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HMRC internal manual

International Manual

Interest imputation: dealing with ‘equity function’ arguments: Introduction


The chapter starting at INTM501000 introduces the topic of applying transfer pricing legislation and principles to the UK lender’s financial activities rather than those of the borrower (dealt with in thin capitalisation guidance). This is mainly concerned with the imputation of interest - taxing the lender on the arm’s length rate of interest - where the actual reward is less than arm’s length. This chapter looks at the proposition, which is sometimes put forward against HMRC’s imputation arguments, that a loan is performing the function of equity in the financial structure of the borrower, and should therefore be treated as interest-free in the computations of the lender. This is often referred to as “quasi equity”, since it is claimed that although the form of the funding remains debt, the true character of the funding is equity.

It could be argued that the equity function argument is invalid in the transfer pricing context: transfer pricing treats the parties to a transaction as if they were at arm’s length from each other, negating equity participation. Transfer pricing puts aside such connections to arrive at an arm’s length answer. However, the reasoning for the equity function argument follows the same line as thin cap, that if debt is non-arm’s length it is, in effect, equity. Given the nature of the argument, it should follow that the equity argument should not even be considered unless it relates to a UK company lending to a subsidiary or to another entity in which it would be conceivable for it to take an equity stake. A company is very unlikely to take an equity stake in a fellow subsidiary. However, it may occur occasionally, for example, where there are restrictions on the ways in which a company can invest in a particular territory.

Perhaps a better term would be “flexible finance”, where money is advanced without the usual terms and conditions and it is necessary to determine the appropriate treatment, year on year.

The equity function argument comes up either in response to HMRC seeking to impute interest, or when companies occasionally approach HMRC seeking agreement on the transfer pricing treatment of an outward loan. There is no formal clearance process designed for this issue, but it is perfectly reasonable to discuss the issue without HMRC being able to provide certainty as to treatment.

However, although advanced thin capitalisation agreements (ATCAs) were not originally designed with this sort of issue in mind, there is no reason in principle why a case which was significant and complex enough should not be subject to an ATCA covering the tax treatment of this issue. An ATCA also offers the possibility of a more flexible treatment over time - for example agreeing that interest will be imputed once the borrower has established itself and is able to service the loan, subject to an agreed schedule.

If accepted, the equity function argument means that the sum advanced will, unless recharacterised again at some point in the future, generate neither interest income nor dividends. The recipient will hopefully provide a dividend return in the long run (though the “equity function” money will itself provide no entitlement), since the money will be put to work in the borrower’s business, but this is unquantifiable and uncertain, and not the basis on which money would be lent between unconnected persons.