INTM503040 – Intra-group funding: downstream loans - dealing with ‘equity function’ arguments

Equity function examples

In each of the following examples numbers have been used for illustrative purposes only, and in the limited circumstances of each example itself. They are not intended to indicate anything in the way of a safe harbour or formulaic approach in equity function cases. The UK approach is based upon the arm’s length principle, which considers what would have happened to a transaction if it had been performed between independent participators. Thus, each case needs to be considered on its own merits.

UKCo and OSCo

The year is 2002. A well-known UK group, UKCo, has had a 100% subsidiary, OSCo, in a European country for four years. There is a double taxation agreement (DTA) between the UK and the European country, with appropriate Articles on Associated Enterprises and Mutual Agreement.

It has come to the notice of the Inspector dealing with UKCo’s return that there is an interest- free loan from UKCo to OSCo. The Inspector has not previously enquired into this aspect of the return and there has been no indication in the returns that the loan was interest-free.

When the Inspector suggests that interest should be imputed on the loan from UKCo to OSCo, the agent contends that the loan is performing an equity function.

The European country does not have any safe harbours for thin capitalisation purposes, but its legislation broadly follows the OECD Transfer-Pricing Guidelines for Multinational Enterprises and Tax Administrations. That is, the thin capitalisation rules are determined in accordance with the arm’s length principle. The OECD Guidelines allow, in the case of loans made between connected parties, for the possibility that a loan transaction would not have happened at all between unconnected parties.

In general, the debt:equity ratio for businesses similar to OSCo’s is about 1.5:1.

Consider the position in each of the following variations on the equity function theme. In each case, the £40m loan from UKCo to OSCo was made in year one, at which time there were projections for OSCo’s business which have been shown to be broadly correct by subsequent events.

Example 1

OSCo has four years’ losses, a negative debt:equity ratio and no interest cover. Although it is within four years of start-up, so that a poor trading position might be expected while establishing a presence in the market, its future does not look good.

A third-party lender, having had to write off a £5m loan in year 2, would be highly unlikely to make a new loan.

The company appears to have been under-capitalised from the start. In the absence of any other relevant factors it is reasonable to suppose that OSCo would not have been able to obtain a loan from a third-party lender. Unless there are any other factors to the contrary, the Inspector should accept the equity function contention, but suggest that the position be formalised by converting the loan to equity. At the time the ‘loan’ was made, it looked like debt, but the sequence of events which followed may, at arm's length, have forced a recharacterisation of the loan as equity. A ‘wait and see’ policy would not be desirable.

Example 2

There is a third-party bank overdraft here, but it is small and the circumstances under which OSCo obtained it are not known. Perhaps the bank, knowing the UK group, is confident that any default by OSCo will be made good by the parent. Even if that is not the case, a loss by the bank of £20k will not be catastrophic. In the absence of other factors, the overdraft is not strong evidence of the ability to obtain third-party loans.

There is some suggestion that the company is starting to become profitable, but the debt:equity ratio and interest cover figures are poor. There may be something in the argument that OSCo is still in a start-up position, however. The Inspector should not accept completely that the entire loan is performing an equity function. If it could be agreed that £33m of the loan was a genuine loan and £7m equity, then the debt:equity ratio would be about 1.5. The poor interest cover might suggest that the amount to be reclassified as equity should be greater, but if projections for the company are that it will continue to increase its profitability over the coming years, it would not be correct to agree a permanent reclassification. In the circumstances, the Inspector would agree the £7m reclassification and no more, and that position would be maintained permanently.

The Inspector would look for a reclassification of part of the loan as equity, with interest being imputed at the arm’s length Euro rate on the remainder, and ask the agent to do the additional computations and submit an amended return. Previous years also need to be considered on the same basis.

Example 3

At £1m the bank overdraft is now rather more significant, but the conditions and terms under which it was granted need to be known before accepting that it is evidence of a genuine third- party loan.

At 1.86 the debt:equity ratio is high, but perhaps not unreasonably so. The general figure of 1.5 for similar businesses is likely to be an average of a range, and it is possible that the range includes OSCo’s figure. It will be necessary to pinpoint the position of OSCo within that range. The OECD Guidelines indicate that if, having made allowances for business differences, there is still a range of arm’s length values, then no adjustment should be made to a figure within that range. It has to be said, however, that with three years’ profits OSCo cannot in this case be said to be in start-up mode.

The interest cover figure is not good, but needs to be considered in the light of what would be expected by third-party lenders in OSCo’s circumstances. It looks as if OSCo is likely to have the means to repay the interest and capital of the loan.

In the absence of other relevant factors, the Inspector would contend that the whole of the £40m was a genuine loan, upon which interest should be imputed at the arm’s length Euro rate, and would ask the agent to compute the amount and make an amended return. Previous years also need to be considered.

Example 4

In this case there is a genuine third-party loan, although it is not large by comparison to the UKCo figure. OSCo can certainly demonstrate that it would have been able to obtain a loan from an unconnected entity. The debt:equity and interest cover figures do seem to indicate that OSCo could service its debts. The Inspector would reject a contention that any of the loan performs an equity function, request computation of imputed interest and an amended return. Previous years would also be taken into account.

