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HMRC internal manual

International Manual

Interest imputation: transfer pricing the lender: working a case

Pricing the transaction

The Thin Cap Practical guidance at INTM510000 considers the question of what a borrower could and would have borrowed at arm’s length. For interest imputation cases this is still relevant, but the emphasis is bound to change, since the focus in this guidance is on the lender rather than the borrower. Where a UK company has made a loan, in whatever circumstances, HMRC’s prime responsibility is to ensure that for tax purposes that UK lender is taxed on a fair return for the use of the money.

The loan agreement

The absence of a formal loan agreement is not conclusive evidence that no loan exists, or that it has no agreed terms. Companies which are not at arm’s length from each other may consider it unnecessary to write down terms which are understood between them, although it would be bad practice not to record a relationship to which transfer pricing obligations apply. On the other hand, connected parties may write down a set of terms and then vary or ignore them. An agreement may be written, verbal or implied, and may amount to no more than a tacit understanding that a lender will not pursue an outstanding sum for an unspecified time. In the end, what happens in practice is more important than what is written down or discussed. It may be possible to infer the existence of an agreement from the fact of non-pursuit of an outstanding debt.

The CT legislation entitles HMRC to request that the lending company demonstrate that the arm’s length standard has been applied in relation to its intra-group lending and to provide supporting documentation (see INTM433000 on record-keeping obligations).

Counter arguments - equity function

The next chapter (INTM502000) covers the representations which may be made on behalf of a UK lender that a downstream (parent to subsidiary) loan fulfils the purpose of equity capital in the hands of its subsidiary. This argument is also extended to non-parent/subsidiary cases.

Counter arguments - that the loan is already on arm’s length terms

If this can be demonstrated, the case can be closed. The considerations are no different from those covered in the practical guidance from INTM510000, except that the main focus is on the lender. If evidence is presented on the borrower’s behalf as to any limitation on its borrowing capacity, it should be considered.

Once the issue is settled, the company should self-assess the imputed interest year-on-year in accordance with the terms agreed. If the other party to the transaction is liable to UK Corporation Tax, it may be entitled to claim a compensating adjustment under TIOPA10/S174 to avoid double taxation (see INTM542180 for details). Any cross-border adjustment of this nature would be pursued through the Mutual Agreement Procedure (INTM470010).

Counter arguments - can’t pay or won’t pay?

The lender may contend that the borrower has insufficient profits to pay interest. This is a relevant consideration when examining how much the company could and would have borrowed at arm’s length. There may, in fact, be sufficient cash flow to pay the interest and it may be that a third party lender would have been paid. Local thin capitalisation rules will be a consideration, but these may be based on a safe harbour rule which HMRC would not itself apply, so that the basis of the computations of the lender and the borrower may not match. Acceptance of local thin cap rules without question would mean that rather than applying UK transfer pricing legislation to outward lending, such transactions would be taxed in the UK on the basis of the rules of the borrower’s territory.

A claim that the borrower has insufficient profits or cash-flow should be tested in a practical way, looking carefully at how the borrower has used the funds. Has the money been used to develop an asset, say, or used as working capital? Is the use likely to be income-generating? Has the lender lost out, and if so why and to what degree? Has the borrower paid dividends, waived the liability of a group company, sought a guarantee from other group companies or sought further equity from its parent? Would the borrower have behaved in the same way and made the same decisions if the lender had been a third party lender in a position to exercise legal rights? The answer may be no; defaulting on a loan and breaching banking agreements is expensive and can jeopardise the independence, even the existence of a business and raise the future cost of debt. The overriding issue is whether it is appropriate for any deficiency to the lender to be adjusted for by transfer pricing.

On a practical note, it is interesting that, in the course of thin cap enquiries where the UK borrower wants to retain its interest deductions, the idea that the lender should be treated as taking an equity stake in the business is often met with resistance by the borrower; it is usually argued that lending arrangements should for the time being be kept in place, even if default seems inevitable.

Interest rate

If interest is to be imputed on an outward loan, an interest rate must be agreed. The rate will be determined by, amongst other things:

  • the currency of the loan
  • the amount and duration of the loan
  • the scale, degree, and nature of the risks involved.

The subject of interest rate risk is covered in some detail at INTM577030.

It is not going to be easy to determine an appropriate interest rate for a loan which may be informal, with few stated terms and perhaps no expectation of monetary discipline. It is advisable to look for a reasonable rate and move on, rather than to draw out the process arguing over basis points (hundredths of a percentage point). Once the rate is agreed, the company will be expected to prepare and submit the interest calculation as part of revised computations for past years and as part of the return for future years.

Transfer pricing is about computational adjustments. HMRC cannot insist that actual payments are made (other than tax payments) to reflect a hypothetical arm’s length arrangement. However, if adjustments are not reflected in the real world, the actual results and the arm’s length position can drift further and further apart as time goes by.