UK and International Tax news
Tax Avoidance Using Total Return Swaps
Friday 31st January 2014
HMRC has recently issued an amended guidance note on revised draft legislation published in respect of a measure to immediately close down avoidance schemes using total return swaps.
When the measure was first announced in the Autumn Statement [see our UK Tax News item of 11 December 2013], concerns were raised about its potentially wide effect on normal commercial transactions. As a result, revised clauses to the draft legislation were published on 23 January that should clarify the effect of the clauses, although the revisions do not however make substantive changes.
The new legislation is intended to close down an avoidance scheme in which a company enters into a derivative contract, a total return swap, with a parent company or another group company, generally located in a tax haven. Under the contract, all of the profits of the company are paid away in return for much smaller payments back. A deduction is claimed for the payment under the contract, leaving little or no profits chargeable to tax.
The Government considers that it is not acceptable for groups to try to obtain tax relief for payments that are in substance distributions of profit, and the measure aims to prevent this by providing that no deduction is given for arrangements where there is a payment in substance of the profits of a company to another company in the same group.
Revisions to the draft legislation should allow however for arrangements not to be caught by the legislation if they are arrangements of a kind which companies carrying on the same kind of business as the company would enter into in the ordinary course of that business.
Further revisions are to ensure that credits caught by the clause are not brought into account only to the extent that debits have been disallowed in respect of the same arrangements.
HMRC has included in its guidance some examples of situations where the new rules will or will not apply including the following:
A company carries on a financial business in the UK employing a number of skilled traders. The company enters a contract where 100% of the profits, as shown in the accounts, are paid to a fellow group company located in a tax haven. The other group company agrees to pay a sum equal to 20% of the profits back to that other company, and to meet losses made by that company, should any arise. This is caught by the legislation, as in substance the profits of the business are paid to the fellow group company.
A client of a banking group wishes to get exposure to a certain class of equities. It enters into a contract with a bank. The bank does not itself hold those equities, which are held by an overseas group company. The contract with the customer has to be entered into by the bank, and not with the overseas group company, for commercial and regulatory reasons.
It is not possible to transfer the equities from the overseas group company to the bank, again for regulatory and commercial reasons. So the bank enters into the contract with the customer, then uses a total return swap to pass on the return from the equities from the overseas group company to the bank. This will not be caught by the new clauses as the contract is passing on the return from equities, not the profits of a company and this is in the ordinary course of the bank’s business.
A group is involved in a securitisation of mortgage portfolios. A group company has issued mortgages to thousands of individual customers. These mortgages are used in a securitisation to back bond issues by a special purpose vehicle. As part of the securitisation, total return swaps are used to transfer the return on the mortgages between group companies. These arrangements are not caught by the new legislation since, while returns on different types of lending are exchanged, these contracts do not at any point move the profits of a company and is entered into in the ordinary course of business.
A bank has a UK subsidiary which trades in derivatives. The derivatives are hedged within the group by entering into a total return swap with a fellow subsidiary. This is not caught by the legislation as the total return swap moves the return on derivative contracts, rather than profits of the company, and is entered into in the normal course of business.
A UK subsidiary of a banking group makes a loan to a client in the UK. It enters a credit default swap with an overseas company in the same banking group to hedge against losses on the loan. This is not caught by the legislation as it does not involve paying away the profits of the business, just hedging one specific transaction, and will be in the ordinary course of business.Contact Us