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HMRC internal manual

International Manual

HM Revenue & Customs
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Interest imputation: dealing with ‘equity function’ arguments: Issues affecting equity function cases

Safe harbours

It is not uncommon for overseas tax regimes to have ‘safe harbour’ rules for thin capitalisation, even when they apply the arm’s length principle for transfer-pricing purposes. This means that the thin capitalisation legislation does not bite as long as, say, the debt:equity ratio of a company remains within a prescribed value of 3:1. If the company exceeds this ratio, it is still open to the company to argue that its ratio conforms to the arm’s length standard.

The thin capitalisation practices of the particular country are something to bear in mind in an equity function case, though it is not a determining factor and the arm’s length principle applies, in accordance with OECD guidance and UK legislation.

Some countries may have restrictions on the way in which foreign investment can be applied within their borders. For example, it may be a legal requirement that certain types of companies must be majority-owned by residents, or there may be government regulatory requirements. This may give rise to investment from the UK which is a mixture of share capital and an interest-free loan, and it may be contended that the loan performs an equity function because the UK company is prevented from subscribing more in share capital owing to the legal restrictions. In such a case HMRC’s position is, as indicated above, to start from the legal form of the investment: if it is legally a loan, then that is the basis for the tax position. However, judgement needs to be made in the light of all the facts. A relevant factor would be whether the loan gave the investor powers of influence or control similar to those of a shareholder with an increased stake. If help is needed, the Transfer Pricing Team at CTIAA Business International can advise.

Capital contributions

As mentioned in INTM502010, company law provisions of some foreign jurisdictions, notably the USA, allow for the making of capital contributions to companies. A capital contribution is a contribution to the equity capital of a company. It is not a loan and creates no obligation to transfer economic benefit to the maker of the contribution.

In the UK there is no company law provision regarding capital contributions. If a UK company receives a capital contribution it will appear as such on the balance sheet within shareholders’ funds. If the company makes a capital contribution, it will normally be included in the accounts as an added cost of investment in a subsidiary.

If a UK company contends that a sum paid to an overseas affiliate is a capital contribution rather than a loan, HMRC can only accept the contention if there is clear evidence supporting it. For example, there should be a written agreement that a capital contribution has been made rather than a loan, and evidence of the appropriate treatment in the company accounts. If there is a possibility that the money can be repaid, it is a ‘money debt’ under the loan relationships legislation. It is necessary to examine all the circumstances surrounding the money transfer before making a decision. From HMRC’s point of view, the amount contributed should not be distributable. Generally in financial transfer pricing, it is expected that treatment of an ambiguous item will be agreed upon for a period of time, the duration of a thin cap agreement, for instance, or the time for which the treatment of outward lending is settled.

For the chargeable gains aspect of capital contributions see CG43500 onwards, and for the loan relationships aspect of capital contributions see CT51200 onwards.

For the treatment of foreign exchange losses where an equity function argument is in point, see CFM62280. The Corporate Finance Manual describes the workings of FA93/S136 - at CFM61010 - and then goes on to discuss the changes to the rules brought in by FA2002.