10 October 2008 ‘Disguised Interest’ reform HMRC Issues Revised Draft Legislation For more information please HMRC have issued, to a limited audience, revised draft legislation and speak to your usual Deloitte guidance notes on the proposals to introduce a ‘principles-based’ contact or any of the following: approach to the taxation of ‘disguised interest’. The new proposals were discussed at a recent meeting. Background As a reminder, HMRC launched a consultation process in December 2007 proposing a new principles-based approach, which is designed to Stephen Weston secure that an investment return economically equivalent to interest is Tel: 020 7007 4568 taxed in the same way as interest. The proposals seek to tax such a Email: email@example.com return as a credit under the loan relationships regime, even though the underlying items are not loan relationships. There will be a just and reasonable apportionment where more than one company is party to Ben Moseley an arrangement. Tel: 0161 455 8577 Email: firstname.lastname@example.org HMRC have recognised the concerns and comments raised during the consultation process, and the previously wide scope of the proposals has been narrowed considerably. The ‘principle’ underlying the original proposals was not understood or agreed and potentially had a very David Boneham wide scope. Tel: 020 7007 0038 Email: email@example.com HMRC’s new proposals are much more targeted anti-avoidance, albeit worded broadly in an attempt to make it difficult for structured finance planning to sidestep detailed rules. As a result, the latest proposals appear to be more workable, although perhaps rather less ‘principles- based’. It is understood that a number of concerns about detailed aspects were raised at the discussion meeting and, should the Treasury decide to go ahead, it is hoped that further changes will be made. The key points can be summarised as follows: Tax advantage test The draft legislation now contains a motive test, such that the rules will not apply unless the main purpose, or one of the main purposes, of the arrangement is that the return is not brought into account for corporation tax purposes. This should ensure that most non tax-motivated transactions are excluded from the scope of the rules. HMRC have chosen to take this route rather than introducing a wide range of specific identified exclusions. Excluded shares In addition to the motive test, there are some specific exclusions from the rules; for instance shareholdings in controlled foreign companies ("CFCs"), companies that would be CFCs but for satisfying an exemption, group trading companies and certain group investment companies. These exclusions should cover many of the situations where concerns have been raised about potential double taxation. However, the exclusions are tightly drafted (in particular, applying where the arrangement involves only a shareholding in the entity concerned), so it is not certain that all instances of double taxation will be covered. Whilst CFCs that meet one of the exemptions, or where profits are apportioned, are excluded, the draft does not exclude companies which are not subject to a lower level of tax. In addition, the proposals would apply to determine the profits of CFCs – thereby disqualifying some from exemption. There is still some concern that the proposal is not completely linked to the separate discussions on Foreign Profits. 'Redeemable' shares Under a principles-based approach, many redeemable preference shares (and other shares where it is expected that the investor will realise an interest-like return and effectively recover the initial investment) could be caught due to their nature; however, there would be no corresponding provisions to provide relief for the associated expense. HMRC have therefore decided to exclude such 'redeemable' shares from the proposed legislation. These will instead be covered by an amended form of the existing legislation at FA 1996 s.91D – which will be included in the new Corporation Tax Act 2009 (the first instalment of the Tax Law rewrite in the corporation tax area). Foreign currency transactions The draft legislation includes a clause to disallow foreign exchange losses. HMRC's draft guidance states that, where a return is denominated in a low interest rate foreign currency, exchange gains which bring this return up to a sterling rate will be taxable; whereas if the return is in a high yield currency, foreign exchange losses will not be deductible. This suggests a one-sided approach, and HMRC's guidance on this provision generally is confusing in that it assumes that foreign exchange differences will ‘adjust’ a non-sterling return to a sterling rate, which economic theory may dictate, but economic reality will not necessarily secure. Of course, non-sterling returns could only fall within the scope of the rules if the tax advantage test mentioned above were to be satisfied. Further work is needed in this area. Exclusivity of other regimes HMRC have confirmed in their guidance on these proposals, and in the recent workshops, that they expect the exclusivity provisions contained in the loan relationships, derivatives, and intangibles codes to prevail over the disguised interest regime. For example, any returns on a loan relationship should not be capable of being taxed under these proposals. Brought forward losses The February 2008 draft legislation indicated that arrangements involving the introduction of income- producing assets into a company with brought forward non-trade deficits, in order to use these attributes, could be caught by the legislation. This was strongly resisted during the consultation process; HMRC have dropped this explicit proposal and accept that using economic losses is not tax avoidance. Timing The draft legislation is proposed to take effect in relation to arrangements entered into on or after 1 April 2009; therefore existing arrangements, and transactions taking place before this date, should not be affected. Sections 91A-E, FA 1996 (excluding 91D) will be repealed in respect of new transactions. This approach is welcomed. There are expected to be grandfathering provisions for shareholdings currently taxed under FA 1996 Section 91A-E (excluding 91D), although these are not contained in the draft clauses circulated. The proposals on transfers of income streams are now part of a separate consultation process. Next Steps The Treasury has yet to decide whether or not to recommend the proposals to Minsters. Should Ministers decide to go ahead, it is expected that a public consultation will be launched, possibly at the Pre Budget Report 2008. In our view, the latest proposals do look more workable and it is possible that legislation will be enacted in some form as part of Finance Act 2009. Groups should therefore consider the potential impact on future and/or existing transactions. Your usual Deloitte contact, or one of the contacts listed at the front of this bulletin, would be happy to discuss the proposals in more detail. In this publication Deloitte refers to one or more of Deloitte Touche Tohmatsu (“DTT”), a Swiss Verein, its member firms, and their respective subsidiaries and affiliates. As a Swiss Verein (association), neither DTT nor any of its member firms has any liability for each other’s acts or omissions. Each of the member firms is a separate and independent legal entity operating under the names “Deloitte”, “Deloitte & Touche”, “Deloitte & Touche Tohmatsu”, or other related names. Services are provided by the member firms or their subsidiaries or affiliates and not by the DTT Verein. In the UK Deloitte & Touche LLP is the member firm of DTT, and services are provided by Deloitte & Touche LLP and its subsidiaries. For more information, please visit the firm’s website at www.deloitte.co.uk. Deloitte & Touche LLP is authorised and regulated by the Financial Services Authority. This publication has been written in general terms and therefore cannot be relied on to cover specific situations; application of the principles set out will depend upon the particular circumstances involved and we recommend that you obtain professional advice before acting or refraining from acting on any of the contents of this publication. Deloitte & Touche LLP would be pleased to advise readers on how to apply the principles set out in this publication to their specific circumstances. Deloitte & Touche LLP accepts no duty of care or liability for any loss occasioned to any person acting or refraining from action as a result of any material in this publication. © Deloitte & Touche LLP 2008. 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