27 June 2019
The content of this note is based on the writer’s own reading and interpretation of relatively new UK tax law regarding the hybrid mismatch rules. Unfortunately, there is little or no commentary from HMRC on the area to which this note relates and the tax/legal profession is divided.
This note sets out the UK hybrid entity double deduction mismatch rules which are designed to counter a hybrid entity (in this case a UK company-“UKCO”) from claiming a double deduction in circumstances where UKCO forms a “branch” for US tax purposes under the US Check the Box (“CTB”) rules.
The double deduction arises as follows:
Typically, UKCO undertakes low risk work which might for example promote sales made by its US parent company (“Inc”.) to third parties. UKCO incurs costs which are payable to third parties e.g. rent, salaries, media costs etc.
UKCO is a disregarded entity for US tax purposes, under the CTB rules (although a separate taxable entity for UK corporation tax purposes). It is regarded as being a hybrid entity under these rules.
UKCO’s costs are deductible both in the UK and in the US. Under the hybrid tax rules, as a disregarded entity, a double deduction mismatch arises.
All of the following conditions must be met to fall within the hybrid rules. These are as set out below:
Condition A: Inc. makes a payment to UKCO for which it (i.e. Inc.) cannot claim a deduction; (this would apply under the CTB rules)
Condition B: As a result of the payment, an amount of ordinary income arises to UKCO for the relevant accounting period;
Condition C: This payment is made “in direct consequence” of a payment to Inc. from an unrelated person – e.g. its own customers; I come back to this below.
Condition D: The receipt in Condition C is reported as ordinary income of Inc.
If all of the above conditions are satisfied then the effect of the legislation is to restrict UK tax deductions to the extent that the deductions exceed so-called “dual inclusion income”. The restriction is, the writer believes, carried forward to a year when there no longer appears to be dual inclusion income arising. Dual inclusion income means an amount that is taxed as income of UKCO and as income of Inc. To obtain this position, UKCO would have to earn income directly from third parties. If the fee income is derived from Inc. alone- in this case, under the cost plus basis of transfer pricing, then at first sight it would appear that none of the operating costs in UKCO in an accounting period would be deductible.
To understand the meaning of “in direct consequence of” the writer has considered the ordinary meaning of this phrase in the Oxford English Reference Dictionary. This defines “[direct] consequence” as meaning “as a[n] [immediate] result or effect of…” In other words, the payment would need to be made as a direct result of the payment made by the unrelated party to Inc. Clearly, this is not the case here. UKCO is not in receipt of a payment from Inc as a direct result of the latter company receiving fees from its unrelated clients, but, instead, UKCO is receiving income for the provision of marketing services (say) to Inc, whether or not Inc derives payment or not for the services that it provides to its third party clients. UKCO therefore carries on a wholly separate activity which is not reliant on income derived by Inc., and at best is an indirect consequence.
The firm has not corresponded with HMRC on this matter, and typically, HMRC have not updated and completed their draft guidelines on these new rules following consultation back in 2017, nor following a change in tax law in 2018.
There is a good deal of uncertainty and debate amongst tax advisors on whether cost plus arrangements are affected by the hybrid rules. We understand that HMRC do not intend that these rules be read so narrowly, and HMRC may accept that it may be onerous for groups to change their contracts so that these fall outside the hybrid rules.
Nevertheless, going forward, given the potential disallowance of some or all operating costs of a UK subsidiary in these circumstances, and where it is possible to change the terms of their existing contracts then it is suggested that groups in this circumstance look into this so that arrangements are made such that unrelated party income flows to the UK subsidiary.
It should be borne in mind that Australia and other territories have similar hybrid mismatch rules, and it is suggested that the point is raised by multi-national groups with their overseas tax advisors as well, in case these taxing authorities have also adopted these OECD rules (Action Plan 2-hybrid mismatch rules).