INTM544050 - Thin capitalisation: interest as a distribution - ICTA88/S209(2)(da) (repealed)

Factors to be taken into account when considering whether ICTA88/S209(2)(da) applies: ICTA88/S209(8C)

S209(2)(da) has been repealed with effect from 1 April 2004 as explained at INTM560000 but continues to apply to interest payments made before that date.

The first factor to consider is whether there is the necessary relationship between borrower and lender for ICTA88/S209(2)(da) to apply. See INTM544040 for details.

Where the necessary relationship is present, the Inspector then has to consider whether a return on a security is excessive for the purposes of ICTA88/S209(2)(da). It is only the amount of the excessive interest, if any, which can be re-characterised as a distribution under the provisions of ICTA88/S209(2)(da).

The factors to be taken into account in deciding what amount of interest is excessive are set out in ICTA88/S209(8B) and are as follows:

• could the borrower have borrowed all or part of the sum in question at arm’s length, i.e. leaving aside the relationship with the borrower?
• would the borrower have borrowed all or part of the money at arm’s length, in the absence of the shareholding relationship with the lender?
• what rate of interest and other terms would the loan attract at arm’s length?

In determining whether the sum in question '‘could'’ have been borrowed at arm’s length the legislation in ICTA88/S209 provides that in certain circumstances the UK borrower may be regarded as part of a larger borrowing unit.

It is important to note that the legislation allows an Inspector to consider not only whether the sum in question '‘could'’ have been borrowed at arm’s length but whether it '‘would'’ have been borrowed at arm’s length. It may well be that a UK company has spare borrowing capacity but has no commercial need for additional borrowing. Often it will be quite clear in a particular scenario that a UK borrower needed the funds in question, perhaps for a corporate acquisition or to acquire an asset, or to repay existing debts and borrow at more favourable rates from fellow group companies or to provide additional working capital. However, there may be no specific purpose for the making of a particular loan, or the stated purpose may be rather nebulous. In such circumstances Inspectors should be prepared to test the reasons given for taking on additional interest-bearing debt. If the UK company has a genuine commercial need for additional funding this should have been identified by the directors and the sums involved should have been quantified. The company may also have considered whether to raise the additional funds in the form of equity, and may have compared the terms of the funding provided by a fellow group company with those available from by third party lenders. If so, there should be documentation to demonstrate all of this and Inspectors should be prepared to request this in appropriate cases. The company may have taken such steps to demonstrate that the group borrowing is on an arm’s length basis.

It is also important to consider the capacity of the UK company to meet its own funding requirements; if perhaps it has surplus cash or valuable investments which it does not need to carry on its business. In such circumstances it may be possible to argue that at arm’s length the company would have met its funding needs differently and may not have borrowed, or may have borrowed a lesser sum.

In considering whether the rate of interest and other terms of the loan are arm’s length, bear in mind factors such as:

• the length of the loan. Can the borrower demonstrate a need for funding over the period envisaged in the loan agreement?
• the capacity of the borrower to make early repayments of loan principal. Most third party loan agreements contain provision for the borrower to pre-pay part or the entire loan principal if circumstances permit. There may be early redemption penalties in such circumstances, but in an arm’s length arrangement the borrower would want the flexibility to pay down debt if he should choose to do so. Remember that a company needs to be able to pay its interest costs and also to reward its shareholders. Where its shareholders and loan creditors are distinct (as would usually be the case at arm’s length), it needs to ensure that there will be sufficient profits after interest costs to meet the shareholder’s expectations as regards dividend payments, as well as to make investments and meet other contingencies. These factors are of course less important where the shareholder and creditor are the same person, but an Inspector is required to have regard to what would happen with an arm’s length creditor.
• the interest payments. Has the intra-group funding replaced a bank loan from a third party where the rate of interest was lower? If so, prima facie the new borrowing is not on arm’s length terms. How does the rate on the intra-group funding compare with third party rates for similar funding, especially rates on third party advances to the particular borrower?
• the fact that most companies will have a mixed debt profile, including a short-term, possibly revolving facility with flexible payment in and out, as well medium to long- term debt linked to major items expenditure. Terms should be appropriate to the nature of the debt.