Thin capitalisation: practical guidance: opening a case: origins and destinations of debt
Purpose of the borrowing
Part 4 of TIOPA 2010 has no purpose test. It simply requires the arm’s length principle to be applied to the funding. Borrowing tends to take place with a commercial object in mind, and the issue of purpose applies more often to the question: why hasn’t the company repaid some or all of the debt? Purpose is, however, of key significance for CTA09/S441-S442, which is used to challenge loans where there is a purpose “which is not amongst the business or other commercial purposes of the company.
Transfer pricing is a one way street
Under TIOPA10, adjustments cannot be made or accepted by which transfer pricing adjustments are used to create or increase a tax advantage for the taxpayer under scrutiny. The intention of the transfer pricing legislation is to undo tax advantages (TIOPA10/S147).
The “would” test applies
TIOPA10/S152 says that all factors should be taken into account in working out what the arm’s length provision would be. including:
- the amount of the loan,
- the interest rate and other terms, and
- the question of whether the loan would have been made at all.
“Would” means, in the context of an arm’s length provision: would the lender have lent this amount on these terms and would the borrower have borrowed it? Both viewpoints must be considered.
Interest imputation - transfer pricing of outward lending
Is all the company’s outward lending on an arm’s length basis?
What has the company done with its surplus cash? Does the interest return appear low for the amount held by the company in cash and outward loans? Outward lending may be of an informal nature (only visible in high intra-group debtor balances in the Notes to the Accounts), and it may be classified as short-term. Balances with its own UK subsidiaries are relatively low risk, but loans to non-UK group companies, whether subsidiaries of the lender or not, may not be properly priced.
If an intra-group loan to a UK company is creating a significant tax deduction in the UK, perhaps not matched by an equal tax cost to the lender, the global group has in place an efficient piece of tax planning. Ordinarily, a company with a significant debt burden might be expected to want to reduce it where it is able to, but it can be advantageous for group tax purposes leave it in place. It is easy enough to on-lend money within the group without disturbing the debt obligation. Consider what the UK borrower does with any cash it accumulates: is it reasonable to suggest that some might be applied to repay debt, especially if it is lent on to other group members for a low return? HMRC cannot insist that debt is actually repaid, but for corporation tax purposes interest may be imputed on the outward lending to offset or cancel the detrimental effect which the arrangements have created. A loan which has to any extent outlived its commercial purpose may also be challenged under CTA09/S441 as having an unallowable purpose.
This possibility needs to be weighed against the fact that active companies need cash for working capital. While it may be justifiable to impute interest on low-return outward, it may be appropriate to exclude a proportion of the cash from imputation as it represents working capital employed in the business.
Companies may be part of group cash pooling arrangements, and therefore potentially be in the position of net lender to the pool, which means that the pool is no longer just a convenient arrangement to minimise group borrowing, but a route through which a company in surplus lends to the group often on an unrecognised long-term basis. The UK borrower may be paying interest at long-term rates and receiving interest at overnight rates. It is not unknown for a UK company to receive a substantial and formally recognised loan at x% interest, only for most of it to be lent straight back into a cash pool administered by the lender which pays x minus 1.5%. This is unlikely to happen between parties whose transactions are on an arm’s length basis?
Outward lending is a legitimate part of a thin cap review, and can be adjusted for by a clause in the ATCA or as part of an enquiry settlement.
Upward lending: loans from subsidiaries
Subsidiaries of UK companies return profits to their shareholders in the form of dividends. If instead they lend the money up the ownership chain, that creates a tax deduction in the computations of the UK parent. If the subsidiaries are located overseas, the UK group is incurring costs for the use of money it would otherwise be entitled to receive as dividends. Upward lending is inherently uncommercial, except where it represents the temporary advance of funds which will in due course be required by the subsidiary for a business purpose of its own. A legitimate explanation is that surplus cash may be available in advance of the time when the reserves are recognised which would enable dividends to be paid up. Either way, it should be temporary. Upward lending denies the strategic head of the group free access to the funds generated by group activities.