Interest imputation: transfer pricing the lender: tax implications of outward lending
The arm’s length principle, as endorsed in OECD guidance and applied in UK transfer pricing legislation (INTM432010 onwards), applies to the lending and borrowing of money just as it applies to the purchase and sale of goods and the provision of services. Article 9 of the OECD Model Tax Convention says that the arm’s length principle should be applied where:
“…conditions are made or imposed between the two enterprises in their commercial or financial relations which differ from those which would be made between independent enterprises”
and this obviously includes the provision of funding.
Thin capitalisation, covered in the modules at INTM542000 and INTM510000, looks at the borrower, while this chapter concerns transfer pricing aspects of the taxation of the lender, usually a UK company lending to other group companies, within or outside the UK. Other financial transfer pricing issues arise in this outward facing context, such as guarantee and other fees, but this chapter concentrates on lending.
The relevant legislation is within S446 CTA09 (on loan relationship treatment of transfer pricing adjustments) and Part 4 of TIOPA10, which replaced ICTA88/SCH28AA and has effect for all accounting periods ending on or after 1s t April 2010.
The term “outward lending” really reflects the position before 2004, when transfer pricing did not generally apply to UK/UK transactions. Perhaps “onward lending” is more appropriate. However, the term usefully distinguishes the transfer pricing of lending from the transfer pricing of borrowing (thin capitalisation), where the tags “inward investment” or “inward lending” are similarly out-of-date, but still convenient shorthand.
At arm’s length, lenders generally expect a commercial return on their money, reflecting the level and types of risk involved. There are many sound commercial reasons why lending takes place between members of the same group of companies: efficient money management, economies of scale, the advantages of concentrating the strength of a group centrally in negotiations with a third party lender, sharing temporary surpluses, the benefits of running “in-house” treasury functions such as cash pooling, but these should all be rewarded in line with services provided on an arm’s length basis. There is specific guidance at INTM503000 on the activities of treasury and group finance companies.
Where the thin cap legislation applies, it produces a reduction in finance costs in the borrower’s tax computations. Interest imputation focuses on the lender, and it is a matter of increasing (sometimes from zero) the UK lender’s reward for making the money available. A transfer pricing adjustment only applies for tax computation purposes; it does not entail creating or increasing an actual interest charge. For this reason, the interest is said to be “imputed” as income of the lender for tax purposes.
Participatory relationship provision
TIOPA10/S148 requires a “participatory relationship” between the parties for the legislation to apply. This is equivalent to the “special relationship” mentioned in the old legislation at ICTA88/SCH28AA. See INTM542020 on the pre-conditions that have to be in place for these transfer pricing rules to be applicable.
The lender-borrower relationship
Aspects of arm’s length and non-arm’s length lending and borrowing are considered in detail in the modules on thin capitalisation at INTM540000 and INTM570000. Many of the practical concerns and considerations covered there apply here, though with different emphasis because those modules are largely concerned with the borrower. Guidance is therefore not duplicated and the focus here is on particular aspects of outward lending.
If the borrower is offshore, it may not be possible to look closely at the borrower, and focus will naturally be on the UK entity which may not to be getting an arm’s length reward. Pragmatically, it may be better in these cases to agree a reasonable rate of return for the lender rather than becoming embroiled in issues connected with the borrower.
The lender’s reward
When considering whether the lender is getting an inadequate return one should consider the options realistically available. The UK lender may lose the benefit of having the funds available for other, possibly more lucrative purposes, including other investments, meeting trading expenses, research and development, etc. It may be obliged to borrow to make up the shortfall. The company may even be borrowing to lend, without making a “turn” on the transactions. Where the company has the role of arranger or guarantor of the loan, it may not receive proper payment for the work it has done.
Where investment is made by way of a loan, there are a number of different ways in which the lender may lose out some examples are:
- no interest is charged, or the rate charged is less than an arm’s length rate. Transfer pricing legislation applies to the provision of the loan (see INTM501020 and INTM501040).
- whether interest is nominally charged or not, it may be claimed that the recipient company is thinly capitalised and cannot service the debt, so no interest is recognised in the tax computations.
- it may be claimed, correctly or not, that the loan is performing an equity function, and that interest should not be charged (see INTM502010).
- payment of interest may be deferred without a commensurate adjustment in the interest rate