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HMRC internal manual

International Manual

HM Revenue & Customs
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Interest imputation: transfer pricing the lender: detecting and evaluating loans to connected parties

Identifying and evaluating loans to connected parties

The first task is to establish that the necessary relationship exists between borrower and lender for the transfer pricing rules to apply. See INTM542020.

The expectation may be that loans between connected UK companies will bear little or no interest, but the opposite may instead be true. UK/UK intra-group loans in particular may feature excessive interest rates to increase deductions for the borrower and bolster the profits of the lender, with a view to taking early advantage of reliefs available to the lender (unused losses, brought forward items, etc), which would otherwise not be useable until a later accounting period, if at all. However, if this was to occur, it should be tackled through the taxation of the borrower, who has the transfer pricing advantage.

Information from the accounts and other sources on related party transactions and explicit loans should of course be checked against the arm’s length standard, but this guidance concentrates on the less obvious. Pointers to identifying potentially non arm’s length loans may include the following:

  • Statutory accounts showing long- or short-term balances due from associated companies. Formal loans may be identified as such, but there may also be current account balances which represent an accumulation of debts on trading or other normally short-term account, where payment is not demanded or even expected. Outstanding balances may accumulate without being recognised as loans, but they may become de facto loans which may be vulnerable to a challenge on transfer-pricing grounds if not otherwise explicable.
  • Connected borrowers may not be separately identified in the lender’s accounts. If the balance of group debtors is significant, a comparison with the level of interest receivable might indicate whether it is likely that a reasonable rate of return is in place. However, if debtor level seems high relative to other figures in the accounts, only an analysis identifying the precise nature and longevity of the debts, the circumstances in which they arose, and their terms, including any repayment provisions, will confirm the position.
  • Where balances due from connected parties appear to have built up, the caseworker should find out whether there are any lending or credit terms attached to the debts, and whether these are on an arm’s length basis. It should be possible to assess whether debts on trading account (or similar), bare comparison with the firm’s ordinary commercial terms, as applied to third parties. Terms of credit and the practices employed in collecting from late payers vary from business to business, but policies should exist in any business which trades with third parties, for employees to follow. Once a debt has been outstanding for longer than would be acceptable from a third party customer, it is arguable that the debt should become interest-bearing. By not seeking payment, the company is in effect advancing funds to the group debtor, by lending them the amount due. One would not normally expect a company to pursue related party debtors according to the same escalating process applied to third party debtors, but the effect should be the same. Trade debts are usually treated as short-term in the accounts of the trading company since trade credit is unlikely to be offered for long-term settlement, but a balance may be outstanding for a substantial period if the debt is rolled forward. The change in the nature of the debt from ordinary trading terms to something longer-term may not be recognised in the accounts of the parties. However, since transfer pricing requires no motive test, it is irrelevant whether the arrangement is documented or intentional.
  • Balances on trade accounts tend to overlap, vary in length, etc so it may be difficult to identify precise sums outstanding or the duration of the lending. This does not mean that the legislation applies any less to these ‘informal’ loans than to formal loans under written lending agreements, but a pragmatic approach based on, say, average amounts outstanding over a period may be acceptable, so long as it does not sweep up balances which are not (or not at that time) informal loans.
  • Interest should be imputed on these informal loans in a flexible and practical way. It may be appropriate to allow the lender the benefit of the credit period which it extends to third party customers, and impute interest only from the date from which a comparable third party debt would become “overdue”. Alternatively, if it appears that there was never an intention to settle the intra-group debt, or the debt is not of a type which bears comparison with third party credit terms, it might be arguable that no period of grace is applicable and interest should be charged with effect from the moment the debt comes into existence.
  • In common with more formal arrangements, there is also an issue of whether the lender is pursuing an uncommercial practice of allowing free or cheap use of funds which it has itself borrowed more expensively. This would of course have to take into account mismatches which were attributable to changes in arm’s length borrowing and lending rates over time. As with other onward lending, leaving debts uncollected may make it difficult for the lending company to settle its own debts or meet other liabilities, and there may an argument for adjustments to the lender’s own interest deductions, on the basis that if the company had pursued and been paid in a timely manner, it might otherwise have been able to reduce its own debt burden or would not have run up so much debt in the first place.

There is practical guidance on working downstream (parent to subsidiary) lending cases in the chapter on dealing with equity function arguments, from INTM502000 onwards. While that section is aimed specifically at cases where companies claim that outward loans to overseas affiliates are performing the function of equity, it includes much useful material on handling downstream lending cases generally.