Debt cap: calculating the disallowance of financing expense amounts: loan relationships debits
Interaction with other tax rules
TIOPA10/S313 specifies that a financing expense amount, in respect of a loan relationship, comprises the debit that is brought into account for tax purposes, provided it is not an ‘excluded debit’. In many cases, this will be the debit shown in the company’s accounts. In other cases, the accounting debit will be modified as a result of particular tax rules.
A UK company issues securities into the market, at a discount to their face value. The liability is measured on an amortised cost basis, and the income statement of the company shows a financing expense - computed by reference to the effective interest rate (CFM21640) - that takes into account the interest payable on the bonds, the original issue discount, and fees and costs that are integral to the issue of the bonds.
All of the costs and expenses are allowable loan relationships debits under CTA09/S307(3)(c), and the tax treatment of the company’s borrowing is not subject to any special rules. The relevant financing expense amount will be the debit shown in the income statement.
As in example 1, a UK company issues securities into the market. In this case, however, the securities are convertible into shares in the issuing company. Under FRS 26, the company’s accounts recognise a financial liability and, separately, an obligation of the company to issue its own shares (an equity instrument). There is a fuller explanation of the accounting at CFM21260.
Suppose that the face value of the bonds is £50 million, and they are issued for £45 million. The fair value of the financial liability at the time of issue is £35 million, while the fair value of the equity component is £10 million. The difference between the £35 million at which the financial liability is initially recognised, and the final fair value of £50 million, is brought into account over the life of the bonds, so the amount charged to the income statement will include debits for this ‘notional finance expense’.
For tax purposes, CTA09/S415 applies (CFM37670) and the financial liability - the host contract - is treated as a separate loan relationship; the ‘notional finance expense’ is allowed for tax purposes. This treatment is followed when computing the company’s financing expense amount.
(If the same accounting treatment is followed in the group’s consolidated accounts, the notional finance expense comes within TIOPA10/S332(1)(b) - amortisation of discounts relating to amounts borrowed - and will therefore also be included in the available amount.)
A UK company enters into a tax avoidance scheme. As a result of HMRC enquiries into the scheme, it is agreed that a particular debtor loan relationship of the company has an unallowable purpose. Debits in respect of this borrowing are therefore not brought into account for loan relationships purposes, under CTA09/S441. The disallowed debits are therefore not financing expense amounts of the company for debt cap purposes.
If the debt is owed to an entity outside the group, and is therefore part of the group’s liabilities disclosed in its consolidated accounts, the interest on the debt will still contribute to the available amount.
A UK company has a £75 million loan from a fellow group member resident in the Cayman Islands. The interest on the loan is excessive at 10% and gives a UK tax advantage. It is agreed that an adjustment be made under TIOPA10/PART 4 and the arm’s length interest on the loan is agreed at 6%. The excessive interest is 4% which is £3 million a year. When calculating the financing expenses of the UK company the arm’s length amount of interest £4.5 million should be used. The excessive interest is disregarded. (Similarly, where it is agreed that a company has borrowed more than an arm’s length amount, the arm’s length amount should be used in computing UK net debt for the purposes of the gateway test).