The United Kingdom Floats “Principles-based” Proposals
Attacking Certain Financial Transactions
By James J. Tobin,
Esq.
Ernst & Young LLP, New York, NY
In December, the U.K. Revenue issued a “consultation
document” entitled “A Principles-based Approach to
Financial Product Avoidance” in which it set forth proposed
legislation to address schemes involving disguised interest and
transfers of income streams that, according to the document, yield tax
results that are inconsistent with the economics of the
transactions.
I suspect that some of you are probably wondering why I've chosen
to comment on a U.K. development, rather than take my usual barbs at
the U.S. Treasury, IRS, or Congress. Could it be because recent U.S.
developments, such as the ODL regulations or Treasury's §163(j)
study report, haven't gotten me riled up enough? Perhaps. But, more
likely, it's because I've been spending quite a bit of time in London
recently and this one caught my attention; and maybe I just want to
make the point that it's not only the United States that gets things
wrong.
Whatever the reason, though, the consultation document is deserving
of some comments, especially about the United Kingdom's proposed
approach for resolving the tax avoidance in
question.
Background
The consultation document was spawned by the U.K.’s
Pre-budget Announcement earlier in the year in which the government
said, as part of its simplification package, that it would publish a
consultation document later in the year on a principles-based approach
to avoidance transactions involving financial products.
The idea of a so-called principles-based approach is interesting,
and I'll be focusing on that shortly. But before doing so, let's
quickly review the underlying matters with which the U.K. government
is concerned. In this regard, as to disguised interest, the
consultation document says:
Disguised
interest avoidance schemes exploit differences in tax treatment
between interest and other receipts such as dividends, and seek to
convert taxable interest into an exempt dividend or capital gain. For
example a person subscribes for shares without the characteristics of
ordinary shares (such as cumulative redeemable preference shares) that
provide a dividend economically equivalent to interest, and after a
period the initial share subscription is repaid.
Regarding the income stream issue, the document
says:
Selling
an income stream is a device designed to try to turn economic income
into a return that is treated by tax law as capital. For example, a
company might intend to pay a large dividend on which the recipient
would be liable to income tax. Schemes were developed for the
shareholder to sell the right to receive that dividend without selling
the shares, to, say, a bank in exchange for an amount almost equal to
the dividend. In consequence, the income tax bill on the receipt was
eliminated.
It's not terribly surprising that the U.K. Revenue is unhappy with
such “schemes”--our own IRS tends to get annoyed at
transactions designed to change the character of an item of income to
the detriment of the tax collector--and the document itself notes that
attempts have been made in the past to address these through
legislative change. Apparently, those attempts have not been entirely
successful, so a new approach has now been proposed, and that's where
things get interesting.
Disguised Interest
The proposed rules are intended to target schemes that are designed
to exploit differences in tax treatment between interest and other
receipts, such as dividends, and seek to convert taxable interest into
an exempt dividend or capital gain. The draft legislation aims to tax
a “return” (whether that return is paid currently or the
return is rolled up in the increase in value of shares or other
assets) if a company is party to an arrangement designed to produce a
“tax privileged investment return.” This latter term is
meant to encompass transactions that effectively yield an
interest-like return from money or any other asset.
The return may be taxed even if it is not reflected in the accounts
of the company to which the return accrues. If some method of
“concealing” the return has been employed, the commentary
suggests that it may be possible to separate this return out from the
other activities of the company and to tax it in accordance with the
proposed rules, though this is not clear from the proposed legislation
itself.
Transfers of Income Streams
This section of the consultation document aims to ensure that
consideration received for the transfer of an income stream is treated
as income. The stated purpose of these provisions is the
following:
Receipts
which are derived from a right to receive income and do not involve
any loss of capital are economic substitutes for income and are to be
treated for tax purposes as
income.
The “Principled Approach”
The document states that, “The Government often responds to
avoidance by setting out detailed rules that try to close a loophole
specifically and to block possible future loopholes in the same area.
This can increase complexity and may enable taxpayers to look closely
at the detail to see if there is an unintended way of working round
it.”
Sound familiar? That is, of course, often the way legislative
“solutions” are developed in the United States. And even
in the unusual case where our legislation is not narrowly targeted and
overly complex, you can be sure that the implementing regulations will
fit the description quoted above. So what to do instead? The
consultation document states:
We
have therefore considered whether what we are calling a
“principles-based” approach has a role to play in
legislation that seeks to prevent taxpayers exploiting distinctions in
tax law in order to pay less tax than the tax principles require.
