(f) the replacement of the Treasury consents legislation (sections 765 to 767 of ICTA) with a reporting requirement in relation to “high risk” transactions above a de minimis value of £100 million (with draft clauses being published in December this year for inclusion in Finance Bill 2009).
2.3 These are interesting developments and will, on balance, be welcomed by industry. The Treasury has largely met calls from industry that the foreign profits exemption should be decoupled from the remainder of the package proposed in the original consultation (see for instance the CBI’s position, in its letter to the Treasury of 18 June 2008). The Hundred Group has also previously expressed the belief that a foreign dividends exemption covering past profits would result in a greater tendency to repatriate foreign profits by way of dividends leading to lower interest deductions (because the relative attraction of lending to a parent company in the UK would diminish). It is interesting to note that the Treasury expects these changes to result in a net loss to the Exchequer in the long run.
2.4 The repeal of the “exempt activities” exemption will, however, not be welcomed. The exemption covered CFCs which carried on certain activities (provided they did not include a UK tax avoidance purposes) and satisfied certain requirements, namely that:
(a) the CFC must have a business establishment in its territory of residence;
(b) its business affairs must be “effectively managed” in its territory of residence (which, in relation to CFCs in other EU member states, meant that such a CFC should have sufficient individuals working for it in that territory who have the competence and authority to undertake (substantially) all of the company's business (paragraph 8(5) and (6), Schedule 25, ICTA 1988)); and
(c) its main business must not consist of certain precluded activities (for example, investment business and dealing in goods for delivery to or from the UK or to or from connected or associated persons).
2.5 Holding companies which met the first and second requirements and which, for example, derived 90% of their gross income from companies resident in the same jurisdiction as the holding company (where those companies also carried on exempt activities but which were not themselves holding companies) could also qualify for the “exempt activities” exemption. It is these holding companies which are going to be worst affected by the change, although some relief may be given by a 24-month transition period to allow holding company structures to be unwound (for which details are awaited). There is concern however, that it will not be possible to unwind some of these structures as the holding companies may themselves have a standalone commercial purpose. Other solutions may need to be found.
2.6 As for the reform of the CFC legislation, it has been perceived in the financial press that the Government was forced to shelve its plans to push ahead with a new “controlled companies” regime as a result of the flight from the UK tax net (by way of so-called “corporate inversions”) of some high profile parent companies of multinational groups (e.g. United Business Media plc, Shire plc and Henderson Group plc) and the threat of others to follow. The Government now concedes that it will not be able to implement any reform of the CFC rules until Finance Bill 2010. The position was further complicated by the decision in Vodafone 2 v The Commissioners of Her Majesty’s Revenue & Customs  EWHC 1569 in which Evans-Lombe J decided that sections 747 and 748 ICTA were incompatible with Article 43 and would therefore have to be set aside when considering the tax position of UK companies in respect to any of their subsidiaries properly established in EC member states, notwithstanding the fact that the subsidiary may exist for a tax avoidance purpose. The judge also raised doubts obiter dicta as to whether the Government’s recent amendment of the legislation (section 751A ICTA; to create a rebate system for subsidiaries in EC member states but only to the extent that the profits attributed to the UK parent resulted from the economic activity of the employees of the subsidiary) was, itself compatible with Article 43. This means that the CFC legislation may now be inapplicable in relation to subsidiaries in other EU member states.
2.7 However, the Government will now launch a fresh consultation on reform of the CFC rules and have, in their open letters, sought to reassure industry that future changes will not seek to increase the scope of the CFC rules and will ensure that profits genuinely earned in overseas subsidiaries are outside the scope of the rules.
3 PRINCIPLES BASED AVOIDANCE
3.1 In early December 2007, HMRC and HM Treasury published a document entitled “Principles-based approach to financial products avoidance: a consultation document” which contained proposals for statutory provisions in relation to disguised interest, being a return designed to be economically equivalent to interest, and the sale of income streams. HMRC suggested in the Consultation Document that “principlesbased” legislation was a viable approach to tackling tax avoidance, potentially moving away from closely articulated and prescriptive legislation which is focused on preventing the avoidance of taxation in very specific circumstances. The draft legislation set out in the Consultation Document proved highly controversial, and introduction in Finance Bill 2008 was postponed until, at the earliest, Finance Bill 2009. During the summer and autumn of 2008 several meetings and workshops were arranged between HMRC and a small group of tax professionals and industry representatives at which the draft legislation, and indeed the reasoning behind the draft legislation, was discussed.
3.2 Those workshops have led to a revised Consultation Document accompanying the Pre- Budget Report. This document provides a further refined version of the draft legislation which was the subject of this summer’s workshops.
