OT22009 - Interest and Financing

OTO Commentary. Replacement and Transferred Borrowing.

Just as borrowing to pay interest would not qualify under S494, it is arguable that if a company re-schedules its debt and borrows money which it uses to replace an earlier borrowing, perhaps because better terms are available, the money borrowed has been used to refinance an earlier loan rather than to "meet expenditure incurred by the company in carrying on oil extraction activities ...". There is no specific rule for S494 (as there is, for example, in s354(1)(c) ICTA) which treats a loan taken out to repay an existing qualifying loan as itself qualifying. Where, however, the new loan is on broadly similar terms to the old one and there is no significant increase in the interest payable, so that in substance the borrower’s position has not changed, the Inspector will not apply this literalist interpretation, but should accept that the interest continues to qualify for a deduction. If in these circumstances it is considered that the level of the debt is excessive, the Inspector will only challenge it on grounds that would have applied had the original loan remained in place. The mere fact of re- financing will not be treated as additional grounds for challenging the level of the debt.

On the other hand, the terms of the loan may be changed significantly with the result that additional interest will be payable. Examples might be because the interest rate is increased or the term extended beyond the term of the original loan. This is a change of substance to the company’s financing arrangements. In those circumstances it may be appropriate, depending on the facts of the case, to restrict the interest deductions on the new loan to what would have been allowed under the original debt. The Inspector will refer the papers to the Assistant Director to consider whether this is the approach to be taken once the facts and background information have been established.

The foregoing paragraphs cover the situation where there is a change of creditor. It can also happen that an existing loan is taken over by a new debtor. This may happen, for example, where an asset and its associated funding are transferred between two group companies. Interest is deductible under s494 only where money borrowed by the company is used to meet expenditure incurred by the company. So on a strict reading the loan will not qualify in the new debtor’s hands merely because it was originally used to meet qualifying expenditure by the previous debtor. The loan will only qualify in the new debtor’s hands to the extent that the new debtor can be shown to have borrowed money and used it for a qualifying purpose in acquiring the assets taken over from the previous debtor. Here the potential difficulty for the new borrower is that under s494(2)(a)(i) expenditure on acquiring oil rights from a connected person does not qualify.

Again, if there is no change to the substance of the financing arrangement, the Inspector should not apply this literalist interpretation. The mere fact that the loan has been transferred should not be treated as preventing the loan from continuing to qualify under s494. On the other hand, if there is any change of substance that could result in the new debtor obtaining more interest relief than the previous debtor would have obtained, it may be appropriate to restrict the ring fence interest deduction. Again this is a matter the Inspector may refer to the Assistant Director.