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HMRC internal manual

Company Taxation Manual

Distributions: general: securities within CTA10/S1015(4)

CTA10/S1000 (1) F and CTA10/S1015 (4) treat as a distribution all interest or other distribution under securities where the consideration given by the company for the use of the principal secured is to any extent dependent on the results of the business of the company or on any part of the business.

The provision is aimed at securities that allow the subscriber to participate in the company profits. The legislation ensures that the company does not get a deduction for interest in computing CT profits if the interest is a distribution of profits. It will apply even if the consideration does not exceed a reasonable commercial rate, although CTA10/S1032 disapplies this legislation in some circumstances.

The provision relates to the ‘results of the company’s business’. ‘Business’ has a wider meaning than ‘trade’ and can, for example, relate to the asset performance of an investment company.

‘Results’ has a broader meaning than ‘profits’ and consideration varying with gross receipts or rental receipts would reflect the results of the business.

The provision of CTA10/S1015 (4) is broad in its potential because it applies to consideration which is ‘to any extent dependent’ on the results of the business or on any part of it. The provisions of CTA10/S1015 (4) would apply, therefore, in circumstances where only part of the business results were to any extent reflected in the consideration paid under the security. For example, a security issued by a company whose terms to some extent reflect the performance of some of its assets may fall within the provisions of CTA10/S1015 (4). However, a purposive approach should be adopted in applying the legislation. It is aimed at what are really equity risk returns dressed up as interest and should not be applied blindly. CTISA (Technical) will advise in cases of difficulty - see ‘Technical Help’ on the left bar.

Some alternative finance arrangements involve profit sharing agreements. If the alternative finance arrangement meets the conditions of CTA10/S1019 (see CFM44100) the provisions of CTA10/S1015 (4) will not apply and, accordingly, the profit share return paid by the company will not constitute a distribution.

Particular circumstances: examples

The way in which CTA10/S1015 (4) applies may be illustrated by the following examples.

Limited or non-recourse loans

A limited or non-recourse loan is one where the lender’s rights to recover interest and/or capital do not extend to all the assets of the business, and so the lender assumes additional risk. Distribution treatment applies potentially for this reason. It reflects the purpose of the legislation as, if there are no profits, a company pays no dividends. A limited or non-recourse loan has some similarity to a non-cumulative preference share which pays dividends at a fixed rate, but only if profits are sufficient. The effect of the loan is to transfer the risk from borrower to lender and risk is a characteristic of share capital. Each agreement will need to be considered by reference to its terms.

Performance of underlying assets

If a company passes on a return to a lender that reflects the performance of an underlying asset, the return will fall potentially within the provisions of CTA10/S1015 (4) This is because the performance of the asset is likely to represent part of the business.

An example of such a case would be a car hire company which issues a security that reflects the income flow from a number of its hire cars. It would not be appropriate to ignore the issuer and contend that the interest return is related to the assets as opposed to the business of the issuer. It is the business of the car hire firm to earn profits from hiring out cars and the interest on the security is dependent to some extent on the results of part of the business of the company.

A security with a return linked to the performance of an asset that the issuer has no intention of selling will generally fall within the provisions of CTA10/S1015 (4) such that distribution treatment will apply. However, by contrast, a security with returns linked to the value of an asset, which is central to that company’s business so that the company could not conceive of selling it, is unlikely to fall within CTA10/S1015 (4).

Performance of underlying assets - issuer of a security acting only as a conduit

In some circumstances where a bank or similar financial institution is an intermediary in sub-participation arrangements or where the performance of the security is linked to particular assets, the bank or financial institution may in reality be a conduit, making its profits from the margin or fees relating to the transaction.

The part of the business relevant in considering CTA10/S1015 (4) may be the earning of profits from the margin or fees and not from the underlying assets; in these circumstances, distribution treatment will not apply.

Performance of underlying assets - acting as a conduit

Banks sometimes act as an intermediary in sub-participation agreements. If a company has a business which includes making loans and simply passes on interest received from money it has lent on commercial terms and calculated by reference to an established formula with variation in the rate of interest arising out of movements in the market generally, the interest is unlikely to be a distribution of profits. The interest is likely to be an expense in the earning of profits with the company acting merely as a conduit.

For other companies, where making loans is not part of the business and they issue securities (linked to the performance of underlying assets) to raise finance, the interest paid out will not be an expense in earning profits and distribution treatment of CTA10/S1015 (4)is likely to apply. In practice, if it is claimed that such interest is passed through a company in a way that makes it an expense in earning profits, it will be worthwhile to establish if an official regulatory body such as the FSA regulates the company. If such a body does not regulate it, it is probable that the interest will fall within the provisions CTA10/S1015 (4)

Asset linked securities - assumption of risk

In some cases a company may not be acting merely as a conduit where the return on a security is linked to the performance of underlying assets. This may arise when the issuer of the security continues to pay interest, even if the assets under-perform by comparison with the expectations. The assumption of risk in these circumstances by the issuer may be sufficient to show that the return is not dependent upon the results of the business and hence will not fall within CTA10/S1015 (4)

Asset linked securities - return linked to performance of issuing company’s shares

A company may issue a security with interest that reflects wholly or partly the performance of its own shares; CTA10/S1015 (4) will apply in these circumstances. The return on the security is clearly dependent upon the results of company’s business because the performance of the shares reflects the company’s performance.

Return on security linked to the performance of a subsidiary company of the issuer

Where a company issues a security the return on which reflects the performance of a subsidiary of the company, the interest or other distribution will generally fall within CTA10/S1015(4) It would be unusual if the results of the company’s business did not in these circumstances depend to some extent in turn on the results of the subsidiary. The company would be expected to receive dividends or other returns from a business asset, its subsidiary, and its business decisions would generally reflect the performance of its fellow group member. Any arguments to the contrary on particular facts should be carefully considered and, in cases of uncertainty, referred to CTISA (Technical) - see ‘Technical Help’ on the left bar.

Relationship between CTA10/S1008 and CTA10/S1015 (4)

CTA10/S1008 removes distribution treatment from interest and other distributions otherwise within CTA10/S1000 (1) E.

The kinds of securities where this might apply are those issued at a premium and those where the returns are linked to the performance of underlying assets where the principal secured, apart from CTA10/S1008 is less than the amount paid for the security. An example of the latter is a security where the performance is linked to the performance of the FTSE100 so that the amount returned may be less than the amount paid for the security because the value of FTSE shares may have fallen.

CTA10/S1008 does not disapply CTA10/S1000 (1) F. It is therefore possible for the returns on a security to fall within the exclusion from distribution treatment under CTA10/S1000 (1) E but nonetheless be treated as a distribution under CTA10/S1000 (1) F.

In practice, the returns from securities issued by banks and securities houses are the most likely to escape distribution treatment under CTA10/S1008. They are also the most likely to be unaffected by CTA10/S1000 (1) F and CTA10/S1015 (4) where asset linked securities are involved. This is because the nature of the issuer’s business will often be such that it will be acting as a conduit in the transaction. The interest on the security will frequently represent an expense in making the profit earned from fees or margins within the arrangements.

Companies outside the financial sector are less likely to issue asset linked securities where the interest or other distributions fall outside CTA10/S1000(1)F and CTA10/S1015(4), even though distribution treatment under CTA10/S1000 (1) E may have been disapplied by CTA10/S1008. Their business is unlikely to involve the making profits on margins or from fees for arranging securities.