The arm’s length principle, as embraced by Schedule 28AA ICTA 1988 and enshrined in OECD guidance (see INTM432010 et seq.), applies to the lending and borrowing of money in the same way as it applies to the purchase and sale of goods and the provision of services. At arm’s length lenders expect a commercial return (interest, typically) for allowing someone else the use of their money, and they expect the level of the return to take into account the risks involved in handing over their funds. There are sound commercial reasons why lending takes place between members of a group of companies, reasons of money management, the advantages of negotiating centrally with a third party lender, benefits of running treasury functions "in-house", etc.
Article 11, the Interest Article of the OECD Model Tax Treaty says that:
Where, by reason of a special relationship between the payer and the beneficial owner or between both of them and some other person, the amount of the interest, having regard to the debt-claim for which it is paid, exceeds the amount which would have been agreed upon by the payer and the beneficial owner in the absence of such relationship, the provisions of this Article shall apply only to the last-mentioned amount. In such case, the excess part of the payments shall remain taxable according to the laws of each Contracting State, due regard being had to the other provisions of this Convention.
Nothing is said about other factors such as the reasonableness
or otherwise of the debt itself and in practice those words allow
only a consideration of whether the interest is at market rate.
However, many UK double taxation agreements have modified wording,
which allow other features than simply the interest rate to be
taken into account, and which takes account of the problem of thin
capitalisation.
ICTA88/S808A was introduced in order to put on the statute HM
Revenue & Customs' understanding of how the special
relationship provision worked. The section applies when a UK treaty
has an Interest Article which has been modified as described above.
The section then specifies that all factors should be taken into
account in determining whether the interest is excessive and, in
particular, the amount of the loan (or whether a loan would have
been made at all without the special relationship), the rate of
interest and other terms that would have been agreed upon if no
special relationship existed. 808(2) requires that the special
relationship provision shall be construed as requiring account to
be taken of all factors, including-
As with transfer pricing generally, it is genuinely difficult to
arrive at a rate of return on a loan or advance to an affiliated
company which equates to an arm's length return. For a third party
lender, there are considerations of risk (relating both to the
credit-worthiness of the borrower and the purpose of the loan),
length of term, nature of any security or guarantee, ever- changing
market rates, etc. The reason for making transfer pricing enquiries
in relation to loans or advances is to establish whether there are
terms which you would not expect to find if the transaction had
been carried out between two independent persons. This might be,
most obviously, an uncommercially low (or nil) interest rate or
complicity in late or non-payment.
Where there is a tax motive to the transfer pricing, it may
be more straightforward for multinational groups to reduce UK
taxable profits by means of financial transactions than by the
pricing of goods, services etc. Lending to overseas affiliates is
relatively cheap and easy to set up. A single loan agreement which
grants the UK lender less than an arm's length return will initiate
a possibly long-term, regular series of transactions on
uncommercial terms which transfers funds out of the UK and denies a
commercial reward for their use. Effective outward lending which is
disadvantageous to the UK may even be achieved simply by the UK
company not collecting debts from group debtors overseas for
trading or other transactions. Whatever the means, the UK lender
foregoes the benefit of its own funds - not having them available
for trading expenses, investment, research, etc. - yet is denied a
commercial return on the use of its money. When a UK company lends
to a connected party overseas, we look to see what sort of terms an
independent financial institution might apply if it were the
lender, having regard to all the circumstances. We also look at the
other end of the transaction: what a prudent borrower at arm's
length to the lender would do: would they borrow the money at all?
A lesser sum? Would the terms suit them? Would they alternatively
seek new investment? It is a question both of whether, as
independent parties, the lender and borrower
could have entered into such an arrangement and
whether they
would do so. Even if the borrower could manage to
borrow "to the hilt", would they in reality have done so?
The current transfer-pricing code at ICTA88/SCH28AA and the
previous code at ICTA 1988/S770 to S773 both extend beyond the
purchase and sale of goods to transfers of intangible rights, hire
charges, management expenses, provision of finance, and the like.
ICTA88/S770 was extended in its scope by means of ICTA88/S773(4),
which brought transactions involving the letting of property,
intangibles, services and other business facilities within the
scope of ICTA88/S770. This includes loans and similar arrangements,
as explained at
INTM501040. ICTA88/SCH28AA is more
widely drawn than ICTA88/S770 so that outward investment falls
within the scope of the main transfer-pricing code without the need
for additional provisions.
Where investment is made by way of a loan, there are a number
of different ways to arrange terms to disadvantage the UK from a
tax point of view
It is important to note that with effect from 1 April 2004 the transfer pricing legislation at ICTA88/SCH28AA applies to intra-UK as well as cross border funding (See INTM560000).
