Global Tax Alert | 18 February 2014
Progress of UK consultation regarding taxation of corporate debt and derivative contracts
Update on working groups
Draft clauses for inclusion in the UK Finance Bill 2014 which relate to changes to (i)the partnership rules in the loan relationship and derivative contract regimes and (ii) the bond fund rules were published in January. These changes form part of the Government's ongoing consultation on reform of the corporate debt and derivative contracts legislation and have been formulated following a number of working group meetings attended by representatives from HMRC (HM Revenue & Customs), industry and the professions (including EY) during the course of last year.
The consultation is now at an important stage. HMRC and Ministers are in the process of deciding which aspects of the reform to prioritize and which aspects to drop or postpone recognizing that space for legislation in Finance Bill 2015 may be limited given that 2015 will be a general election year.
Since it is difficult for those who are not actually participating in the various working groups to keep fully up to date with developments, this Alert summarizes the progress made to date and make some predictions as to what might follow. Readers should then be in a position to assess what the reforms might mean for them.
Working group 1: framework and anti-avoidance
Tax and accountancy
The fundamental approach to the two regimes is to remain unchanged: the accounts of the company will remain the starting point for determining the amounts to be brought into account for tax purposes. However, HMRC has proposed the inclusion of a statutory override to the accounting treatment where the accounts do not provide an ”appropriate” result. HMRC considers that it already has such a power through the inclusion of the ”fairly represents” wording in sections 307 and 595 of the Corporation Tax Act 2009, (although that view is not universally shared), but can see benefit in a more explicit statutory override to the accounts.
Respondents to the consultation have not necessarily welcomed this suggestion. It has been suggested that an ”override,” the scope of which is uncertain, would not necessarily contribute to a clear and simpler regime, which is one of the main goals of the reform. While HMRC has been clear that any override would be a ”two-way street” that is capable of applying to the benefit of both HMRC and taxpayers where the accounting treatment produces the ”wrong” result, there remains some skepticism about how useful such a rule would be.
Discussion on this will be ongoing. However, it is possible that the issue will ultimately be folded into consideration of the overarching targeted anti-avoidance rule (TAAR) or ”regime TAAR” discussed below. That might offer HMRC the ability to override the accounting treatment where tax avoidance is involved, but offer taxpayers who are not engaged in avoidance certainty on their tax position.
Unallowable purposes provisions
Originally, the changes to the unallowable purpose provisions were tabled as Finance Bill 2014 matters. However, following discussions with Working Group 1, any changes in this area have been postponed until Finance Bill 2015. Three of the six specific areas for change identified in the consultation document caused particular concern:
- • Fungible funding: HMRC's concern relates to the argument that no unallowable purpose can be attributed to any particular loan relationship where avoidance arrangements are funded out of a fungible pool of funds. HMRC's proposed counteraction was to disallow a proportion of any debit arising from such a pool. However, while simple to articulate, it has proved more difficult than envisaged to work out how such a rule might be included within existing ”unallowable purpose” provisions. It is now expected that this change will be introduced as a separate rule in Finance Bill 2015.
- • Netting losses against gains on derivative contracts: Currently, only net rather than gross debits arising on a derivative contract are disallowed where a company has an unallowable purpose. As a result, previously taxed credits effectively ”protect” debits that arise in a subsequent period from the application of the unallowable purpose rule. HMRC originally proposed removing this feature of the rules but concern was expressed that this might produce unfair results. HMRC acknowledged the difficulties with the original proposal and are now considering a more limited withdrawal of the netting rule to be introduced in Finance Bill 2015, targeted specifically at avoidance arrangements structured to generate losses.
- • Group tax advantage: It appears unlikely that this aspect of the proposed reform will represent a return to proposals announced a few years ago which sought to take into account a ”group purpose” behind a loan relationship or a derivative contract. Rather, the focus seems to be on identifying a tax advantage on a group-wide basis and preventing a taxpayer from being able to argue that, while a group as a whole has obtained a tax advantage, no individual company in the group has done so. Given that the concept of a ”tax advantage” is used throughout the Taxes Acts, there is a risk of ”collateral damage” to other provisions and, therefore, the additional time that is being made available to study this proposal is welcome.
