Check for tax disallowances where client structures have ‘check the box’ entities

Tue 03 Dec 2019

This note is a reminder to consider the potential implications of the UK hybrid & other mismatch rules effective from 1 January 2017, particularly where a client’s corporate structure includes ‘check the box’ entities for US tax purposes (which are looked through for US tax purposes such that transactions between the entity and its investor are ignored for US tax).

FA 2018 Sch7 introduced a relaxation of the application of the hybrid & other mismatch rules, in the form of new TIOPA 2010 s259ID (chapter 9 “Hybrid entity double deduction mismatches”). If four conditions are met, the counteraction otherwise applicable can be reduced or eliminated.  One of these conditions requires that a payment from an investor in a hybrid to the hybrid, is made in direct consequence of the payment by an unrelated party to the investor.  There is some uncertainty on how far ‘in direct consequence of’ is meant to be read.  Some background and examples of the potential issues that might arise in practice are discussed below.

If you are a group with cross border activity involving the UK, and particularly if you have a US connection, please get in touch with a member of the Mazars international tax team for a further discussion of the possible application of the hybrid and other mismatch rules. 

Background

Some background on the hybrid and other mismatch rules in the UK can be found here.  HMRC’s guidance on hybrid & other mismatch rules can be found here.

The particular issue covered in this note is the uncertainty of application of the easement introduced in FA 2018 Sch7 for the application of chapter 9 (Hybrid entity double deduction mismatches).

That chapter applies if the following conditions are met:

1. There is an amount that could be deducted from the income of a hybrid entity (e.g. the ‘check the box’ entity for US tax purposes) for the taxable period and also from the income of an investor in the hybrid entity for assessing that investor’s taxable profits.
2. Either the investor, or the hybrid entity (e.g. the ‘check the box’ entity for US tax purposes) are within the charge to CT in the relevant deduction period.
3. Either: (i) the hybrid entity and the investor are related at any time in the relevant deduction period; or (ii) the arrangement is a structured arrangement (one designed to secure the double deduction, or that shares the economic benefit of the double deduction). 

If the above conditions apply where the ‘check the box’ entity is resident in the UK for corporation tax purposes, the amount deductible in both the UK and US is disallowed for UK tax purposes, which increases UK corporation tax payable.  At UK rates of 19% and US rates of 21%, if UK profits are adjusted from say £5 to £100, the UK tax become £19 instead of less than £1.  This extra tax may or may not be creditable in the US and could represent an extra cost for the group.

However, it is possible to reduce any disallowance to the extent that either :

• The hybrid entity (check the box entity) has ‘ordinary income’ which is taxable in both the UK and the US (dual inclusion income), or
• There is ‘TIOPA s259ID’ income.  Such income must meet four conditions:
  • The investor makes a payment to the hybrid entity which is not deductible in the investor’s territory (for example this would be the case for a payment from a US parent to its UK ‘check the box’ subsidiary);
  • This payment results in ‘ordinary income’ for the hybrid entity for the deduction period;
  • The payment is made in direct consequence of a payment made to the investor by an unrelated person (unrelated to both the investor and the hybrid entity);
  • As a result of the payment by the unrelated party to the investor, an amount of ordinary income arises to the investor.

Practical examples where there is uncertainty with ‘in direct consequence of’

Some examples we are coming across in practice where the application of TIOPA 2010 s259ID is uncertain is as follows:

Marketing costs undertaken by the UK entity on behalf of the US entity. 

Here the UK hybrid entity might undertake marketing activity and bill the US related party investor.  If this marketing activity is successful, the US investor contracts directly with an external client.  The UK entity helps maintain this client relationship during the period of the contract and bills its US investor accordingly.  The US investor bills the external client directly according to its contract.

Could one argue that the price charged to all external clients will cover the cost of both successful and unsuccessful marketing, and that therefore the income arises as a direct consequence of the work done by the UK entity?

Alternatively does one take the view that as the marketing activity is not focussed exclusively on the external client, the costs incurred by the hybrid entity and billed on to its US investor are not directly in consequence of a fee paid by an external client to the US investor.

Maintenance/repair costs undertaken in the UK by a UK check the box subsidiary of a US parent in respect of the US parent’s UK customer

Here the US parent has entered into a contract for UK maintenance work with an external non-UK client that has a UK presence.  The UK subsidiary will undertake the maintenance work and bill the US parent on a cost plus basis for work actually done in relation to the contract.  The parent will bill its external client according to its contract with its external customer, which may be based on a fixed fee, so that if no work needs to be done, the cost is the same as if work is required. 

Does one take the view that the fee from the US parent to the external client arises in direct consequence of work done by the UK subsidiary and billed to the US parent?

Alternatively does one take the view that because the UK subsidiary only bills the US parent if it has to do any work, this has no direct consequence on the fixed fee raised by the US parent to the external client?

A contract for the supply of goods, where the goods are supplied from the UK to the US  and then to the external client

UK subsidiary (check the box entity) manufactures a product on the instructions of the US parent.  The product is shipped to the US and may have further work done by the US parent.  The finished product is then sold on by the US parent to the external client.

Does one take the view that the product could not be sold to the external client without the UK having done its work, so that the payment from the US parent to the UK subsidiary is in direct consequence of the work invoiced by the US subsidiary to its client?

Alternatively, does one take the view that the external client will only pay for the product if the US finishing work is done, so that the payment from the US parent to the UK subsidiary does not arise in direct consequence of the payment from the external client to the US parent?