For those of you who are relatively new IFS newsletter readers, I normally attach to this introduction an article on a business structuring topic which has relevance to international tax. This month, I intend to prepare a summary of the IBSA discussion we are holding at our meeting at Ince & Co on 29 September on ‘Growth: Funding, M&A and Structuring your Business for Success’ for those who are unfortunate enough not to be able to attend the meeting. You will, however, be able to enjoy a fuller discussion of this topic at our annual conference to be held on 19 November at The Landmark Hotel London, which will cover not only funding issues affecting the development of SMEs, but also international tax issues, intellectual property issues, the relevance of global current economic conditions to business, and general business planning including exit arrangements. For those interested in attending this conference, please (CLICK HERE).
Funding individual entities within a group can be through internally generated funds as well as external arrangements. Internal funding is commonly tax driven and relies on both the deduction of interest charges in the paying entity coupled with the avoidance of any relevant withholding tax on interest payable to non-residents by that entity. Moreover, if the group uses hybrid arrangements, the interest receivable by the corresponding group entity may avoid a tax charge in the recipient’s country. Thus, a typical arrangement would be for a group company to be financed by a Luxembourg company which makes a loan to the entity requiring funds and in turn issues PECs (Preferred Equity Certificates) to the parent funding entity. Provided the interest payable falls within the transfer pricing guidelines, ie is at an arm’s length rate, the interest may be deductible in the paying entity and exempt from withholding tax under the relevant double tax treaty with Luxembourg. In turn, the Luxembourg entity includes the interest income as taxable profits but claims a deduction for the amount payable under the PECs according to a relevant Luxembourg tax ruling deeming the amount payable under the PEC as allowable interest deduction.
A US parent will be able to treat the amount received under the PEC as dividend income which is taxable only on a receipts basis rather an accrual one, thereby providing tax deferral if the Luxembourg company merely accrues the PEC cost. Moreover, as a result of the ability to convert the capital and income under the PEC into equity, an eventual sale of the equity can provide a capital gain which is more advantageously treated than income. The net effect is that tax in the paying entity’s country of residence has been reduced through this hybrid instrument, whilst a tax deferral coupled ultimately with a lower-taxed capital gain is achieved in the US.
The OECD has recommended in Action Plan 2 of its BEPS initiative that such hybrid arrangements constitute unacceptable tax avoidance and should no longer be tolerated within OECD countries. The full recommendations of the OECD are due to be published in mid-October in respect of this and other Action Plans under the BEPS initiative, such as Treaty Access limitations. Thus immediately thereafter, Philip Baker QC and I will be summarising these various initiatives in a webinar to be broadcast at 12:00 hrs on 23 October. For those interested in listening to this webinar, please (CLICK HERE).
There are some arrangements which are both relevant for internally generated finance and external funding; these create tax deductible payments without the corresponding withholding tax and other charges. Deeply discounted securities are effectively loans made where the ‘interest’ element is already taken into account within the funds loaned to the recipient entity, which is then obliged to pay the full amount of the loan back to the payor on redemption. The expression ‘a rose by any other name’ springs to mind, but under current UK tax legislation, the difference between the actual cash received through the loan arrangements and the amount ultimately payable is not considered interest subject to withholding tax. If hybrid arrangements are to be abolished, then surely similar techniques must also be vulnerable.
I have spoken at a couple of seminars recently on residence planning, particularly as they relate to exit strategies on sales of businesses. I have also attended a recent round table discussion at Howard Kennedy on the ‘business of divorce’ which discussed how the value of businesses can be affected by matrimonial difficulties. The connection I made between the two was the real life example of an individual leaving the UK prior to selling his business, believing that his wife would come with him. His mistake was to think that his wife loved him more than she loved her grandchildren who were, of course, remaining in the UK with their parents. She decided to stay in the UK; the couple got divorced, and the associated settlement and legal fees exceeded the tax savings by a considerable margin. The moral is that the first question one should ask a client who is considering changing his place of residence is “have you discussed this with your partner?”
I will be sending out a further newsletter in the next couple of weeks summarising the IBSA discussion group meeting of 29 September and hope to see many of you at future events.
With kind regards
Roy Saunders