HMRC considers that a regime TAAR is important in order to protect the Exchequer from abusive transactions. Such a rule would apply to arrangements which have a main purpose of exploiting or avoiding the loan relationship or derivative contract rules to obtain a tax advantage for the parties to the arrangement.
It is, therefore, almost certain that a regime TAAR will be included in Finance Bill 2015. It is expected that it will replace some existing anti-avoidance rules but many will remain on the statute books, most likely the rules dealing with group mismatch schemes, unallowable purpose and risk transfer schemes. It is hoped that the legislation that finally emerges is clear and certain in its application. It may seem tempting to draft a provision that states that any arrangement with a main purpose of circumventing any aspect of the loan relationship or derivative code will not achieve the desired effect. This is certainly the approach taken in section 363A CTA 2009 in the context of the legislation on deemed releases. However, section 363A has proved to be uncertain in its application and it is hoped, therefore, that any regime TAAR will be more tightly focused.
Working group 2: Debt releases, groups and partnerships
Treatment of debt releases
In many cases, companies in distress seek to avoid statutory insolvency processes and instead reach agreements on a consensual restructuring with their creditors. The problem is that no general relief applies to corporate rescues with the result that taxpayers often need to rely on a patchwork of other reliefs not all of which are entirely certain in their application.
The Working Group has concluded that a general corporate rescue exemption should be considered. Such an exemption might apply to debt releases generally (and not merely to deemed releases under section 361 CTA 2009). In addition, such an exemption might apply before a formal insolvency process is initiated. It is likely that this will be a high priority for inclusion in Finance Bill 2015.
Draft legislation, for enactment in Finance Bill 2014, was published in January to set out some general rules applicable to partnerships. The main rule proposed is that a partner in a partnership is treated as being party to a pro rata share of any loan relationship or derivative contract of the partnership. The aim of this rule is to reduce the scope for differences between the treatment of companies that enter into loan relationships directly and those that enter into them through partnerships. The draft legislation also makes it clear that the measure of profit on a loan relationship held through a partnership is to be determined by reference to accounts of the partnership, and not accounts of the individual partners, thereby putting existing HMRC practice on a statutory footing.
There are, however, some gaps and deficiencies in the relatively brief legislation. For example, it does not deal explicitly with what happens on a change of partnership sharing ratios or a transfer of partnership interests. The treatment of transfers between a partnership and its partners is not entirely clear. The use of a single ”blended rate” to determine a partner's ”appropriate share” of both partnership profits and assets is capable of producing some odd results in some situations.
It remains to be seen whether all of these difficulties are resolved in Finance Act 2014. However, given the wide variety of circumstances in which partnerships are used it does seem likely that there will be some need for further legislation in Finance Bill 2015.
The Working Group has looked at the group continuity rule that applies to certain intra-group transfers of loan relationships and derivative contracts. In addition, the regime that applies to loan relationships between connected companies has come under the microscope and consideration has been given to whether it is necessary for such relationships to be taxed on a mandatory amortized cost basis.
That process appears to have concluded with a general consensus that no radical change to this aspect of the rules is needed.
Working group 3: Accounting related matters
Tax to follow the profit and loss account
Currently, amounts recognized in a company's statement of total recognized gains and losses and statement of other comprehensive income (OCI) are brought into tax under the loan relationship and derivative contract rules alongside those recognized in the profit and loss account. There are then a series of deviations from this rule (such as those relating to tax hedging contained in the Loan Relationships and Derivative Contracts (Disregard and Bringing into Account of Profits and Losses) Regulations 2004 (the Disregard Regulations) which take out of the charge to tax certain amounts recognized in statements such as OCI. Those that remain within the charge to tax create cash tax volatility which is not reflected within the numbers in the profit before tax figure resulting in a difference between the reported financial position and the tax outcome.
