Anti-hybrid rules: Broad reach, ongoing scrutiny

The UK's anti-hybrid rules, or more formally, the hybrid and other mismatches rules, were introduced in 2016 and have applied since 1 January 2017. They were the UK's response to an international project, led by the OECD, to counter arrangements designed to exploit differences between countries’ tax systems. Almost ten years on, they remain one of the more far-reaching and complex areas of corporate tax –  and a continuing area of interest for HMRC.

At their simplest, the rules address a “mismatch” in which two countries treat the same entity, payment or instrument differently for tax purposes, so that an expense is relieved twice, or relieved in one country without being taxed in the other. Where that happens, the rules broadly seek to counteract it. They might, for example, deny a UK corporation tax deduction for an expense that the recipient does not tax.

This may seem reasonable at first glance, but the difficulty is that not all in-scope arrangements are obvious, and the rules can catch expenses associated with entirely ordinary commercial activity. And, crucially, the rules apply automatically. There is no motive test and no size threshold.

A group does not need to have set out to achieve a mismatch, and need not be large or complex, for these rules to bite. Some arrangements are within their scope by design; in many other cases, groups are caught despite wholly normal commercial arrangements. Either way, the analysis still has to be done.

A common misconception is that the rules are only about financing, being just one more restriction on interest deductibility applying to cross-border intra-group loans or complex financing arrangements. In fact, they reach much further: Ordinary trading expenses can be disallowed where they are paid by, or to, a hybrid entity.

We recently saw this in practice. A UK company’s US parent had elected, under the US check-the-box rules, to treat it as disregarded, so that, for US tax purposes, the UK company was simply a branch of its parent. That meant its everyday third-party costs, including wages, were effectively deducted in both countries, and were therefore fully disallowed in the UK as double deductions.

A relief can apply where the same income is taxed in both countries, but it did not help here: The UK company’s only income came from a related group company and was ignored for US tax. As the arrangement had been in place for several years, the cumulative cost of putting it right was significant.

From 6 April 2022, any hybrid arrangements or mismatches have had to be reported directly on corporation tax returns. To enable this, HMRC expanded the supplementary page CT600B of the corporation tax return, adding ten boxes specifically on hybrids.

Companies now have to confirm whether they are a hybrid entity, whether they transact with a hybrid entity in the same group, whether there is a mismatch involving a financial instrument or a permanent establishment, and whether any counteraction has been taken, for example. There are further entries for the amounts involved where the rules apply.

Being within the scope of the rules is not the same as owing tax under them, but a group still has to analyse to know which side of that line it falls and to support its position.

The form is completed only by exception, so it is easy to assume it does not apply. But the disclosure gives HMRC a clear view of where hybrids may be an issue, and the enquiries it supports can reach back to earlier periods.

Even where a group concludes that no counteraction is required, it still needs to reach that conclusion properly and keep evidence of the analysis behind it.

Issues tend to cluster around a familiar set of features. In our experience, the areas most deserving of a second look are:

• US entities, particularly US LLCs, where the interaction with US check-the-box treatment can create a hybrid exposure, including on ordinary trading payments
• Foreign branches and permanent establishments, where profits or deductions are recognised differently in the two countries
• Imported mismatches, where a UK payment indirectly funds a mismatch elsewhere in the group, even if the UK arrangement does not appear to have any hybrid characteristics on its own
• Hybrid financial instruments that are treated as debt in one country and as equity in another

A group may fall within scope as a result of any one of these features, and groups with a US connection are particularly likely to do so. This list is not exhaustive, however, and we have encountered cases without any of these features.

Given HMRC's continued focus, groups should review the position regularly, rather than only when a return falls due. It is particularly worth revisiting after any transaction, change in the business or reorganisation. These are the moments when a new mismatch can quietly arise, whether through a new US entity in the group, a financing arrangement put in place, or a branch opened overseas.

Businesses need to be vigilant, because the rules operate mechanically. Once the conditions are met, relief is denied, and there’s no scope for discretion or account taken of motive or purpose. Given that exposures that go unnoticed will tend to recur year after year, the amounts at stake can balloon. It is rarely possible to mitigate a counteraction after the event, so almost everything depends on identifying an issue early.

Because the analysis often depends on the tax treatment of group members and investors outside the UK, gathering the necessary information can take time. Education is often required, so that stakeholders understand why they are being asked for information and can provide an appropriate response. Building the review into the compliance cycle, well ahead of filing, avoids a last-minute scramble and the risk of a disclosure that cannot be properly supported.

Approval code: NTEH7062630