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HMRC internal manual

Corporate Finance Manual

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HM Revenue & Customs
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Foreign exchange: matching under the Disregard Regulations: thin capitalisation

Matching by a thinly capitalised company

A UK company holding shares in an overseas subsidiary may have a loan from another group company that is wholly or partly matched to the shares, either under CTA09/S328 or under regulation 3 of the Disregard Regulations. For example, if X group wishes to acquire shares in a US operation for $100 million, X plc may borrow $100 million externally and then on-lend the money to a holding company (with a sterling functional currency) that acquires the shares.

It is, however, possible that the holding company would not be able to borrow as much as $100 million at arm’s length. If the loan is interest-free, this does not give rise to any problems. If, however, the loan from X plc carries interest, ICTA88/SCH28AA/PARA1 may apply in order to disallow interest payable by the holding company on part, or even all, of the loan.

In such circumstances, the borrowing company may be supported by a guarantee, or guarantees, from one or more other companies in the group. Where that is the case, ICTA88/SCH28AA/PARA6D provides for the guarantor to claim a compensating adjustment - in respect of the non arm’s length portion of the loan, the guarantor is then deemed to have borrowed the money and paid the interest itself. This means that it can claim debits for the interest, and get the relief that is denied to the actual borrowing company. Guidance on this is at INTM563010+.

ICTA88/SCH28AA/PARA1 does not apply directly to exchange gains and losses. But CTA09/s447 works in conjunction with the transfer pricing provisions to ensure that exchange gains and losses on the non arm’s length portion of a loan are also left out of account (see CFM38540). The effect of ICTA88/SCH28AA/PARA6D is that the guarantor will bring into account exchange gains and losses on the non arm’s length portion of the loan.

Some of the exchange gains or losses arising in the borrowing company may, however, be matched to an eligible asset. Regulation 5(4) of the Disregard Regulations allows exchange gains and losses in the guarantor company (or guarantor companies, if there is more than one) to similarly be treated as ‘matched’ and hence disregarded.

Example

X (Holdings) Ltd is a company with a sterling functional currency, which has not adopted IAS, or FRS 23 and 26, and therefore continues to use SSAP 20. In year ended 31 December 2008, it borrows $100 million from its parent company, X plc, at a commercial rate of interest and uses part of the funds to buy shares in a US company for $60 million. In its accounts, it takes exchange gains and losses on $60 million of the liability to reserves.

It is agreed that, at arm’s length, X (Holdings) Ltd would only be able to borrow $25 million. However, it has the benefit of a guarantee from another group company, X Finance Ltd (which also has a sterling functional currency). This effectively increases its borrowing capacity to $100 million. The guarantor company makes a claim under ICTA88/SCH28AA/PARA6D.

Under Sch 28AA, the interest debits in X (Holdings) Ltd are restricted to those arising on the ‘arm’s length portion’ of the loan - $25 million. X Finance Ltd is, however, treated as if it had a debtor loan relationship of $75 million, and will get relief for interest debits that are thereby deemed to arise.

The $60 million that is matched to shares is apportioned rateably between the ’arm’s length’ and ’non arm’s length’ portions of the loan. Thus, for the purposes of bringing into account exchange gains and losses on X (Holdings) Ltd:

  • 60% of the arm’s length portion of the borrowing (60% x $25 million = $15 million) is matched, and therefore, under CTA09/S328, exchange gains and losses on this portion of the loan are left out of account. Exchange gains or losses on the remaining $10 million are taxed or allowed.
  • 60% of the non arm’s length portion of the borrowing (60% x $75 million = $45 million) is matched, and CTA09/S328 applies to exchange differences on this amount. Exchange gains and losses on the remaining $30 million fall within CTA09/S447, and are therefore not brought into account.

But without regulation 5(4), the effect of ICTA88/SCH28AA/PARA6D would be to bring into account on X Finance Ltd exchange differences on the whole of the non arm’s length portion of the loan - $75 million. Regulation 5(4) corrects this mismatch. Exchange differences on the ‘matched’ $45 million are disregarded, and X Finance Ltd will bring into account only those exchange gains or losses arising on the ‘unmatched’ $30 million.

Notwithstanding Sch 28AA, the matching rules still apply to $60 million of the borrowing by X (Holdings) Ltd. If, in a later period, it sells the shares in the US company (and substantial shareholdings exemption does not apply to the disposal), it will bring back into account (as a chargeable gain or allowable loss) exchange differences arising on $60 million of the loan. There is no question of X Finance Ltd having to bring an amount back into account.

There is further guidance on the interaction of Sch 28AA with loans and derivatives that are matched to assets at INTM432135.