This part of GOV.UK is being rebuilt – find out what beta means

HMRC internal manual

International Manual

Controlled Foreign Companies: The CFC Charge Gateway Chapter 9 - Exemptions for profits from Qualifying Loan Relationships: Transfer pricing adjustments in the context of Chapter 9

When calculating the UK measure of profits of a CFC (the assumed taxable total profits, transactions between the CFC and other connected persons have to be priced in accordance with the arm’s length principle. Another consequence of taking account of the assumptions made when calculating the assumed taxable total profits are that the CFC is assumed to be a company tax resident in the UK. This means that the CFC can be assumed to have made a claim for a compensating adjustment under TIOPA10/S174 if that provides a beneficial outcome in relation to the calculation of the CFC’s assumed taxable total profits.

There may be transactions between two CFCs, whereby one CFC’s profits are increased because of a transfer pricing adjustment, and the other CFC’s profits are calculated taking account of an assumed claim for a compensating adjustment. The amount of the compensating adjustment is unaffected by the outcome of any claim under Chapter 9 in respect of the CFC whose profits have been increased in line with the arm’s length principle. At first glance this may seem odd, and even to confer some sort of advantage.

However, as the example diagram shows, the overall outcome means the profits from lending to the ultimate debtor are only considered once in relation to the CFC rules. To the extent the profits “pass through” one of the CFCs, those profits are only effectively brought into charge and partially exempted in relation to the second CFC.

In the example diagram in the link below, Finco 1 (Ireland) issues shares to UK Parent and used the funds to make an interest free loan to Finco 2 (resident in say Luxembourg or Netherlands), which in turn makes a loan at interest to Ultimate Debtor. Assume that Finco 2 receives £10m interest from Ultimate Debtor in an accounting period.

Ireland does not have transfer pricing rules that would apply to the interest free loan. Netherlands and Luxembourg would both allow Finco 2 to claim a deemed interest deduction in respect of the interest free loan. Assume that the deemed interest deduction is £9.9m. When set against the interest received from the loan to Ultimate Debtor, this leaves Finco 2 with a very small profit of £100,000 which is charged at the Luxembourg or Netherlands full rate of tax. However the effective rate of tax is much lower because of the deemed interest deduction. This structure creates the CFC shelter for the interest received on the loan to Ultimate Debtor.

Finco 1 applies the transfer pricing rules in calculating its assumed taxable total profits and imputes interest of £9.9m in respect of the interest free loan. For the sake of this example Finco 1 has no expenses and so the NTFPs are £9.9m. UK Parent makes a valid claim under Chapter 9 for the accounting period in respect of Finco 1’s profits and so only £2.475m profits are apportioned to UK Parent.

Finco 2, in calculating its own assumed taxable profits will take account of an assumed claim to a compensating adjustment, in the same amount as the interest imputed in calculating the CFC profits of Finco 1. This leaves Finco 2 with a small profit of £100,000. UK Parent makes a valid claim under Chapter 9 for the accounting period in respect of Finco 2’s profits and so only £25,000 profits are apportioned to the UK Parent.

So of the £10m interest paid by the ultimate debtor:

  • £9.9m is profit of Finco 1 - £2.475m of which are apportioned by the UK
  • £0.1m is profit of Finco 2  - £0.025m of which are apportioned to the UK

Essentially Finco 2 is acting as a conduit in this structure – at the end of the day only one amount of interest (received from Ultimate Debtor) is being sheltered and only a quarter of that interest is in effect apportioned to and taxed in the UK. If Finco 2 was not able to take account of the full compensating adjustment in calculating its assumed taxable total profits, then more than a quarter of that interest would be apportioned and taxed in the UK.

Use this link to view the example diagram