INTM503050 – Intra-group funding: downstream loans - dealing with ‘equity function’ arguments

Issues affecting equity function cases

Safe harbours

The UM Denmark example at INTM503040 contains an example of a ‘safe harbour’ with respect to thin capitalisation. Some countries, even while adopting the arm’s length principle for transfer-pricing purposes, do have safe harbours when it comes to thin capitalisation cases. In such cases, the thin capitalisation rules do not apply if the debt:equity ratio of a company does not exceed a prescribed value. If it does, it is still open to the company to argue that its ratio conforms with the arm’s length standard.

The thin capitalisation practices of the particular country are one indication in the consideration of an equity function case, and details should be obtained whenever an enquiry is started. However, this is not a determining factor and it is the arm’s length principle which applies. The company contending that a loan performs an equity function, or its agent, should provide the Inspector with the relevant information. If there is difficulty in doing this, CT & VAT, International CT may be able to help.

Foreign legal restrictions

Some countries may have restrictions on the way in which foreign investment can take place within their borders. For example, it may be a legal requirement that certain types of companies must be majority-owned by residents, or there may be government regulatory requirements. This may give rise to investment from the UK which is a mixture of share capital and an interest-free loan, and the UK company may contend that the loan performs an equity function because it is prevented from subscribing the entire amount in share capital owing to the legal restrictions. In such a case HM Revenue & Customs’s position is, as indicated above, to start from the legal form of the investment: if it is legally a loan, then that is the basis for the tax position. However, the circumstances are sometimes not clear cut, and a judgement may need to be made in the light of all the facts. If help is needed, CT & VAT, International CT will try to assist. . Members of CT & VAT, International CT are happy to discuss cases on the telephone, but may request a more formal submission if some thought needs to be given to a case. A submission constructed according to ADM6.109 ensures the best service.

The above example is just one in which foreign legal requirements may potentially affect the UK tax position, and it is not possible to list them all. In each case, the Inspector needs to make a careful judgement based upon the facts.

Capital contributions

The company law provisions of some foreign jurisdictions, notably the USA, allow for the making of capital contributions to companies. A capital contribution is a contribution to the equity capital of a company. It is not a loan and creates no obligation to transfer economic benefit to the maker of the contribution.

In the UK there is no company law provision regarding capital contributions. If a UK company receives a capital contribution it is normally reported within shareholders’ funds. If it makes a capital contribution it will normally be included in the accounts as an added cost of investment in a subsidiary.

If a UK company contends that a sum paid to an overseas affiliate is a capital contribution rather than a loan, HM Revenue & Customs can only accept the contention if there is evidence supporting it. For example, there should be a written agreement that a capital contribution has been made rather than a loan, and evidence of the appropriate treatment in the company accounts. If there is a possibility that the money can be repaid, it is a ‘money debt’ under the loan relationships legislation. It is necessary to examine all the circumstances surrounding the money transfer before making a decision. From HM Revenue & Customs’s point of view, the amount contributed should not be distributable.

For the chargeable gains aspect of capital contributions see CG43500 onwards, and for the loan relationships aspect of capital contributions see CT12120 onwards.

For the treatment of foreign exchange losses where an equity function argument is in point see CT13894. The Corporate Finance Manual describes the workings of FA93/S136 - at CFM9820 - and then goes on to discuss the changes to the rules brought in by FA2002.