INTM489430 - The Unassessed Transfer Pricing Profits Examples: Example 9 - Hedging

Facts

  • Company A is the parent of a multinational group. Company B and Company C are subsidiaries. Company A and Company B are resident in a low tax jurisdiction, and Company C is UK resident.
  • Company C requires £50m of funding to expand its business. Company A lends £50m to Company C at an interest rate of SONIA (Sterling Overnight Index Average) +2%.
  • Company C enters into an interest rate swap with Company B to hedge the interest rate risk on the loan.
  • In the relevant accounting period the interest payable by Company C on the loan is £2m, and Company C is required under the hedging contract to pay Company B £2.5m.
  • The loan is a loan relationship under CTA09/Part 5, and profits and losses arising to Company C from the interest rate swap are taxed as income under CTA09/Part 7.

Analysis

  • There are two provisions: the loan between Company A and Company C; and the interest rate swap between Company C and Company B in relation to the loan.
  • HMRC considers that at arm’s length Company C would only have been able to secure borrowing of £40m.
  • Therefore under the transfer pricing requirement, Company C’s profits should not have reflected any deduction for the interest paid (in this year £400k) and hedging payments made (£0.5m) in respect of the surplus £10m loan. Therefore there are unassessed transfer pricing profits arising from both provisions.
  • There is an ETMO in respect of the £400k interest payments and the £0.5m hedging payment, because the profits arising from both provisions have been subject to a tax rate in Company A and Company B’s jurisdiction which is less than 80% of the corporation tax amount that would have been due if the same sum had been brought into account by Company C.
  • The TDC is met in relation to both provisions because it is reasonable to assume that, in the absence of a commercial reason for the excess £10m loan, then the arrangements to which both transactions relate were designed to achieve a UK tax reduction for Company C.
  • However, the UTPP rules do not apply because any unassessed transfer pricing profits in relation to the provisions arise wholly from excepted loan relationship arrangements. This includes profits arising in relation to the derivative contract, which was entered into entirely as a hedge of risk in connection with a qualifying loan relationship.
  • When applying the TDC to derivative contracts, HMRC recognises that in many cases a derivative contract hedging instrument is entered into on a commercial basis to mitigate a group’s risk exposure, and it will depend on the facts and circumstances of the particular case whether or not the UTPP legislation applies.