Recently we were asked to confirm that a minority equity investment by a US entity into a UK one, followed by an arm’s length loan, was not within the hybrid mismatch rules.
Piece of cake, you would think. The US company is taking a 35% stake in a UK business. It is a purely arm’s length transaction between unconnected parties. But, no, this is the UK’s hybrid mismatch legislation which we only wish was Pythonesque in its similarity to the Spanish Inquisition.
We can at least dispense with the majority of the rules as the UK company has not “checked the box” for US purposes and so remains a taxable entity for both UK and US purposes. There are no Permanent Establishment issues and the loan made as part of the deal is a plain vanilla one, money has been lent for a specific period of time, interest will be charged and then the capital repaid. No funny business or conversion conditions.
However, that is not the end of the matter. As might be expected, the US investor is a limited liability company that has not checked the box for US purposes and has two members. It is, therefore, a partnership for US purposes, but a company for the UK. It is a HYBRID!!!
This means we still have to consider the Hybrid Payee rules in Chapter 7 and being the hybrid mismatch rules there are five conditions to be met. The first three are fairly easy to consider:
- Is there a payment or quasi payment under an arrangement? Well there is a payment of interest under a loan agreement, so yes.
- Is a payee a hybrid entity? The money has been paid to the US LLC so they are a payee and it is regarded as a distinct and separate entity for UK tax purposes but it is not for US tax, therefore it is a hybrid entity.
- Is the payer within the charge to UK corporation tax (CT)? The borrower is a UK incorporated company and not tax resident elsewhere so it is within UK CT. (There are other ways a company can come within this condition but we don’t need to consider those here).
The next two, not so much.
Condition D sounds quite straightforward when you decipher it: is it reasonable to suppose that if the hybrid mismatch rules did not exist, the UK company would be able to claim a deduction whilst no-one would be taxable upon the income? Here, we have a US LLC and it would normally not be taxable upon the interest income, but the UK company will not know this or about the structure above the LLC. However, as this is an article about the hybrid mismatch legislation (which would end here if it was unreasonable to suppose etc), we will say it is reasonable to make this assumption.
Condition E – that the payer and the hybrid payee (or an investor in the hybrid payee) are in the same control group, or there is a structured arrangement – goes to the heart of this article.
With a 35% shareholding, the two companies are not in the same control group, but there is the question of whether the two entities are part of a structured arrangement. This is where it is reasonable to suppose (again) that the arrangement is designed to secure that the UK company has a deduction, whilst no-one is taxable upon the income or that the users share the economic benefit of the mismatch.
The legislation is also clear that the transaction can still fall within the rules, even if there are commercial reasons for it, but it was structured to obtain the mismatch. In our particular case, the US LLC was the main trading entity of the group and all the commercial activity, both “foreign and domestic”, went through it. All previous transactions for the group involved the LLC and there was nothing special about this one. The structure had not been designed to secure any deduction/non-inclusion mismatch, it had been designed without a thought to the UK side of things – the US did not know or really care if the UK got a deduction or not, whilst the UK was not aware (and, again, not interested) of the US tax treatment. There was simply no question of the transaction being made in any other way. It was not designed to secure any mismatch and nothing was being shared between the parties.
This time the legislation does not apply, but you can see how easily it could, even with a minority shareholding. For instance, if the LLC had been a special purpose vehicle set up for the transaction, it suggests the tax treatment might be an important consideration. If the UK entity is asked to check the box by the investor, again that suggests a tax motivation, or if the structure is altered subsequent to a discussion about tax. All of this is highly subjective and made more difficult due to the minority investment and the incomplete knowledge between the two parties. I say “incomplete” as there will likely be some knowledge, but that could be more dangerous than total ignorance here (for instance, if you assume there is no check the box election when there actually is, was it reasonable of you not to ask?).
To go back to the title of the article, you can be happily sitting in the meeting room having secured a minority investment from a US group and out pops Michael Palin and co. to ask if anyone has considered if Part 6A Taxation (International and Other Provisions) Act 2010 applies? Not something that will win the best joke at the Edinburgh Festival Fringe, but may cause a sharp intake of breath.
By Andrew Parkes, national technical director at Andersen in the UK