3.3 The HMRC commentary to the draft legislation on disguised interest still identifies that “the object of the disguised interest legislation is to replace...piecemeal responses [to particular avoidance schemes] with a comprehensive rule ensuring that a time value of money return is charged to corporation tax in all circumstances where an arrangement is structured with the intention that (apart from the legislation) the return would arise in a form that is not charged to tax as income”. This statement seems to echo the original aim of HMRC in the December 2007 Consultation Document in attempting to create a statutory rule which, through the operation of an overarching principle, would be capable of defeating attempts to avoid tax based on the asymmetry between the legal form of instruments and arrangements and their equivalent economic effect.
3.4 With that aim in mind, the original draft legislation in the December 2007 Consultation Document contained a specific statutory “principle” that a return which was designed to equate in substance to a return on an investment at interest, but which was not taxable as interest, should be taxed as interest. No elaboration was given of exactly how the legislative “principle” interrelated with the other draft legislation. By contrast, the draft legislation in the revised Consultation Document replaces the original principle with a provision relating to where a return is “economically equivalent to interest” and identifies a series of criteria to determine whether such economic equivalence is present in a relevant arrangement. These criteria are that it must be reasonable to assume that the return is by reference to the time value of that amount of money, that the return is at a rate reasonably comparable to a commercial rate of interest and that there must be no practical likelihood of the return not arising as expected. The terms used, such as “time value of money”, “reasonably comparable” and “commercial rate of interest”, are deliberately not defined (to prevent avoidance attempts). The legislation therefore creates a very wide gateway with a series of exemptions, including exemptions for particular classes of instruments, being introduced to avoid an unfair tax result.
These exemptions include straightforward intra-group share investments to attempt to prevent the risk of double taxation from tiers of group company shareholdings. Arrangements which do not have as their main purpose, or one of their main purposes, tax avoidance are also excluded. The draft legislation introduces new provisions on preference shares accounted for as liabilities rather than as equity, which HMRC accept “raise tax issues which are of a different order to those raised by non-loan transactions producing disguised interest”. Accordingly, HMRC has proposed that such preference shares will be taxed under a revised version of the “shares as debt” rules in Finance Act 1996. To the extent that the preference shares are held for unallowable purposes (such as where a main purpose for arrangements involving such shares is tax avoidance), the fair value movements on the shares will be taxed as interest. Intra-group shareholdings of such preference shares will not, however, be within the scope of the revised draft legislation.
3.5 The changes made in the revised Consultation Document leave the draft legislation in an interesting position, particularly when one compares the wording of the draft legislation with HMRC’s stated intentions in the accompanying commentary in the revised Consultation Document. It is unclear whether the draft legislation is now merely closely articulated anti-avoidance legislation of a type very familiar to tax practitioners, or whether HMRC’s object of it applying “in all circumstances” suggests that some form of over-arching principle remains embedded in the legislation which might be discerned other than by reference to the clear words of the legislation.
3.6 As currently drafted, the legislation on the transfer of income streams catches transfers of income (called “relevant receipts”) in circumstances where the underlying asset from which the relevant receipts arise is not also transferred. The result is that the transferor is to be taxed to income on the market value of the right to the relevant receipts as if they had not been transferred. Unlike the original draft legislation published in December 2007, the revised legislation also aims to limit the tax charge on a transferee where the transferee is a company and where the transaction is accounted for by the transferee as a financial asset so that the transferee is taxed just on its return from acquiring the stream of income in certain situations.
3.7 HMRC has requested responses to the revised Consultation Document, following which “a decision will be made on whether legislation should be included in Finance Bill 2009”. Taken together, the draft legislation on disguised interest and the transfer of income streams is likely to require some study before its impact is fully understood. At first sight, however, both sets of legislation still appear to raise some questions and it seems reasonable to say that the discussion of these important legislative proposals is not yet concluded.
4.1 Qualified Investor Schemes: A QIS is a type of authorised investment fund which is authorised by the FSA and marketed to a sophisticated, non-retail investor base and which can undertake a wider range of investment activities than other authorised investment funds. Current tax rules under the Authorised Investment Funds (Tax) Regulations 2006 (SI 2006/964) impose a tax charge based on an annual increase in the value of a QIS holding on investors in the QIS who (whether alone or together with associates and connected persons) hold a 10% or greater holding in any QIS (“substantial investors”) even if that holding then falls below the 10% threshold.
