• UK anti-hybrid rules and PE funds

UK anti-hybrid rules and PE funds

The UK has implemented anti-hybrid rules based on Action 2 of BEPS for company accounting periods beginning on or after 1 January 2017. The aim of these rules is to provide parity and eliminate instances of tax arbitrage in international corporate tax structures. For example, eliminating double deductions or deductions with no corresponding income pick up in cross border structures.

The UK anti-hybrid rules are extremely complex. Whilst they may apply to private equity manager and advisor entities (for example, certain UK LLP or US LLC entities which can have different tax treatments in different countries) the main application is to fund portfolio companies. In this context, the rules broadly seek to disallow UK corporate tax deductions for interest in structures that have either a ‘hybrid instrument’ or a ‘hybrid entity’.

The application of the rules depends on several factors including: the structure of the private equity fund, the financing of the portfolio company and the international tax profile of the investors in the fund.

The difficulty in complying with these rules is that the portfolio company needs to assess the impact for its UK corporate tax reporting but will need input from the private equity fund and to know the tax status of its investors in order to self-assess. Some high level examples of how the rules apply are as follows:

 

Hybrid instrument:

In this case there are no hybrid entities in the structure but the shareholder loan provided to the portfolio company from the fund is a hybrid instrument. For example, it may be an instrument which is treated as debt for UK tax purposes but equity for US tax purposes.

In this scenario, the process for determining any disallowance in the UK portfolio company is broadly as follows:

  1. Apply UK transfer pricing rules to calculate the interest deduction available to the company before application of the anti-hybrid rules.
  2. Where possible, determine the local tax treatment of fund investors on their share of the corresponding interest income.
  3. Investors who are subject to local taxes at the highest marginal rates within 12 months of the portfolio company year-end should be ‘good’ investors and their share of the interest should be deductible. For example, ‘good investors’ may include:
    1. UK corporate investors
    2. UK individuals (to the extent the interest is paid), or
    3. Tax exempt investors if they would be fully subject to local taxes if you ignore their tax exempt status.
  4. Investors who are subject to local taxes at favourable rates within 12 months of the portfolio company year-end (e.g. US individual investors with qualified dividend treatment) may be ‘partially good’ and part of their share of the interest may be deductible.
  5. Other investors can be assessed case by case.

In practice, we have found that funds often have enough ‘good’ or ‘partially good’ investors to preserve the portfolio company’s UK tax deduction after application of transfer pricing rules.

 

Hybrid entity:

Hybrid entities may feature in the portfolio company structure but are more typically present in the fund structure itself. For example, the fund itself may be a partnership which is transparent for UK tax purposes but opaque in other relevant investor jurisdictions. Another common example of hybrid entities include fund feeder entities set up for US tax exempt investors that have ‘checked the box’ to be treated as companies for US tax purposes.

The calculation for hybrid entities is similar to that for hybrid instruments but there are some extra steps in the rules which currently produce slightly larger disallowances in the portfolio company than in the equivalent calculation for hybrid instruments. HMRC is aware of the issue and clarification is being sought on the point. In the interim, we are looking at such structures on a case-by-case basis.

 

Ed NevensHelen Jones

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