It is proposed that the profit and loss account should be the starting point for determining the taxable amounts in respect of financial instruments. In addition, accounting standards are changing. For example, under IFRS 9 more hedges qualifying for hedge accounting and fair value movements relating to own credit risk on issued debt, are likely to be recognized in OCI rather than profit and loss. Therefore, the combined effect of the tax and accounting changes should be to produce less (taxable) fair value volatility in a company's profit and loss account.
However, with IFRS 9 unlikely to become mandatory for UK companies until accounting periods beginning on or after 1 January 2017, it will be some time before the benefits of such a simplification would be seen. Furthermore, such a regime is likely to benefit the larger companies which have dedicated treasury departments and expertise who are able to deal with the compliance associated with maintaining hedge accounting. For smaller companies, maintaining hedge accounting may not be so straightforward. As a result, a simple ”follow the profit and loss account” approach could still result in cash tax volatility.
Legislation in this area is almost certain to be contained in Finance Bill 2015. Deviations from the revised rule are likely to still be required and the Disregard Regulations are unlikely to be substantively repealed in the near future.
Perhaps one of the most radical proposals in the entire reform package is the suggestion that foreign exchange differences on non-trading balances or instruments would not be subject to corporation tax unless they are in a hedging relationship with a taxable item (the treatment of trading balances would not be affected). This suggestion has, in part, been motivated by a perception that reliefs for foreign exchange losses on non-trading balances have been exploited as part of tax avoidance schemes.
The suggestion has received a mixed response. While it has the benefit of simplicity, determining whether or not a balance or instrument is non-trading in nature is not always straightforward and relies on consideration of case law which is unlikely to deliver the desired certainty.
It has, therefore, been suggested that it may be better to focus efforts on improving the current regime by addressing the deficiencies identified. However, given HMRC's clear concern about avoidance in this area, it may be that a more radical proposal will be pursued.
Other hedging relationships
As mentioned above, the Disregard Regulations are likely to remain in place in some form. It may be that the regime set out in the Disregard Regulations becomes one that has to be elected into rather than, as currently, a regime that automatically applies unless a company opts out.
The deadlines for making elections under the Disregard Regulations are currently seen as unduly short. While HMRC needs to be comfortable that any relaxation of these deadlines does not expose the Exchequer to the risk of abuse, it appears likely that there will be some change − possibly prior to 31 December 2014 so that they take effect for accounting periods beginning on or after 1 January 2015.
Working group 4: bond funds and corporate streaming
The bond fund rules in section 490 Corporation Tax Act 2009 provide that companies with holdings in bond funds must treat that holding as a loan relationship and bring in debits and credits on the basis of fair value accounting. HMRC originally proposed to abolish these rules as they felt that they were being abused in a number of tax avoidance schemes.
Feedback from the life assurance and asset management industries was that abolishing the rules would lead to inadvertent consequences that would impact funds, life assurance providers and other long-term savings. HMRC has responded to this feedback and has now proposed retaining the rules but with a specific TAAR to combat potential avoidance.
Draft legislation to implement the TAAR on bond funds has been published for inclusion in Finance Bill 2014, together with draft guidance notes. The TAAR applies where arrangements are entered into in relation to a bond fund (or related fund) where the purpose or one of the main purposes of the arrangement is to obtain a tax advantage. Despite being very broadly drafted, HMRC have confirmed in the draft guidance that they would expect that funds that are widely held would be at low risk of being within the TAAR.
In relation to the corporate streaming rules, HMRC has listened to representations from the life assurance and investment funds industries to the effect that the suggested abolition of the corporate streaming rules applicable to authorized investment funds could have adverse consequences and has agreed to reflect on these concerns. It appears likely that any change to the corporate streaming rules could be implemented by means of secondary legislation. Therefore, it is unlikely that this topic will take up much space in Finance Bill 2015.
For additional information with respect to this Alert, please contact the following:
Ernst & Young LLP (United Kingdom), London
- • Jonathan Richards
+44 20 7951 6428
- • Fiona Thomson
+44 20 7951 3913
- • Stuart Chalcraft
+44 20 7951 1190
Ernst & Young LLP, UK Tax Desk, New York
- • Sarah Churton
+1 212 773 5994
- • Matthew Newnes
+1 212 773 5185