Substantial investors are taxed on any increase in the value of their QIS holding between certain measuring dates as if the increase were income of the substantial investor. The income is then charged to income tax under Chapter 8 of Part V of ITTOIA 2005 (income not otherwise charged) or corporation tax under Case VI of Schedule D depending on the corporate status or otherwise of the substantial investor. HMRC proposes that this restriction will be relaxed, allowing substantial investors to benefit from a capital treatment when investing in a QIS, and that a corresponding requirement that the QIS be “widely held” will introduced to ensure that the QIS does not effectively become the captive of those substantial investors. The “genuine diversity of ownership test” will broadly require that the units of a QIS are widely held and not limited to specific investors or persons connected with such investors. Under draft regulations published by the Government in July 2008 as part of a consultation exercise, a QIS would only be widely held if its documents required the units of the QIS to be made widely available and to be actively marketed. The draft regulations also included details of a clearance procedure to enable a QIS to apply for confirmation that it meets the genuine diversity of ownership condition. Consequently, the “genuine diversity of ownership test” is expected to operate in a similar manner to the broadly equivalent test in the property authorised investment funds regime.
In view of the restricted nature of the investor base being targeted by each QIS, the proposed changes are likely to be welcomed by the QIS market. Some concerns were raised during the consultation process regarding the QIS regime during this summer that elements of the “genuine diversity of ownership” test may be highly subjective, and it remains to be seen how these concerns will, if at all, be addressed in the Finance Bill 2009.
4.2 Trading and Investment: One interesting point tucked away on page 74 of the Pre- Budget Report announces the intention of HMRC to discuss with the asset management industry the “potential for increased legislative certainty on the distinction between trading and investment in relation to the tax treatment of transactions of Authorised Investment Funds”. Given the centrality of the distinction between trading and investment for an AIF (with any trading of assets by an authorised fund potentially leading to double taxation), HMRC has attempted to address this area in guidance previously. Any “legislative certainty” in this area would be received with considerable interest.
5 REAL ESTATE
5.1 SDLT residential property avoidance: New regulations will be introduced to provide HMRC with additional means of identifying SDLT avoidance in relation to residential property to support the extension of the disclosure of tax avoidance schemes legislation to cover this area of tax avoidance in April 2008.
5.2 REITs: Legislation will be introduced in Finance Bill 2009 to make changes to the UK REIT regime. The conditions to be met by a company or group in the REIT regime will be amended for accounting periods beginning on and after 1 April 2009 to ensure that the conditions cannot be circumvented by the creation of new group structures for the purposes of accessing the benefits of the REIT regime. The avoidance which HMRC appear to be concerned with relates to a number of property groups which do not have a sufficiently high proportion of property rental income coming from third party tenants and which have created, or have contemplated creating, group structures (through separating their property holding and operating activities into several distinct tax groups but which remain under common economic ownership) in order to fall within the scope of the REIT regime. HMRC consider that such planning “would not be consistent with the aims of the REIT regime” and have proposed measures to widen the test of group relationship to include economic as well as share ownership tests. Draft legislation is promised in the New Year for introduction in Finance Bill 2009.
6 OTHER ITEMS OF INTEREST
6.1 Islamic sukuk: Earlier this year, the Government introduced regulation-making powers under section 157 and Schedule 46 of the Finance Act 2008 to facilitate the issuance by it of sovereign sukuk and that, pursuant to a response document released in June 2008, it had settled on a preferred form of sukuk issuance broadly analogous to Treasury Bills. The Government has now decided that issuing sovereign sukuk “would not offer value for money at the present time but it will keep the situation under review”.
However, the Government has decided that new legislation will be introduced in Finance Bill 2009 to provide relief from stamp duty land tax for alternative finance investment bonds. Relief for SDLT is already available under section 71A of the Finance Act 2003 in relation to (i) transfers of “a major interest” in land to a “financial institution” (broadly being a bank, building society, a subsidiary of a bank or building society, other entities entitled to carry on consumer credit or hire business, authorised deposit-takers outside the UK and special purpose sukuk bond issuers), (ii) the grant of a lease back to the other person party to the alternative finance arrangements and (iii) any subsequent transfer of that major interest to that person resulting from a right to direct the transfer of the major interest in land to him under the arrangements.
The Government now wants to augment this relief with a further SDLT relief to encourage the issuance of alternative finance investment bonds. A response to the consultation published on 26 June 2008 in this area is due in January 2009. Currently, because sukuk must usually be structured so that the bond represents a co-ownership interest in the underlying asset, where the asset underlying the sukuk is a chargeable interest in land the transfer of the sukuk bond may be subject to SDLT. The original consultation envisaged that where the requirements of section 48A FA 2005 were met, the transfer of a chargeable interest in land to a special purpose bond issuer, the transfer of that chargeable interest back to the originator and the issue and transfer of the sukuk bonds themselves would all be exempt from SDLT. Legislation is expected in Finance Bill 2009. A consultation regarding the regulatory treatment of sukuk is also promised in the “near future”.