UM Denmark

UM plc is a UK company with a 100% subsidiary, UM Denmark, and the following information is available.

In Denmark all interest paid to banks and other third parties, whether domestic or foreign, is deductible for tax purposes. Interest paid to a foreign parent or other affiliated company is deductible provided the rate of interest is not in excess of normal commercial rates. If a Danish company has debts to its foreign group company exceeding the debt:equity ratio of 4:1, the interest on the part of the debt exceeding the ratio may not be deducted for tax purposes.

UM Denmark started trading on 1 April 1998 and its accounting date is 31 December.

A loan of DKr11m (in sterling, at £1 = DKr11) was made to UM Denmark by UM plc during the early part of the accounting period ended 31 December 1999.

Projections for UM Denmark prepared in February 1998 are as follows:

The following is an extract from the UM Denmark Balance Sheet at 31 December 1998:

And the following is a summary of the Profit & Loss Account at 31 December 1998:

The UM Denmark accountant reports that the net loss for 1999 is expected to be DKr6m. On being asked about the loan from the UK he indicates that it is the company view that the loan is performing an equity function.

Salient points in the case:

The loan from plc was made in the first accounting period falling under Corporation Tax Self Assessment (CTSA), so there is no need to consider the wording of the UK/Denmark DTA. This is because the company must self assess its tax liability, and must do so in line with the current UK legislation, which requires the imputation of interest under particular circumstances. It cannot anticipate the outcome of any likely mutual agreement procedure. The company will have had to take a view on whether or not the loan was performing an equity function when completing its return. It does not, however, have to identify this specifically in the return, so the Inspector will need to be vigilant in examining the return.

When UM Denmark was set up it had a debt:equity ratio of 1:1 and healthy projections for both profit and cash flow in the medium to long term. There is little doubt that, even by the relatively conservative criteria that apply in the UK, it could have borrowed additional funds at the time it was set up.

Third-party lenders would tolerate debt:equity ratios which are outside the ‘normal’ range when a company is first set up. They recognise that a fledgling company may require a period of time in which to start to generate profits. Amongst other things, such lenders will look to see that the equity holders have committed a significant amount of their own funds to the venture, as a measure of their confidence and commitment to it. Importantly, they will also want to see realistic and justifiable projections of profit and cash flow.

In a start-up situation a third-party lender will have to rely upon the projections to assess the income cover position, and will question critically the assumptions upon which they are based. Projected losses in the early period of trading will not necessarily preclude a loan, provided the borrower is expected to bring debt:equity ratios and interest cover within acceptable levels within a reasonable period (typically 2-3 years). Having taken this view, the lender will review the situation if the borrower does not perform as expected.

UM Denmark made a loss in the period to 31 December 1998, but this was not out of line with the projections produced and the loss was effectively funded out of equity. On the basis of the original projections there would have been no cause for concern on the part of a third- party lender at this stage.

The position is different in 1999, however, for which the accountant reports an anticipated loss much greater than the projection. The loan from the UK was made early in 1999, and it is necessary to find out when in that year it became clear that performance would fall short of the projections, and why. It is also important to find out how the projections have been revised for 2000 onwards, and to understand the rationale for the revisions.

This information may influence the view on how much additional borrowing UM Denmark would and could have obtained in early 1999. However, the information about the thin capitalisation rules in Denmark suggests that funding criteria in Denmark are more liberal than in the UK. It seems likely that, unless something calamitous and lasting has affected the company’s results, UM Denmark would have been able to raise additional funds on the open market. This is evidence of what the Danish authorities might accept, though it is not conclusive for UK purposes.

The fact that a debt:equity ratio of 4:1 is acceptable for foreign group company debts for Danish tax purposes might form a basis of a calculation of the additional debt UM Denmark could have raised. Management accounts for the company at 31 December 1999, if available, would enable a calculation to be made of the amount of debt the company could have raised on that basis. If management accounts are not available, an examination of the position at 31 December 1998 might help. At that time there was already equity of DKr7m, so UM Denmark could easily have borrowed more than DKr5m – true whether one looks at total debt or just at foreign group debt.

In this case, the conclusion would be that the absence of compelling reasons to do otherwise interest must be imputed on the full amount of the loan from UM plc from the time it was made. The interest is taxable on the accruals basis under the UK loan relationship legislation.

On the basis of the original projections, and the fact that UM Denmark is servicing its third- party debt, the argument that the Danish company cannot pay the interest is unacceptable. Enquiries would be worthwhile to establish whether the company proposed to fund its losses through further borrowing.

The question of the rate at which interest is to be imputed remains. Since the loan was made in Sterling, the calculation would be made by reference to Sterling interest rates rather than by taking the rate of 10% charged by the Danish bank on its DKr11m. There is a certain amount of risk involved in lending to start-up companies, so a rate of LIBOR plus a margin which adequately reflected the risks would be appropriate.