INTM575030 - Thin capitalisation: working a case - the earliest stages: Risk assessment 3 - what to look for
Purpose of the borrowing
Schedule 28AA has no purpose test. It simply requires the arm’s length principle to be applied. It does not matter if the companies involved slipped into an unequal arrangement unthinkingly or unknowingly. It only matters that they found themselves there.
For FA96/SCH9/PARA13, which is used to challenge loans where there appears to be a purpose “which is not amongst the business or other commercial purposes of the companythe question of purpose is of key significance; the purpose of the borrower.
Transfer pricing is a one way street
Under Schedule 28AA, adjustments cannot be made or accepted by which transfer pricing adjustments are used to create a tax advantage for the taxpayer under scrutiny. Schedule 28AA is for undoing tax advantages.
The “would” test applies
ICTA88/SCH28AA/PARA1A(2) says that we take into account
- the amount of the loan,
- the interest rate and other terms, and
- the question of whether the loan would have been made at all.
“Would” means: (at arm’s length) would the lender have lent it and would the borrower have borrowed it? Both viewpoints must be considered.
Interest imputation - transfer pricing of outward lending
Is all the company’s outward lending on an arm’s length basis?
What has the company done with its surplus cash? Does the interest return appear low for the amount held by the company in cash and outward loans? Outward lending may be of an informal nature (only visible in high group debtor balances in the Notes to the Accounts), and it may be short-term. Balances with its own UK subsidiaries are relatively low risk, but loans to non-UK group companies, whether subsidiaries of the lender or not, may not be properly priced.
If an intra group loan to a UK company is creating a significant tax deduction in the UK, possibly not matched by an equal tax cost in the country where the interest is received, the global group has an efficient piece of tax planning in place, to which it may become attached. Ordinarily, a company with a significant debt burden might be expected to want to reduce that debt. It is worth looking closely at what the UK borrower is doing with any cash it accumulates: is it reasonable to suggest that some might be applied to pay down part of its debt, rather than holding on to it and getting a low return from, say, onlending to other group members? If it is reasonable to say that, acting at arm’s length i.e. in its own interests, the borrower would not have lent out the money but would have used it to reduce its own debt? If that is so then interest may be imputed on the outward lending to offset or cancel the detrimental effect which the arrangements have created. This possibility needs to be weighed against the fact that cash balances can vary through the year, depending on the commercial activity of the company, that all companies need to be liquid, to have sufficient working capital. One solution for the purposes of an Advance Thin Capitalisation Agreement (“ATCA”) is to impute interest on low-return outward lending to counterbalance the higher interest costs which the company is paying on the money it borrows, but perhaps setting aside a proportion of the cash held as working capital.
Companies may legitimately be part of group pooling arrangements, but can potentially be in the position of net lender to the pool, which means that the pool has moved from being a convenient arrangement to minimise group borrowing to being a case of outward lending.
Outward lending is an issue worth checking in the course of considering thin cap concerns, but of course outward lending may require examination even where there is no problem with the company’s own borrowing. However, interest imputation alone would not warrant an ATCA; it is a Profit & Loss Account issue. If a purely outward lending ATCA is presented and it has significance and complexity, it should be referred to the Transfer Pricing Team at Business International. The International Manual has advice on dealing with interest imputation issues such as the “equity function” argument (i.e. a loan from a UK company to an affiliate standing in for equity investment when the lender is not in a position to pay interest)(See Intra-Group Funding, starting at INTM500000)
Upward lending: loans from subsidiaries
Subsidiaries return profits to their shareholders in the form of dividends. If instead they lend the money back up the family tree, that creates a tax deduction in the computations of the UK parent. If the subsidiaries are located overseas, the UK group is incurring costs for the use of money that it in fact owns. Upward lending is inherently uncommercial, except where it represents the temporary lodgement of funds which will in due course be required by the lending subsidiary for a business purpose of its own. There is also the issue that surplus cash may be available before the reserves are recognised which would enable dividends to be paid up. Upward lending denies the strategic head of the group free access to the funds generated by group activities - if the money is lent rather than dividended up, the parent will be inhibited in its ability to invest permanently or very long-term in other ventures or assets.
This issue is pursued in more detail in the Intra-Group Funding module (INTM500000)
