The loan agreement
Counter arguments
Interest rate
Taxation of interest
The lack of a formal loan agreement in no way proves that no loan exists. Most intercompany loans will be documented in some form or another, but companies not at arm's length may not consider it necessary to write down the terms between them. A loan agreement is useful to strengthen HM Revenue & Customs’s case for asserting that a loan exists but it is not essential, and an agreement may be written or implied, perhaps no more than a tacit agreement that the lender will not pursue an outstanding sum for an unspecified time. If the loan agreement exists, it should be obtained and reviewed, and it should be established whether its terms have been honoured in practice. Self Assessment gives HM Revenue & Customs the opportunity to request that the lending company demonstrate that the arm’s length standard has been applied in relation to downstream lending and to provide supporting documentation (see INTM433000 on record-keeping obligations under CTSA Self Assessment).
Equity function
The chapter which follows this one (
INTM503000) is devoted to the
representations which may be made on behalf of a UK lender that a
downstream loan fulfils the purpose of equity capital in the hands
of its subsidiary.
That the loan is on arm's length terms
It is obviously a question of judgement to determine to what
extent and in what form the borrower could or would have borrowed
from a third-party lender. The borrowing company may be able to
provide evidence of willingness on the part of a third party bank
to make a loan, but such evidence should be assessed critically.
There may be a world of difference between a bank merely offering
an opinion on what it would be prepared to lend and putting a real
commitment on the table.. Hypothetical offers may also be
influenced by the prospect of parental company or cross-affiliate
guarantees, or even simple the presence of a large and
credit-worthy multinational looming reassuringly in the background.
The presence of these less tangible influences on a potential
lender may not always be apparent. The Thin Cap/Arbitrage Group at
CT & VAT, International CT will be able to help in assessing
such documents.
If there is an agreement with HM Revenue & Customs to the
imputation of interest it will be necessary to agree on the amount
of interest payable (see
INTM503040). Any amount of the loan
that is treated as equity will continue to be so treated for future
years. Once the issue is settled, the company should self-assess
the imputed interest year-on-year in accordance with the terms
agreed. Where a transfer pricing computational adjustment is made
in an accounting period commencing on or after 1 April 2004, the
group company that is party to the transaction may be entitled to
claim a compensating adjustment (see
INTM562040 for details).
The company may argue that the borrower is generating insufficient profits to allow it to service the loan. This is a contention that should be tested. It is important to consider how the transaction is treated in the accounts of the borrower but this is not a determining factor. Since interest is taxed on the accruals basis, it no longer matters whether interest is actually received or not, but the 'can't pay' argument may lead to a contention from the group that the loan is performing an equity function, in which case see INTM503010 et seq.
If interest is to be imputed on a downstream loan, an interest rate must be agreed. The rate will be determined by
UK lenders may lend at a fixed or a variable rate. If the loan
is in sterling, then it may well use the
LIBOR sterling rate (this is linked
to the
base rate). The interest rate may be
expressed in
basis points. A basis point
represents one hundredth of a per cent. Thus fifty basis points
will equal half a per cent. There are various different LIBOR
rates, including 1 day, 1 week, 1 month, 3 months, or 1 year. The
rate chosen should be appropriate to the duration of the loan.
Generally loans will be medium-term, and a 3-month or 1 year LIBOR
rate will be acceptable. The rate should reflect the duration or
renewal terms of the loan.
LIBOR and other inter bank rates are available for a variety
of currencies, LIBOR itself being available in the currencies
quoted in London. There is no necessary geographic link between a
banking centre and currency (i.e. LIBOR does not = £).
Variable rates for Euro borrowing are generally set by reference to
EURIBOR.
Third party lenders will add a margin to the variable rate,
LIBOR + 1%, for example, so that the actual rate is always one per
cent above the reference rate. LIBOR thus acts as a benchmark. The
margin will depend on the amount of the loan and the degree of
risk. It is very difficult to be prescriptive. If, once agreement
has been reached in principle that interest should be charged,
there is difficulty in setting and agreeing an appropriate rate, CT
& VAT, International CT can provide detail of LIBOR, etc.,
rates, going back a number of years and advise on what rate might
be appropriate in the particular circumstances of the case. Much
data of this sort is now freely available on the internet.
The company should be expected to prepare and submit the
interest calculation itself, as part of the revised computations.
Definitions of the words highlighted above may be found in
the finance glossary at
INTM539000.
Under FA96/SCH9/PARA16, interest imputed under UK transfer-pricing legislation is chargeable as it accrues. The loan relationships legislation provides that where the borrower and lender are connected parties there is no deviation from the accruals basis. For persons and periods covered by this legislation the full amount of interest is assessable regardless of whether or not it is received. This legislation has been in force since 1st April 1996. For earlier periods see INTM501060.
