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Finance Bill: hybrids rules to be relaxed for transparent funds


In 2017 the UK introduced rules counteracting hybrid mismatches (the Regime). 

The hybrid rules can deny a UK tax deduction for payments if (broadly speaking), the payment is made to a person who does not pay tax on their receipt because of "hybridity" in a document or structure. Hybridity is – essentially – a structural mismatch. That might be a mismatch in the way a payment is treated (equity vs. debt for example) or in the different ways that jurisdictions might treat entities (look through vs. opaque).

The UK rules were implemented in response to the OECD's Profit Shifting and Base Erosion Project (BEPS) recommendation that countries take steps to neutralise the effects of such arrangements. The UK was an early adopter of the rules and even "gold plated" certain provisions such that they go further than the BEPS proposals. In practice, taxpayers and their advisers have found that the rules apply to common benign situations and the government has enacted various legislative changes to the rules to try and patch up some of the problems. By contrast, under the equivalent EU rules member states have introduced their hybrid rules much later - from January 2019 and January 2020 (with further rules on "reverse hybrids" due to come into force next year), and the EU mandated rules are generally narrower than the UK regime.

Extensive changes in the 2021 Finance Bill

Extensive provisions in the Finance Bill (running to over 30 pages) make significant amendments to the Regime and address many (albeit not all) of the concerns that have been raised with HMRC by taxpayers, advisors and industry bodies. An aspect of this is the introduction of rules that, broadly, disapply counteractions relating to minority (less than 10%) investors in tax transparent funds.

Transparent funds

Currently, investors in a fund are likely to be considered to "act together" with each other in relation to entities held by the fund. This is important because when parties act together in relation to another person, broadly, the aggregate rights and interests those parties have in the other person are attributed to each other, so that their holdings in that other person are more likely to satisfy the regime's size thresholds (and so more likely to trigger a denial of a tax deduction). In the context of a fund, this would mean that each investor is attributed all the interests of the other investors such that every investor is more likely to have a large enough interest in portfolio companies to bring the Regime into play.

When the proposed amendments to the Regime were announced in November last year, the government said that it would amend the definition of "acting together" to exclude any investor holding less than 10% of a partnership that is a collective investment scheme (subject to anti-fragmentation rules). However, in the Finance Bill, the government has gone for a different approach. Essentially, the draft legislation does not ease the "acting together" definition for funds, indeed, if anything, it makes it clearer that investors in a fund will be treated as acting together, instead it gets to a similar position by telling us to ignore interests of relevant minority investors in tax transparent funds when calculating the size of any mismatch.

For these purposes, helpfully, "fund" is, defined broadly, so that it includes any collective investment scheme (CIS) or alternative investment fund (AIF) for UK financial services law purposes, with there being no requirement that it be widely held. Such funds will be within the new rules, broadly, if they are transparent for UK income tax purposes (so that funds structured as UK limited partnerships, Luxembourg SCSps or Cayman limited partnerships should benefit).

When assessing the size of an investor's interest in the fund, the investor has attributed to it all the interest in the fund held by persons "connected" to it. For these purposes the usual (wide) corporation tax definition of "connected" is used. That definition has its own "acting together" test which could force partners' rights to be aggregated but, helpfully, that is expressly disapplied for these purposes. The "connected" definition also has a standalone limb saying the partners are (in most circumstances) connected with each other and, surprisingly, this does not appear to have been switched off; something which we assume is an oversight and that will hopefully be corrected before the rules are enacted.

It is worth noting that these new rules on transparent funds do not apply in the context of "structured arrangements". Broadly, these are arrangements which it is reasonable to suppose either (i) were designed to secure the tax mismatch or (ii) have terms which share the economic benefit of the mismatch or otherwise reflect the fact it is expected to arise.

The changes relating to investors in transparent funds will have effect from royal assent of the Finance Bill.


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