As INTM503010 suggests, the existence of a loan agreement is important. The agreement may be written or implied. If one exists, then the legal form is that of a loan, and the onus is on the UK company to convince the Inspector that the form should be ignored. Evidence to do so therefore needs to be very persuasive, and the company should be asked to provide reasons why equity was not injected in the first place. HM Revenue & Customs does not accept that cost saving is a valid reason for adopting a different legal form, for example, taking the form of a loan rather than shares to avoid stamp duty.
Although it is not a determining principle, one consideration is
the perspective of the foreign tax official dealing with an
overseas affiliate in deciding what amount of interest-bearing
debt, if any, the overseas company would have been able to obtain
at arm’s length. Note that this is done by reference to such
thin capitalisation rules as apply in the overseas territory (see
INTM570000 onwards), and the company
under enquiry will need to provide the evidence of the overseas
company's local regime.
Some countries have a formula ("safe harbour") to determine
the amount of allowable interest-bearing debt. If there are no safe
harbours, then the question is: what could the overseas company
borrow in its local market, from a third party lender, on a
stand-alone basis? This is effectively working a thin
capitalisation enquiry in reverse, requiring an understanding of
financial ratios such as
debt:equity ratio and
interest cover. Information on safe
harbour regulations can be obtained through CT & VAT,
International CT.
Remember that an equity function argument is not all-or-nothing.
It is possible that part of the transaction constitutes a loan upon
which interest should be imputed and part performs an equity
function. A lot of cases are settled on this basis. See
INTM503040 for some examples.
It is obviously a matter of judgement as to the sort of loan
which a company could have obtained from a third-party lender.
Sometimes the company may be able to provide evidence of an offer
of a loan from a bank, but this should be treated with caution.
Many banks are prepared to give some indication as to what they
would lend in a particular case, but they often include so many
reservations that the indication is worthless. Similarly, where it
appeared that a bank was not willing to lend, it would be useful to
know why not.
If there is an agreement to some 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 be deemed to be equity for future
years. Agreement should be obtained that the equity element should
form part of the subsidiary’s non-distributable reserves. The
UK company should self assess the imputation of interest for later
years by using the arm’s length standard, and bearing in mind
the negotiations that led to the imputation of interest for the
original enquiry year.
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).
It is necessary to agree an interest rate for the imputation of interest to an outward loan. 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 a suitable margin added to the
LIBOR rate, which is linked to the
base rate. There are various LIBOR
rates, for example 1 day, 1 week, 1 month, 3 months, or 1 year.
Generally loans will be medium term loans 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 and a LIBOR equivalent is
available around the world.
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. The margin may also be expressed in
basis points. The margin will depend
on the amount of the loan and the degree of risk. It is very
difficult to be prescriptive. The rate will generally allow the UK
lender to make a ‘turn’ or profit on the transaction.
It may be easier to work backwards from the cost to the lender of
providing the funds (costs of borrowing, administrative costs,
etc).
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 details of LIBOR, etc., rates, going back a number of years
and advise on suitable margins.
Once agreement has been reached in principle on the
imputation of interest, the company should 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.
A possible contention is that a lack of profits in the borrowing
company means that it cannot pay any interest. This is a relevant
consideration when examining the
amount that the company could have borrowed at
arm's length through the debt:equity ratio and interest cover.
There may, in fact, be sufficient income cover to pay the interest.
In other cases, overseas thin capitalisation rules may be based
purely on a safe harbour debt to equity ratio rather than a
consideration of the amount of interest cover. It is necessary to
examine the validity of the argument by looking carefully at the
use to which the funds have been put by the borrower. Have they
been employed in developing an asset, say, or used as working
capital? Is the use likely to be income-generating?
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.
