In the Budget held on 24 March 2010, HMRC published a discussion document regarding the proposed introduction of a generic or principles-based rule to respond to certain arrangements termed “group mismatch schemes”. These proposals were discussed at an open meeting hosted by HMRC on 23 July 2010 and attended by representatives from industry and the tax profession, including Cadwalader.
As described by HMRC in the discussion document, a “group mismatch scheme” is an arrangement relying on an asymmetrical corporation tax treatment in respect of companies in the same group. Such arrangements create tax mismatches through, very broadly, the value of corporation tax relief attributable to a company in respect of a loan relationship or derivative contract exceeding the corporation tax charge (if any) in a counterparty group company. HMRC’s stated concern is that transactions employing tax mismatches which are economically neutral when viewed at a group level will reduce the effective rate of corporation tax over the whole group. The group mismatch in question may be the result of differing accounting treatments for the financial instrument in question, or the differing tax treatment of the transaction for the group companies concerned, or both.
The HMRC discussion document published on 24 March 2010 noted that existing legislation contains several targeted measures to ensure that connected party loans and derivatives are taxed symmetrically. However, HMRC now appears to consider that the network of antiavoidance provisions in the loan relationships and derivatives regimes (which already encompasses legislation introduced in Finance Acts in 2004, 2005, 2006, 2008 and 2009) can be characterised as constituting merely a “piecemeal” approach. Considering the breadth of transactions caught by existing targeted legislation and the effort HMRC has expended to ensure such legislation responds to recently disclosed avoidance arrangements, HMRC’s concerns are perhaps surprising especially when those concerns are placed in the context that many accounting mismatches which may currently exist within UK groups are likely to be lessened when all UK companies will be required to adopt converged UK GAAP or IFRS during the next few years. Nevertheless, HMRC has proposed in the discussion document the introduction of generic, or “principles-based”, legislation as a method of eliminating perceived tax avoidance in this area, possibly following the example of the two previous instances of such “principles-based” legislation in the disguised interest and transfer of income streams legislation.
In this context, HMRC have proposed that the “principle” to be enshrined in any generic antiavoidance legislation should be that “intra-group loans or derivatives should not be used for the purpose of producing an overall tax loss within the group as a result of transactions that do not give rise to any economic loss for the group as a whole”.7 The provenance of this “principle” is perhaps less than clear; such a principle has not been articulated in existing tax legislation, in Parliament or through the Courts in quite this form to date. Indeed, the discussion document does not address situations where intra-group transactions are expressly taxed in an asymmetric manner under the existing legislation. Such situations point to the difficulty for HMRC in elevating a legislative intention (such as for taxation symmetry to be imposed in circumstances where tax avoidance is present) to the status of an over-aching “principle”, and also illustrates the intricate drafting which will be required in ensuring that any anti-avoidance legislation on group mismatch schemes is fully integrated into existing legislation without adversely affecting bona fide commercial transactions.
The HMRC discussion document proposes that a group mismatch scheme would be an “arrangement” (broadly defined) between connected companies where it was reasonable to assume that any part of the arrangement, or any resulting transaction, was “designed” to secure a reduction in the group’s rate of UK tax as a result of the differing tax treatment of the loan or derivative by the companies concerned.8 The use of the term “designed” has been intended by HMRC to signal that the legislation “should not apply merely because of a difference in the rate of tax applying to the two parties, or because one has losses that will shelter any gain”.9 However, the discussion document did not suggest the inclusion in the draft legislation of a typical anti-avoidance “filter” based on a “main purpose”, “main intention” or “motive” test.10
The open meeting on 23 July 2010 gave both HMRC and the tax professionals attending an opportunity to discuss HMRC’s proposals in the discussion document. These discussions were further stimulated by the circulation before the meeting of an early draft of the proposed legislation on group mismatch schemes. HMRC were at pains to emphasise that the draft legislation circulated for the purposes of the open day would change as a result of the ongoing consultation and discussion with interested parties. Nevertheless, certain features within the draft legislation on group mismatch schemes were of considerable interest and added to the information in the discussion document. For example, the proposed sanction for a group mismatch scheme to which a company is a party would be for the “scheme profits and losses” to be left out of account in determining credits and debits for the purposes of the loan relationship and derivative contract regime.11 For this treatment to apply a company would need to fall within certain conditions, namely (i) that it was “certain” that at the time the company enters into the scheme, the scheme would secure a relevant tax advantage; (ii) that the “probability” of a relative tax advantage arising multiplied by the amount of that tax advantage exceeds the probability of a relevant tax disadvantage arising multiplied by the amount of that tax disadvantage; or (iii) that one of the above conditions would be met but for there being “a chance” at the time of entry into the scheme that scheme profits would be made by the group on the scheme being carried out and a second scheme is entered (perhaps several years later) with the purpose of securing that those scheme profits are never made.
As drafted, the proposed legislation would be applicable only to transactions between UK corporation tax payers and controlled foreign companies of UK corporation tax payers and would be restricted to loan relationships and derivative contracts (including quasi-loans and manufactured payments). Both of these features were objectives which commentators saw as desirable prior to the meeting. A series of examples of group mismatch schemes were provided by HMRC in both the discussion document and at the open meeting, perhaps the most interesting of which was a previously unpublished example involving a group company and a third party. This example was based on two companies (“A” and “B”) being associated, with B holding an index-linked gilt and A entering into a total return swap corresponding to B’s gilts and under which A is required to make payments equal to the increase in value or other benefit which B receives in respect of the gilts. HMRC identified the group mismatch as being the absence of taxation on B where the gilts rise in value in consequence of an increase in the retail price index, whereas A obtains a corporation tax deduction on the total return swap. Unlike the examples of a group mismatch scheme published in the HMRC discussion document12, the index linked gilt/ swap example is perhaps indicative of how a series of related or crossreferencing group assets or financial instruments may comprise a group mismatch scheme even though the transaction under which a tax deduction is obtained is with a third party and is on full arm’s length terms. It is interesting, however, to note that HMRC’s concerns with such a transaction would appear to already be addressed through the provisions of the recently enacted FA 2010, schedule 15 (index linked gilt securities: relevant hedging schemes).
In addition to discussions regarding the breadth of legislation (including the difficulties of ascertaining the “probability” of certain tax advantages arising, and the breadth of the definition of “arrangement”), attendees at the open meeting also expressed concern that the draft legislation did not currently contain a “filter” requiring the company entering into a group mismatch scheme to have a main purpose, intention or design of avoiding tax. A taxpayer company’s purpose or intention was only relevant, as currently drafted, in one of the three conditions acting as requirements for falling within the draft group mismatch legislation, leading to concerns that the legislation could inadvertently catch innocent transactions.
It was announced by HMRC that a revised draft of the legislation would be proposed in September 2010. While the timetable for the introduction of legislation on group mismatch schemes has been identified by HMRC as being Finance Bill 2011, this timetable does look very ambitious given the need to dovetail any legislation with other legislative initiatives, discussions and consultations which are ongoing at the present time.