6.2 Stock lending: Transfers and re-transfers of securities under stock lending arrangements are disregarded for capital gains purposes. Where a borrower under a stock lending arrangement becomes insolvent and defaults on the stock loan and it becomes apparent that the securities will not be returned to the stock lender, the lender is deemed to make a disposal of the securities at market value for capital gains purposes (section 263B(4) TCGA 1992).
Arrangements providing for the lending of shares or securities under a stock lending arrangement are exempt from stamp duty and stamp duty reserve tax (“SDRT”) provided that, amongst other things, securities of the same kind and amount are returned to the lender under the arrangement. In the event that the securities are not returned, such as on a default by the borrower, any charge to stamp duty or SDRT would be reinstated to reflect the fact that the stock loan has become an outright sale. A further consequence of such a default would be that the lender would incur a stamp duty or SDRT on purchasing replacement UK shares upon a stock loan defaulting and lent shares not being returned. It is also relevant that a lender’s direct and indirect liabilities on a default under a stock loan might be unanticipated, particularly given that the transfers of the collateral securities under the stock lending arrangement might typically be thought to be exempt from capital gains tax and stamp taxes.
HMRC have announced that Finance Bill 2009 will contain a provision, subject to “appropriate safeguards”, that the lender will not be deemed to dispose of the securities lent in situations where the borrower has become insolvent, provided that the lender uses the collateral provided by the borrower to buy replacement securities of the same kind. The effect is intended to be to allow the disregard of the transfer and transfer back of the securities to continue, so that no capital gains or allowable capital losses will arise for the lender and that the lender will not suffer any stamp duty or SDRT. HMRC is considering similar rules within the legislation dealing with repos. In the current financial environment, one anticipates that this proposed change can only be helpful. The capital gains tax changes apply where the borrower becomes insolvent on or after 24 November 2008, but an election will enable the changes to be backdated to 1 September 2008. The stamp duty and SDRT changes will have effect where the borrower becomes insolvent on or after 1 September 2008. Critically, the changes will therefore cover stock lending arrangements entered into with Lehman Brothers before its collapse in mid-September 2008.
6.3 Release of Trade Debts between Connected Companies. Measures will be introduced in Finance Bill 2009 to ensure that the corporation tax treatment of impairment losses relating to trade debts between connected companies do not result in an asymmetry between the treatment of the connected creditor and the debtor. Currently, it is possible that the formal release of bad trade debts (which may be brought within the loan relationships regime under section 100 FA 1996) by a connected creditor company would not give rise to a tax deduction for impairment losses (as a result of paragraphs 5 of Schedule 9, FA 1996). However, a debtor company may have to recognise a credit for tax purposes in respect of the same release (under section 94(1) ICTA). This situation could arise both to intra-group trade debts and also to trade debts between non-grouped companies when the same individual or company controls both debtor supplier and creditor customer and where the customer is taxed on the amount of the supplier’s release. This change is intended to be effective in accounting periods beginning on or after 1 April 2009 and will only apply where there is a “formal release” of the debt. Draft legislation will be published later this year. Formal release usually requires a release effected by deed but may also include a compromise in satisfaction of a debt under a voluntary arrangement. Failure to pay, bankruptcy or liquidation of the debtor should not give rise to a charge under section 94 ICTA.
6.4 Foreign Exchange Gains and Losses – Change of Accounting Basis: Loan relationships and derivative contracts are generally taxed in accordance with their accounting treatment but, in some circumstances, a company can “match” a loan or derivative contract with investments where the loan or derivative contract is being used to hedge foreign exchange exposure on that investment. Where “matching” takes place, foreign exchange movements on the associated loans or derivative contracts are deferred for tax purposes until the investments are realised. When IAS was introduced and UK GAAP was modified accordingly, transitional provisions (Loan Relationships and Derivatives Contracts (Change of Accounting Practice) Regulations 2004) were introduced to ensure that any credits and debits arising from the change of accounting practice were brought into account in a later accounting period, over a ten year period or not at all.
HMRC has identified a defect in the rules which results in reversals of foreign exchange movements on matched loans and derivative contracts being taxed or relieved as a result of a subsequent change in accounting practice. Draft regulations will be published shortly comprising a new disregard provision to prevent recognition of a transitional adjustment where the foreign exchange movement is otherwise brought into account for corporation tax purposes.
6.5 Late Paid Interest between Connected Companies: In consequence of a recent consultation, HMRC proposes to change the provisions which govern the tax treatment of late paid interest between connected companies. Usually a tax deduction for interest is allowed when it accrues (despite the fact that it might not have been paid). Where two companies are connected, interest which is paid more than 12 months after the end of the accounting period in which it fell due is only allowed as a tax deduction when it is actually paid. The manner in which HMRC proposes to change this rule is not yet known, but draft regulations are expected later this year.