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HMRC internal manual

Corporate Finance Manual

Other tax rules on corporate finance: structured finance: avoidance background: examples

Example of an avoidance scheme to give relief for interest and principal

Example 1: ‘plain vanilla’ loan

The company obtains a loan of £100m at interest from a finance provider. It would typically have to give security for the loan. Over the five-year period it might pay, say, £2.5m interest p.a. giving total repayments of £112.5m. For tax purposes, relief would be available for each annual payment of £2.5m interest, but not for repayment of the £100m principal.

Example 2: a structured finance income alienation scheme

Company A holds an asset on which income of £22.5m a year will arise. It transfers this asset to the finance provider, a bank, for a lump sum of £100m for a period of 5 years, at the end of which it can reacquire the asset for nothing. During the 5 years, income of total £112.5m is paid to the bank.

The income stream acquired by the bank will be enough to repay both the lump sum and interest. There are likely to be arrangements such as options under which the asset and income reverts to the company at the end of 5 years.

The transfer of the asset is in substance by way of security only. As the company has retained substantially all the risks and rewards of ownership of that asset and is in effect simply applying the income that arises from it to repaying the loan, under generally accepted accounting practice (GAAP) it will continue to recognise the asset and will record the lump sum as a financial liability, that is, as a loan. Income from the asset will continue to be shown in the accounts and over 5 years a finance charge equal to the difference between the gross receipts and the lump sum will be debited to profit and loss account.

Relief for interest and principal: claimed tax effect of example 2

The economic substance of example 2 is exactly the same as example 1, Company A has borrowed £100m. In example 1 the borrower has had the benefit of an original income stream of £112.5m that is subsequently paid over to the lender as capital repayments and interest, but in example 2 the borrower has merely arranged for the original income stream to be diverted to the lender and applied directly to repay the lump sum of £100m.

However, in example 2 the borrower claims in effect to escape tax on the £112.5m of income which would arise to it during the period of the arrangement.