CTM15502 - Distributions: general: interest or other value in respect of securities - reasonable commercial return
ICTA88/S209 (2)(d), (3A), (3AA), ICTA88/S209A & ICTA88/S209B
ICTA88/S209 (2)(d) imposes a once and for all test at the time of the issue of the security to determine whether the return to the lender represents a reasonable commercial return.
The test
- Looks at the facts at the time of the issue of the security. There is no scope for considering later unforeseen events. If market interest rates at the time of issue were high and the security was issued at rates which were commercially reasonable at that time, it is not appropriate to reconsider the application of ICTA88/S209 (2)(d) simply because market rates subsequently became lower.
- Looks solely at the position from the point of view of the lender and will include the element of risk present in making the investment in the security.
- Is whether or not the return is commercially reasonable for the use of the principal secured. The test is the rate for the use of the money not the rate which is commercially justified for the overall transaction. The overall transaction might include consideration for other aspects, but the additional consideration is not a factor in considering the reasonableness of the return.
Risk
Risk is an essential element in considering whether or not the rate of return is commercially reasonable. It is inappropriate to consider that a certain interest rate represents a reasonable return at that time in all cases, because the amount of risk will vary according to the terms of each security.
A major factor to be considered is the risk the lender will not receive back some or all of the money invested. A security with low risk factor, such as government bonds, will pay a low rate of interest. In contrast, a security where there is a high risk of the investment not been repaid will need to pay a high rate of interest in order to attract investors.
The degree of risk associated with a security is a question of fact but it can be a complex area. In cases of difficulty, you should consult a Revenue Accountant for advice on whether the rate of return is commercially reasonable.
Replacement securities
If, at a time when market rates had decreased, a borrower issues new securities on the same terms as securities issued earlier, ICTA88/S209 (2)(d) might apply. ICTA88/S209 (2)(d) would apply to the amount of interest paid above that which would be commercially reasonable for a similar security issued at the time of the new security.
Reasonable commercial return: premium on early redemption
A company may borrow on a commercial basis such that, if the loan had run its full term, no distribution would arise. Because of movements in interest rates, the borrower may want to repay the loan early. If in such a case the borrowing company pays a premium on early repayment calculated on a commercial basis and both the lender and the borrower do not take distribution treatment, the Revenue will not seek a distribution.
You should take a broad view of what is a reasonable commercial return once the principal secured has been established if ICTA88/S209 (2)(da) and (e) do not apply, and
- the consideration for the use of the principal is mainly interest, and
- the interest is paid regularly, and
- the company pays the interest to a company or companies which are within the charge to CT and which treats the interest as income chargeable to CT.
Issue of securities by intermediaries
Some issues are made by borrowers through merchant banks or other institutions (sometimes described as managers), who pay a premium on issue to the borrower but then reissue the security on to the market, usually at a discount to the nominal amount.
Although it seems that the managers are paying more than they will receive, the issue premium in these cases can reflect the way in which the managers are rewarded for arranging and underwriting the issue. A pointer to this arrangement will usually be the existence of a single manager with arrangements for reissue to a number of third parties, who are the ultimate lenders providing funds to the borrower.
In such cases, interest or other distributions may be no more than a reasonable commercial return for the use of the principal secured and, if that is so, ICTA88/S209 (2)(d) will not be at point.
Reasonable commercial return: distributions before 1 April 1996
For distributions before 1 April 1996, ICTA88/S209 (2)(d) can apply to an issue on the market between unconnected parties if the issue is made at a premium, and that issue premium is not reflected in the amount that the borrower must pay on redemption or conversion.
The situation is explained by the following example. Consider the case of a security with a face value of £100, which is also the amount payable on redemption. It is issued on the same terms as an earlier issue and cannot be separately identified. In the case where market rates have moved downward since the earlier issue, the later securities are being issued at a higher rate of interest than securities being issued at the same time by other borrowers.
An arms length lender would be prepared to pay a premium for this security and subscribe £102, even though the security will pay only face value of £100 on redemption. The lender is prepared to pay the premium because he will receive a higher rate of interest than represents a reasonable commercial return for the use of the principal secured of £100. A distribution arises under ICTA88/S209 (2)(d) on any excess return calculated by reference to the face value of £100 and not by reference to the amount subscribed of £102.
Reasonable commercial return: distributions on or after 1 April 1996
ICTA88/S209 (3A) provides that for ICTA88/S209 (2)(d) purposes, the reasonable commercial return for the principal secured by a security is treated as the sum of:
- a reasonable commercial return for the use of the principal, and
- a reasonable commercial return for the use of the premium.
In contrast to the position prior to 1 April 1996, the premium is now taken into account in determining a reasonable commercial return. The change was introduced because the premium is treated as income from the borrowing companys loan relationship and consistency of treatment demands that the interest should be a deduction.
In some circumstances where the new consideration exceeds the principal secured, that new consideration is treated as the principal secured under ICTA88/S209 (3AA) and ICTA88/S209 (3A) has no effect.
In most cases where ICTA88/S209 (3AA) operates, the result will be the same as if ICTA88/S209 (3A) applied. However, ICTA88/S209 (3AA) does not require the test of a reasonable commercial return to be applied separately to the principal secured and to the premium.
Reasonable commercial return: distributions on or after 17 April 2002 where the principal secured is less than the amount invested - ICTA88/S209 (3AA)
When ICTA88/S209 (2)(d) came into force, it did not cater for cases where the amount loaned exceeded the amount of capital repaid on redemption. With the exception of securities issued at a premium, such securities were rare. Financial institutions then developed new types of securities where there was no premium but where the amount guaranteed to be repaid on redemption could be much smaller. Such securities often reflect the value of assets or an asset index.
An example would be securities issued as ‘tracker funds’ designed to mimic the performance of the Stock Exchange. The securities may be sold to investors wishing an investment with the returns of the FTSE100. The investor hopes the FTSE100 index will rise in value, but the value of shares can fall. In such circumstances, the principal secured could fall to below the amount invested and might even become negligible.
Consider the case of £100 invested in a normal FTSE100 ‘tracker fund’. The return will be an amount commercially reasonable for that investment of £100. This is because the constituent shares are freely traded on the open market and the returns reflect the risk of holding such shares plus the dividends received on them. But ICTA88/S209 (2)(d) requires the test of commercial reasonableness to be measured against the principal secured, not the amount invested. The principal secured will be negligible because, in theory, the shares might lose almost all their value; any return on such a negligible principal would inevitably constitute more than a commercially reasonable return.
ICTA88/S209 (3AA) applies for returns on investments on or after 17 April 2002 in certain circumstances where the principal secured is less than the amount of the new consideration. It operates by treating the amount of principal secured for the purposes of ICTA88/S209 (2)(d) as increased so that it equals the amount of new consideration. The effect is that for this kind of security, the test of commercially excessive interest applies by reference to the amount invested. It makes it less likely that interest will be re-characterised as a distribution.
The provision can apply to securities issued by any kind of company but, in practice, it will usually be relevant only to financial institutions such as banks and securities houses because other companies are likely to fall outside the conditions of ICTA88/S209A and ICTA88/S209B - see CTM15503.
