INTM502010 – Intra-group funding: practical issues

Practical issues in evaluating an arm's length return

When seeking to evaluate whether a lender has received an arm’s length return on its investment the first task is to establish that the appropriate relationship exists between borrower and lender.

Obviously, for a transfer-pricing challenge to be mounted at all, the company being examined must have the necessary relationship to the borrower, and though this may not be clear at the outset, it must be established straightaway. Unless the relationship between the parties brings them at least potentially within transfer-pricing rules, there is no point embarking on an enquiry on transfer-pricing lines. This may seem an obvious point, but experience suggests that it is worth mentioning. For the definitions of appropriate relationships for the purposes of the transfer-pricing legislation, see INTM560000 in relation to ICTASCH28AA for transactions on or after 1 April 2004 ( INTM432090 pre 1 April 2004), and INTM436030 in relation to ICTA88/S770.

Pointers to identifying potential non arm’s length loans:

• Examination of the accounts may reveal long-term or short-term loans between associated companies. These may represent formal loans based on written agreements with explicit terms or they may represent an accumulation of debts on trading account where payment is not demanded or even expected, either in the shorter or longer term. The latter may result in outstanding balances which have no formal status. These are de facto advances which may be vulnerable to a challenge on transfer- pricing grounds.
• Overseas borrowers may not be separately identified in the UK company's accounts. If the balance of group debtors is significant, run a quick check to see if the balances can be matched up with interest income such that a reasonable rate of return appears to be in place. If this is not clear, or if related interest income is absent, an analysis of these debtors should be requested, identifying the precise nature and longevity of the debts and the circumstances in which they arose.
• Loans to associated companies often arise in association with trading accounts. Balances due for goods, services, etc., provided by the trader to affiliates may build up without the pressure or obligation for repayment which would be present were the debt between parties acting at arm's length. In such circumstances the Inspector should seek to establish whether the credit is as a question of fact on ordinary commercial terms i.e. whether associated companies and third parties are subject to comparable credit terms. The period of credit and collection practices will vary, depending on the type of business. Once a debt from the associate has been outstanding for longer than would be acceptable in the case of a third party customer, it is arguable that the trading debt has become a loan. By not asking for the money back, the company is in effect advancing funds to the group debtor. Trade debts will usually be treated as short-term in the accounts of the trading company, but there may be a balance outstanding for a substantial period if the debt is rolled forward. The change in the nature of the debt may not be recognised in the account of the company and in some cases the company may even be unaware of the implications of granting favourable treatment to an affiliate. Since transfer pricing requires no motive test, it is irrelevant whether the arrangement is intentional or not. Also, with balances on trade account tending to fluctuate, the fact that it may be difficult to identify precise sums outstanding or the duration of the lending does not mean that the legislation applies any less to these 'informal' loans than it does to formal loans under written lending agreements. Pre 1 April 2004 the transfer pricing legislation only applied to cross border group loans.
• Intra-group loans within the UK may have been made or made at excessive interest solely in order to take advantage of brought forward reliefs in the lending company which would otherwise not be available until a subsequent accounting period, or at all.

There is a great deal of practical guidance on working downstream lending cases in the chapter on dealing with equity function arguments, from INTM503000 onwards. While that section is aimed specifically at cases where companies claim that outward loans to overseas affiliates are performing the function of equity, it includes much useful material on handling downstream lending cases generally.