CFM9815 - Taxing forex: special rules: debtor relationships - Sch 28AA applies

Forex and transfer pricing (ICTA88/SCH28AA)

Where, before 1 April 2004, a UK company pays excessive amounts by way of interest or discount to an overseas affiliate, ICTA88/S209 (2)(da) will apply in many cases (see CFM9810). Where, after 1 April 2004, a UK company is thinly capitalised, ICTA88/SCH28AA/PARA1A will apply to restrict the interest deduction. In some pre 1 April 2004 cases S209 (2)(da) does not apply, but the transfer pricing provisions in ICTA88/SCH28AA are applicable.

Tax Bulletin 37A gives an example of where SCH28AA might apply before 1 April 2004 - where the overseas affiliate provides indirect debt funding to a thinly capitalised UK company, by giving a guarantee to a bank which would not otherwise have lent to the UK company. See TB37A to read the article

In summary, Sch 28AA applies where:

• provision has been made between two persons (provision includes the making of a loan, although it goes far wider than this), and
• one of the affected persons participates directly or indirectly in the management, control or capital of the other, or some third party participates directly or indirectly in the management, control or capital of each;
• the provision is on non-arm's length terms, and
• it confers a potential UK tax advantage on one or both persons.

The legislation therefore could be very wide-ranging, but it is limited by ICTA88/SCH28AA/PARA2, which ensures it does not go wider than the formulation of the arm's length principle in Article 9 of the OECD model.

Where a transfer pricing adjustment would disregard all of the profits or losses on a debtor loan relationship, any exchange gains or losses arising on the debt are also wholly disregarded under FA96/SCH9/PARA11A(1).

Where the adjustment disregards a proportion of the profits or losses on the debt, the same proportion of exchange gains and losses are disregarded.

Profits and losses go wider than merely interest, but it does not include exchange gains and losses. ICTA88/SCH28AA/PARA8 stops the transfer-pricing provisions from applying to exchange gains and losses on loan relationships, thus preventing double counting.

Not every debtor loan relationship that is not on arm's length terms will come within Sch 28AA. In particular, Sch 28AA will generally not apply to an interest-free or low interest inward loan, because there is no UK tax advantage. See CFM9815a.