Principles-based legislation would embody a principle of UK taxation,
and would be accompanied by a statement of how the legislation intends
to operate by reference to that principle.
In the case of disguised interest, this statement of principle
would be: “A return designed to be economically equivalent to
interest is to be taxed in the same way as interest.”
For transfers of an income stream, the enunciated principle would
be, “Receipts which are derived from a right to receive income
and do not involve any loss of capital are economic substitutes for
income and are to be treated for tax purposes as income.”
The consultation document
continues:
The
principles-based legislation described in [the document] should
improve certainty - even if taxpayers were to find that some of the
detail of their specific case was not mentioned in the legislation,
they would know whether and, if so, how to apply the legislation, as
they would understand the underlying principle. By elucidating a
principle underlying the taxation of an area, it could also achieve
conceptual simplicity and a more coherent
regime.
Making
the principle apparent on the face of the legislation would eliminate
the need to have lots of detailed rules. This would promote fairness
and consistency in tax treatment…. New principles-based
legislation could be shorter and less complex. And it should be more
difficult for avoiders to argue that a scheme does not contravene
principles than to argue that a scheme meets the literal requirements
of the statute. On the other hand, it is possible that
principles-based legislation might by its breadth sweep in
transactions that for good tax policy reasons ought to be treated
differently, or that existing detailed anti-avoidance rules were
repealed without replacing them effectively.
That pretty much sums up the trade-off that goes into the drafting
of both legislation and regulations in the United States and, as I
alluded to earlier, the United States always seems to come out on the
side of making the rules sufficiently detailed in order to clearly
define the scope of the rules and transactions covered. Thus, the
opportunity to “achieve conceptual simplicity and a more
coherent regime” usually loses out to the worry on the part of
the Treasury or IRS that taxpayers will argue that their specific
situation is not addressed.
Having said all that, it's not clear to me that the approach laid
out in the consultation document cannot be more accurately
characterized as an arbitrary rule, as opposed to a principles-based
approach. In this regard, because the wording is so broad, the rule
could, as a practical matter, apply to recharacterize the return on
any fixed-rate yielding instrument “designed” to produce a
return that is not taxed as interest. Does the term
“designed…to be treated by tax law as capital”
intend to imply that there needs to be a tax avoidance result sought,
or merely that the design produces a tax-exempt return, which would be
the case for any preferred share investment or a share investment in a
finance business, etc. Statements by HMRC seem to indicate the former,
but it is hard to take comfort from the words used in the
document.
I also have to wonder whether, as drafted, the proposed legislation
would, in fact, “achieve conceptual simplicity and a more
coherent regime.” Despite the brief, one-sentence
“principles” referred to earlier, the draft legislation is
fairly complex--requiring six pages of “commentary and
guidance” and numerous examples--and recognizes a need to add in
some type of deemed-paid credit for situations in which there is no
deduction on the other side of the transaction. Not so simple. And the
fact that this additional guidance illustrates that the treatment as
taxable interest will occur even in cases where no tax deduction is
achieved by the entity receiving the funds seems to clearly
demonstrate that the scope of the rule is broader than a perceived tax
avoidance one-sided deduction situation.
The further flaw in the fairness of the principle and its potential
for producing an arbitrage against taxpayers is the one-sided nature
of the regime. The equity holder of a tainted share investment would
be taxed as if it received interest, but the investee entity will not
be deemed to have incurred an interest deduction. In a globalized
world, for a single country to unilaterally change the character of
the yield in a one-sided manner might be said to be lacking in
principles and, in any event, may well be in violation of treaty
provisions. Perhaps if a true principled approach were desired, the
proposal should be modified to be a two-way street, i.e., if the
obligor on a debt or equity instrument obtains a tax deduction, then
the receipt would be taxed to the holder. Correspondingly, if a
deduction is not realized, the holder will not be taxed. Thus, both
double deductions and double tax could be potentially avoided.
However, I doubt there would be either the will or the ability to
achieve this result with a simple and coherent regime. The need for
greater certainty and the reality of complexity in dealing with
cross-border legal, tax, accounting, foreign exchange, and other
burdens are probably too much at odds with the lofty goal that simple
principles can rule our tax lives.
This commentary also will appear in the March 14, 2008, issue of
the Tax Management International Journal. For more information,
in the Tax Management Portfolios, see Isenbergh, 900 T.M.,
Foundations of U.S. International Taxation, and in Tax Practice
Series, see ¶7110, Foreign Income Taxation -- General
Principles.
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