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HMRC internal manual

International Manual

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Interest imputation: dealing with ‘equity function’ arguments: Preparatory work

Risk assessment

Equity function arguments, as described on the previous page, are not straightforward to deal with, but they will be subject to the risk assessment process so that only worthwhile cases will be taken up for enquiry.

If the argument is presented to HMRC with the aim of wholly or partly recharacterising an actual loan, then the initiative lies with the lender to provide evidence of their case.

Treatment in the other territory

If the argument is put forward, it will be important to understand how interest deductions relating to the loan in question are dealt with for tax purposes in the borrower’s territory. This should be the actual treatment, not just the general regime for interest deductions. Treatment varies between territories for different types of business and income e.g. financial and non-financial. More weight will be given to this evidence where there is a modern double taxation agreement between the territories. This issue is developed further at INTM502060.

The question is: what could the overseas company have borrowed from a third party lender, on a stand-alone basis, at the same time as, and under comparable conditions to those pertaining when the loan was taken out? This means, to a limited extent, applying thin capitalisation criteria, in some cases to an overseas company, which will require an appreciation of the issues covered in the chapters of the Thin Cap Practical module at INTM578000 and INTM579000.

Obtaining the important facts and information

Particular attention should be paid to anything providing evidence of the intentions of the businesses’ decision makers, the purpose of the funding, etc, as between indicating towards a debt or an equity character for the funds. It is up to the lender to present a case regarding the impact of the borrower’s apparently limited ability to borrow at arm’s length. Considering the borrower’s viewpoint:

  • what would a prudent borrower do if they were at arm’s length from the lender?
  • would they borrow a lesser sum, or nothing?
  • would they borrow on those particular terms?
  • what terms (if any) might they have obtained elsewhere?
  • do they really need the money, or even if they do, do they need it yet?
  • how has the borrower used the money? This affects lender’s risk and it may also highlight where money has been lent on to other entities within the group.
  • could the borrower in fact afford to settle liabilities arising from the loan in a timely manner (or after a shorter delay)? Is the apparent problem to any extent as a matter of choice; say, a relaxed attitude to settling obligations or a preference for discretionary spending on something else? Delay or default in respect of third party lenders is expensive and risky to the reputation, independence and survival of the borrower; not so with intra-group debt.

These are the usual thin cap issues. It is a question both of whether, as independent parties, the lender and borrower could have entered into such an arrangement, and whether they would have done so.