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HMRC internal manual

International Manual

Interest imputation: dealing with ‘equity function’ arguments: HMRC response

HMRC response to an equity function argument

As discussed at INTM502010, despite the potential for incompatibility between an equity connection (inherently non-arm’s length) and the arm’s length principle, it is frequently argued in thin capitalisation cases that any debt treated as non-arm’s length represents funds that, at arm’s length, would have been provided as equity (or some other interest-free or low interest form). Companies which advance the “equity function” argument are in effect claiming to be at the other end of a transaction from a thinly-capitalised company.

The starting position for HMRC is that:

  • the funding has been provided in the form of a loan, that form was chosen, not another, and there may be documentation supporting that choice. The initial presumption is that form and substance are the same.
  • inferences can be made from the absence or presence of certain legal steps e.g. the positive action of drawing up of a loan agreement, the absence of formal steps towards issuing shares, etc
  • depending on how long the transaction has been in place, further choices will have been made about presentation in the accounts, accounting and tax treatment, etc, which will further point to one interpretation or another.

HMRC is committed by statute to follow the OECD guidance on transfer pricing, and where necessary to adjust the actual provision to the arm’s length provision. It is only if this adjustment cannot be achieved by gradual adjustment that the transaction is recharacterised as something of a different nature. If the actual provision is a loan, recharacterisation as equity should not be an immediate response. Adjustment and recharacterisation are discussed at length at INTM542010.

If the facts and circumstances of a case indicate that the investment is in the form of a loan, there is a strong prima facie case for saying that it should be treated as such for tax purposes. There may not be a wealth of information about the transaction, given that it takes place intra-group, but even accounting treatment represents a conscious decision on the lender’s part, and acquiescence at the very least on the part of the borrower. If there is a document or understanding or an entry in the accounts of the parties which treats the investment as a loan, then it is for the lender to overturn that treatment by demonstrating that the contrary view is a more commercially sound and valid one.

The thinly-capitalised borrower

The lender may claim, possibly with some evidence, that the tax authority in the territory of the borrower is likely to disallow or has disallowed all or part of the interest charge, in accordance with the thin capitalisation rules of that country. Not all countries have thin capitalisation legislation and those that do often have safe harbours and specific limits which allow the borrower to determine with some certainty the likelihood of disallowance of an interest charge. This may not match the UK approach, which applies the arm’s length principle to each case. The question of whether the borrower is thinly capitalised is a consideration to be borne in mind, but it is not a conclusion that should be accepted without persuasive evidence. Guidance in the past has suggested that “standing in the shoes of the borrower’s tax inspector” provides the answer, but this is only likely to be valid where tax treatment is broadly comparable with UK treatment. Even some apparently full-rate countries have special rules which can result in little or no tax on interest, so that imputation of interest at the UK end does not automatically result in double taxation. In any case, where tax treatments do not match, there is the option of the group using the MAP process (INTM470000) to resolve double taxation issues. See also Statement of Practice 1/11 on this subject.

It would be wrong to anticipate the tax treatment of the borrower’s interest deductions without further evidence, and wrong to assume that the territory’s general rules on the tax treatment of interest will necessarily be the ones that will apply to the company and source in question.

A practical response

HMRC has at times been reasonably willing to accept the equity function argument without enquiring very much into the circumstances, in some cases on the understanding that the “loan” in question was actually converted as a matter of reality from debt into equity. HMRC has no powers to make a company convert debt to equity, nor is it certain that any such conversion was carried out. There is also little evidence that the position was ever revisited or reconsidered. This approach seems both inflexible and counterproductive.

There are a variety of possible solutions, which include:

  • Partial recharacterisation - to treat part of the debt as equity. It is arguable that a third party lender might be prepared to make a smaller advance if the owner of the enterprise was pledging, and risking, some of their own money. This might well pave the way for interest to be imputed on at least a proportion of the funding, on the basis that the borrower could be treated as having more equity than was apparent at the outset.
  • Agreement that all or part of the loan would remain interest free until such time (within reasonable limits) as the borrower was in a position to support some debt and pay some interest. Forecasts should show when the investment would be likely to produce sufficient income flow, and this should be based on firm commitments and expectations, not mere possibilities, along the lines of (and perhaps in the form of) an Advance Thin Capitalisation Agreement. A lender agreeing to spare or reduce interest for early periods would then be expected to recoup the undercharge later on. The deferred aspect would represent reward postponed and point to an increased credit risk, both pointing to an increase in the loan price over what might be expected where the loan started to be serviced on more immediate and conventional terms. Once the revised terms are quantified, it should be possible to find third party comparables for the new situation.

This is an area where a certain amount of creativity and flexibility is helpful, in responding to facts of the situation with an appropriate solution.

Under CT rules, the UK lender must make a judgement concerning the equity function argument, and may be assumed to have done so. The lender’s conclusion that the borrower would not otherwise have been able to obtain loan finance will result in a tax return reflecting that decision. That decision (which of course may not be evident at all from the return) is open to enquiry in the normal way, with the appropriate documentation requirements applying (see INTM433000 onwards).