Intra-group funding: group finance companies and the treasury function: Thin capitalisation risk assessment
In the commercial world, financial businesses are likely to be geared at far higher levels than non-financial businesses. It is therefore quite reasonable to expect a treasury or group finance company to have a significantly higher debt-to-equity ratio than the rest of the group (assuming that the rest of the group is principally engaged in non-financial businesses).
The business activity of a treasury or group finance company operating on commercial terms should be subject to a careful analysis to establish the appropriate level of equity funding. As with all thin capitalisation cases, it is important to consider both gearing (debt-based ratios) and profitability levels in determining what would be accepted and expected at arm’s length. Although debt:EBITDA is the more commonly-used ratio for the general run of trading companies, debt:equity remains the normal key ratio for finance-related companies. The required level of equity is directly linked to the level of risk carried by the company in its borrowing and lending activities. This risk may in reality often be borne by more substantial companies within the group, usually the parent or major trading affiliates.
Where the group finance company of an overseas group is located in the UK, there is a risk that the increased arm’s length debt capacity acceptable for a group finance company is ‘gearing up’ the group’s non-financial activities in the UK. This might arise by debt (either from third parties or from non-resident associates) passing through the UK finance company and into the UK operating companies. If this happens, the finance company is likely to be treated as having a greater borrowing capacity than would be attributed to a trading company. However, if that higher level of debt is passed on to a UK associate, it might not be recognised that the test needs to be applied to the trading company as well.
Gearing up and the “series of transactions”
Arrangements to “gear up” a UK non financial group or company may fall within the ‘series of transactions’ provision in TIOPA10/S147(1). It can make a significant difference in some circumstances whether the tripartite arrangements are regarded as “series of transactions” or not.
The overseas lender lends the UK group finance company £100m at interest of 5%. This is on-lent to the UK trading company. The interest flows are
- trading company pays interest of £5m to finance company
- group finance company receives interest of £5m and pays £5m to the overseas lender
The actual aggregated UK position is an interest deduction of £5m
Tax analysis without the “series of transactions” interpretation:
- The UK trading company can only support borrowing of £50m at arm’s length, so there will be a transfer pricing adjustment of £2.5m (£50m x 5%) to reduce the interest paid. The tax deduction for interest is reduced from £5m to £2.5m.
- The UK group finance company has received £5m interest, of which £2.5m has been subject of a transfer pricing disallowance in the computations of the UK trading company, so the group finance co can make a claim under TIOPA10/S182 for £2.5m of the £5m received not to be taxed.
- The UK group finance company has sufficient equity to support arm’s length borrowing of £100m, so there will be no adjustment to the deduction for the £5m interest paid to the overseas company. The finance company’s net position is a deduction of interest of £2.5m.
After applying TIOPA10/Part 4 without invoking the “series of transactions” provision, the net UK position is an interest debit of £5m.
Tax analysis invoking the “series of transactions” interpretation:
The factual and functional analysis demonstrates that the actual provision is a loan by an overseas lender to a UK trading company. This is the “series of transactions” referred to, with the finance company reduced to the role of an intermediary or conduit between the “real” lender and borrower. The parties to the provision are the overseas lender and the UK trading company, so when it comes to considering the availability of a compensating adjustment under TIOPA10/S182 for the £2.5m disallowed, none will be available because the advantaged party is the UK trading company and the disadvantaged person is the overseas lender. An adjustment to the computations of the overseas lender can only be effected via the Mutual Agreement Procedure which allows representatives of the states concerned to try to resolve double taxation issues.
After applying TIOPA10/Part 4 invoking the “series of transactions” provision, the net UK position is an interest deduction of £2.5m in the computations of the UK trading company.
Whether or not the arrangements are caught will depend on a full analysis of the transactions, to establish whether the arrangements fall within the definition of “series of transactions” (see INTM432040).
The application of TIOPA10/S182 to finance transactions can apply equally to full function treasury companies as to single loans routed via a conduit company. However, where the nature, scale and breadth of the activities of a treasury company based in the UK are akin to those that would be carried on by an independent entity and there is effective assessment, monitoring and management of the risks it is more likely that the treasury company is providing funds to the UK group members in the normal course of its business.
By reason of CTA09/S446, any adjustments brought about by Part 4 of TIOPA 2010 or its predecessor, ICTA88/SCH28AA, are accepted as applying to a company’s loan relationship or related transactions.