CFM31100 - Loan relationships: what are loan relationships: guarantees and loan relationships

The guarantor’s debt to the lender

Where a company guarantees a loan taken out by another person, this does not cause the guarantor to become a party to a debtor loan relationship - at this point there is no money debt.

Normally the guarantee will create a personal obligation due from the guarantor to the lender. No instrument is issued to evidence the guarantor’s obligation unless, for example, the lender has a charge over some asset of the guarantor. Consequently, even when the guarantee is called on, any resulting debt due to the bank should not be a debtor loan relationship of the guarantor, though it is likely to be a relevant non-lending relationship within PT6/CH2 - for further discussion see the example at CFM31110.

Further, if the borrower defaults on interest and the guarantor has an obligation to pay the interest to the lender, this is not interest on a loan relationship of the guarantor or even on a relevant non-lending relationship. The obligation to pay the interest is simply a debt due to the bank and, as established by case law, has lost the character of interest in the guarantor’s hands. For instance in Holder v CIR, 16 TC 540, (1932), Viscount Dunedin said,

“The guarantor does not pay on an advance made to him, but pays under his guarantee. It is true that he pays a sum which pays all interest due by the person to whom the advance is made, but his debt is his debt under the guarantee, not a debt in respect of the advance made to him”.

It follows that no deduction is available under the loan relationships code for amounts paid by the guarantor to the lender under the guarantee.

Subrogation and the borrower’s debt to the guarantor

Once the company has paid amounts in consequence of the guarantee, it will usually be entitled to reclaim its outlay from the original borrower. This is a process known as subrogation. The subrogation principle is that, once a guarantor has paid the money under a guarantee, it acquires the lender’s rights against the borrower. That is, it replaces the lender as the creditor party for the original lending, with the same effect as if it had acquired the loan relationship by purchase. Subrogation may happen either by operation of common law or because the particular guarantee contract includes a subrogation clause.

Accordingly, a money debt is created as a result of the subrogation, which is due from the borrower to the guarantor. It is questionable whether this money debt will have arisen from a “transaction for the lending of money” - this will depend on the particular circumstances. Accordingly, it is possible that loan relationships may come into existence to which the guarantor and the borrower are parties.

In practice it should not matter whether the guarantor’s money debt is a creditor loan relationship. If it is not a loan relationship, it will be a relevant non-lending relationship within PT6/CH6 and according to S481(3) amounts in respect of relevant matters such as interest, exchange gains and losses, impairment losses and gains or losses from related transactions will be brought into account under PT5 as if they arose from a loan relationship.

If the borrower is unable to refund the guarantor for the amount paid and the guarantor writes off or releases the debt, the loss may be an allowable debit if the parties are not connected. But as a practical matter most companies giving guarantees are connected to the borrower, so relief for such a loss by a guarantor will be unusual. See the example at CFM31110.

The position of the lender

The lender’s creditor loan relationship persists, despite the borrower’s inability to pay. So in its hands, the receipt of interest is interest on a loan relationship. The settlement of the principal would be a related transaction in respect of the loan relationship, the extinguishment of its rights under the loan relationship by redemption. See CFM31140.

Guarantee fees

A guarantee fee payable by a borrower will normally be a deductible expense arising under a loan relationship, see CFM33060.