INTM503010 - Intra-group funding: downstream loans - dealing with ‘equity function’ arguments

Background

Application of the UK legislation to outward investment

HM Revenue & Customs has always taken the view that an outward loan made by a UK person to a connected party is a business facility, and therefore subject to review under the transfer- pricing legislation.

For accounting periods ending before 1 July 1999 the relevant legislation was ICTA88/S773(4) (‘the old code’), which can be used to impute an arm’s length rate of interest to the lender. The case of Ametalco UK and Ametalco Ltd v CIR (1996 SpC94) supports this view (see INTM501040).

For accounting periods ending after 30 June 1999 the legislation at ICTA88/SCH28AA applies (‘the new code’). It is broadly analogous to Article 9 Of the OECD Model Tax Convention, which covers ‘commercial and financial relations’ between two enterprises and therefore applies to the provision of funding (see INTM501020).

For accounting periods commencing on or after 1 April 2004 ICTA88/SCH28AA is extended to UK/UK transactions (see INTM560000 onwards).

Equity function representations

A UK lender company may suggest that a downstream loan fulfils an ‘equity function’ in the accounts of the borrower. That is, that although the company may have funded a subsidiary using a loan rather than, for example, share capital, the loan performs the same function as equity. The contention is that there should therefore be no imputation of interest.

There are some limited circumstances under which HM Revenue & Customs will accept such a contention. It is important, however, that careful consideration be given to each case, since acceptance that a loan performs an equity function means that it continues to be treated as equity thereafter. Once agreed, this acceptance should apply equally to the lending company, so that the amount is consistently treated as equity and not repaid in a later period.

HM Revenue & Customs response to an equity function argument

The starting position of HM Revenue & Customs is that if the facts and circumstances of a case indicate that the downstream investment by the UK company is in the form of a loan, it should be treated as such for tax purposes. Thus, for example, where there is a loan agreement document or other written understanding, or where the respective accounts of the parties treat the investment as a loan, then it is a loan, and it is for the lender to demonstrate the contrary.

Under the old code HM Revenue & Customs only gives consideration to the equity function argument under particular conditions

• there must be a double taxation agreement (DTA) between the UK and the country of the borrower
• the DTA must contain suitably worded articles on Associated Enterprises and Mutual Agreement Procedures. For the Associated Enterprises Article the appropriate wording allows for adjustments to profits that may be made for tax purposes where transactions have been entered into between associated enterprises (parent and subsidiary companies and companies under common control) on other than arm's length terms. The wording of the Mutual Agreement Procedures Article simply needs to provide for a mutual agreement procedure to be in place. (See INTM470010 on the MAP process)

HM Revenue & Customs accepts that, for pre-CTSA periods, an equity function argument can succeed if

• the UK had imputed interest on the loan under ICTA88/S773(4), and
• the mutual agreement procedure in the DTA had then been invoked, and
• the respective Competent Authorities would have agreed that the imputation of interest on part or all of the loan was not appropriate because part or all of the loan could not have been obtained at arm’s length.

Effectively, this means that the foreign tax authority was likely to disallow a deduction for the interest on thin capitalisation grounds, leading to a reversal of the UK imputation of interest at the ‘corresponding adjustment’ stage. The UK therefore does not proceed with the original imputation of interest in such circumstances.

The above conditions apply because HM Revenue & Customs will only depart from documented fact if the governing DTA provides for the possibility that the parties intended for a different economic substance. CT & VAT, International CT will only entertain the ‘equity function’ argument if there is a possibility of ceding the issue via Mutual Agreement Procedure (MAP) (see INTM470000 onwards on MAP).

An Inspector working a case needs to be reasonably sure that the above position applies before accepting an equity function argument. It is also clear that such an argument should never be accepted if the borrower is situated in a territory which does not have an appropriate DTA with the UK.

Under the new code Self-Assessment obligations apply. The UK lender must make a judgement concerning the equity function argument. The decision may be that the borrower would not have been able to obtain loan finance, resulting in a corresponding Self Assessment. That decision is open to enquiry in the normal way, with the appropriate documentation requirements applying (see INTM433000 onwards).