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HMRC internal manual

International Manual

Controlled Foreign Companies: The CFC Charge Gateway Chapter 9 - Exemptions for profits from Qualifying Loan Relationships: Full Exemption - Qualifying Resources: What are Qualifying Resources?: Funds derived from shares: Rights Issues

The third category of funds derived from shares are funds raised from a rights issue. This is referred to in the legislation as the proceeds of a share issue. The proceeds of a share issue are qualifying resources if the following conditions are met (see TIOPA10/Part 9A/S371IB(7)(c)):

  • The shares are issued by a group company that is not the 75% subsidiary of any other company (typically the group’s ultimate parent company), and
  • the shares are ordinary, non-redeemable shares and are issued to persons who are not members of the CFC group. Typically rights issues are offered to members of the existing ultimate shareholder base of the group.

Proceeds of a rights issue can be qualifying resources if the CFC obtains funds in relation to shares (section 371IB(6)(b)) and the funds are indirectly obtained from the rights issue (section 371IB(7)(c))

Qualifying resources - restriction in relation to UK debt

There is an important restriction on qualifying resources where the source of the funding includes UK debt. The restriction is set out at section 371IB(8), (9) and (9A) to (9D). If a qualifying loan relationship is created as part of an arrangement that increases the group’s UK debt by an amount X, then at least X of the resources must be non-qualifying. The term “arrangement” has a wide meaning and the restriction applies whether the UK debt is created as a direct step in providing funds to the CFC that makes the qualifying loan relationship or is connected with the provision of that loan in some other way.

In the link to the example diagram below, a £1 billion share acquisition of Target is funded by giving the original shareholders £900m of newly issued shares in the acquiring group and £100m cash. The cash is all obtained by new debt taken on in the UK. The shares in Target are passed to CFC in return for new shares issued by the CFC. The CFC sells the shares to Hold Co in return for £500m of shares and £500m debt.

The CFC’s loan to Hold Co is funded by the sale of the newly acquired shares in Target. The sale proceeds fall within section 371IB (6) (b) and (7) (b) so are potentially qualifying resources.

Section 371IC gives the proportion of Y% that is deducted from the qualifying resource using the formula: 

100% x B

   A +B

Here A = £900m and B £100m, so Y% = 10%. Therefore in the absence of subsections 371IB (8) and (9), the qualifying resource proportion X% would be 90%.

However section 371IB (8) and (9) require the non-qualifying resources to at least match the new UK debt, which is £100m. This represents 20% of the loan to Hold Co and so the qualifying resource proportion is correspondingly reduced to 80%.

Use this link to view the first example

The restriction in relation to UK debt remains in place even if the debt created under the arrangement is subsequently repaid. The repayment of the debt does not affect the nature of the resources that went into the creation of the CFC loan.

If the original qualifying loan relationship (“QLR” - INTM217000) made by a financing CFC is subject to a restriction in respect of UK debt, and the QLR is repaid and replaced with another one, which is funded otherwise than through the proceeds of the repayment of the first loan, then the new loan will be considered afresh and section 371IB(8) and (9) would not necessarily continue to be relevant. However this type of restructuring will be considered critically. Consider for example a UK company that subscribed for 1 billion £1 ordinary shares in a CFC, funding the subscription through a rights issue of £600m and new external debt of £400m. The CFC then made a loan of £700m which is a QLR. Any claim that the loan was funded out of qualifying resources would be subject to a restriction under section 371IB(9) in relation to the new UK debt. Some years later the external debt has been repaid and the £700m loan by the financing CFC is also repaid and two new loans made, for £600m and £100m. In this case the restriction would remain; the fact that the original loan by the CFC has been repaid does not alter the fact that the funding of the CFC was a mix of resources.

The restriction simply refers to a debt incurred in the UK. So if a UK company is used as a conduit to pass funds from a financing CFC to another member of the CFC group, it is the gross amount of debt of the UK company, and not the net debt which is taken into account in considering the restriction under section 371IB(9).

In the link to the second example diagram below, Ultimate debtor distributes profits of £100 to UK Parent. UK Parent immediately uses the cash to subscribe for £100m shares in Finco 1, which lends the funds interest free to UK Conduit, which in turn lends the funds at interest to the Ultimate Debtor. In calculating the assumed taxable profits of Finco 1, interest is imputed in respect of the interest free loan and in turn UK Conduit claims a corresponding adjustment in the same amount of interest. The loan from Finco 1 is a qualifying loan relationship, but although the loan is funded by profits of the Ultimate Debtor (and so are the profits of the business of the CFC group in the relevant territory) and the funds are received by Finco 1 in relation to shares issued by it to UK Parent the loan is made as part of an arrangement that involves debt of £100m incurred by a UK member of the CFC group. As such the qualifying resources are reduced by £100m i.e. to nil qualifying resources. It is still possible however to make a claim under section 371ID (for 75% exemption) as long as all the other conditions in Chapter 9 are met.

Use this link to view the second example

The limitation in relation to UK debt incurred by a member of the CFC group that is part of, or connected to an arrangement to provide funds for a qualifying loan relationship is relaxed in two specific cases (see section 371IB(9A)). These are;

  • where the debt is a daylight borrowing facility, and
  • where the debt is used to initially provide the funds for a transaction (typically an acquisition) and the funds are repaid out of a rights issue.

The relaxation in respect of a daylight borrowing facility is provided by sections 371IB(9A) and (9B). Some financing structures will require funds to “kick-start” the financing and typically a daylight borrowing facility is used to provide the necessary funds. In the example above, the Ultimate Debtor may not have sufficient funds to pay the dividend. Instead UK Parent borrows £100m from a bank and lends the money to Ultimate Debtor. The subsequent steps beginning with the payment of the dividend and ending with the loan to Ultimate Debtor take place within a matter of hours. At the end of the series of transactions, Ultimate Debtor repays the temporary loan of £100m to UK Parent which in turn repays the £100m to the bank. The bank receives a fee in return for providing the short-term facility.

Section 371IB(9B) defines the type of funds that can benefit from the relaxation of the restriction in sub-section (9) as UK debt that is repaid within 48 hours. To ensure this relaxation is not exploited, section 371IB(9C) contains a purpose based anti-avoidance rule. If the main purpose, or one of the main purposes of an arrangement that involves repaying the UK debt is to secure the relaxation provided by sub-section (9B), then that relaxation is denied. So if for example there is an arrangement to put in place a facility to gain the exclusion, or if there is an arrangement to recycle a facility (so that there are a series of 48-hour loans) then the main purpose test will deny the application of section 371IB(9B).

The relaxation in respect of a rights issue is provided by section 371IB(9D). Rights issues are typically used to either reduce external borrowings usually where there is a likelihood of borrowing covenants being breached or to fund an acquisition. The relaxation is intended to support the latter scenario, where in some cases it may take some time to raise the necessary funds through a rights issue. The acquisition may be made using short-term external borrowing facilities that are replaced with (and are intended to be replaced with) funds from a rights issue.

There are a number of conditions that must be met for the relaxation in section 371IB(9D) to be given.

  1. There must be an issue of shares that meets the requirements of sections 371IB(7)(c)(i)-(iii) - essentially the issue of new ordinary shares by the ultimate parent of the group to third parties (typically part of the existing shareholder base).
  2. There must be an expectation that the UK debt incurred before the issue of those shares, will be repaid by the company from the funds derived from the issue of those shares.
  3. The above repayment must be made within 6 months from the day on which the loan is incurred, and
  4. The loan must be made by a third party, and in circumstances whereby the third party is not provided with the funds (for example in a back to back arrangement with a bank).