INTM518060 - Thin capitalisation: practical guidance: lending against asset values: offshore property companies

Looking into the financial structure of a property rental company is no different to any other thin cap case. Obtaining the facts and checking their reliability using normal investigative techniques is vital.

It is important to have a detailed knowledge of the company, in particular:

  • what property is owned, its cost, condition, age and when it was acquired
  • the state of the market
  • who is behind the company and what their experience is.

Offshore Structures

A lot of UK commercial property is owned by entities located offshore, and where this is so it adds other risks which may need to be considered. In particular, it is often found that the person behind the company has UK connections. This is a specialised area and help can be sought from Specialist PT International in Bootle.

Offshore structures will commonly have a transfer pricing risk. Lending institutions will want the owners of a company to put in their own money and this will be typically between 15 and 25%. They do not usually mind whether that is done by share capital or by debt. However, particularly if debt can be sourced from a low tax jurisdiction, it is advantageous from the point of view of limiting the company’s liability to UK tax to use debt rather than share capital. If the owner opts for debt to provide their stake in the transactions, a prudent third party lender would seek to ensure that:

  • the owner’s debt is not secured on the property
  • the owner’s debt is repaid after the senior debt is repaid
  • the cash flow of the borrower is used firstly to service the senior debt, and only surplus cash flow is used to service the owner’s debt.

Two major problems are encountered:

  1. Loan to value

The company may argue that although the senior lender would only lend a lower percentage of the property’s value - say 80%, additional finance would have been obtained through junior or mezzanine debt and that the connected party debt should be on the same terms as that other debt. INTM519030 gives some advice on structured debt - senior, mezzanine, etc.

Whilst there is a market in providing additional finance, it is relatively small in relation to the market as a whole. Specialist PT International’s experience of enquiry work on offshore companies suggests that third-party deb in these circumstances is very limited.

In cases of connected party funding, it is rare that evidence exists of the contemporaneous availability of an equivalent third party debt. If material is put forward, it should be tested in exactly the same way as any evidence provided in an enquiry. If the company has sought an offer of a third-party debt at the time, it must be established on what basis the provider was asked to quote, what the likelihood was of the debt ever being taken up, and why it was not. More often than not the evidence will have been provided in response to the HMRC enquiry, and long after the event. This is of low evidential value as it is only an opinion of what may hypothetically have been offered. It also begs the question whether the potential lender had any expectation that the company would take up their offer. What evidence is there that the company might ever have contemplated accepting a third-party offer? Such evidence might include Board minutes and notes of telephone conversations or email discussions with potential lenders.

  1. Margins

Even if the LTV is acceptable, the interest rate charged on connected party debt may be excessive. The facts of a case may indicate debt from, say, a third party bank is less than what could have been obtained. It may then be argued this was the maximum the bank would lend, and therefore greater debt will attract a higher margin. The debt from the bank may, however, be all the company requested, because it wanted to top up the debt with a connected party debt at a much higher rate. In these circumstances, the margin on the connected party loan should not differ from that on the bank debt.

Many of the considerations mentioned in regard to LTVs also apply here. Appropriate commercial databases can also be a help to demonstrate whether any of the loans is out of line with the market.

With both of these problems it can sometimes be worth doing a detailed cash flow exercise which may demonstrate the terms of a connected party loan make the loan uneconomic.

Non-resident company landlords are subject to income tax on their rental income from UK property assets. They are not subject to CGT on UK property disposals. Neither the CT nor the loan relationship rules apply to these entities.

Other points to consider regarding offshore structures include the relevance of the Controlled Foreign Company (CFC) legislation where there is an overseas (subsidiary) group company controlled from the UK. If the overseas company is paying income tax rather than corporation tax in the UK, the CFC regulations may apply and it may be appropriate to impute additional profits on the controlling (UK) company. Detailed technical discussion on this point is outside the scope of this module of the manual but advice is available in either the CFC part of this manual or from the CFC team at CSTD, Business Assets & International.

Similarly, where there is a UK individual behind the structure, Part 13, Chapter 2, ITA07 may apply to make it possible to attribute the income arising offshore to a UK individual. Detailed technical discussion on this point is outside the scope of this manual, but advice is available from Specialist PT International. See also INTM600000.

Generally income tax should be deducted from UK property rental payments to offshore owners unless the recipient is entitled to receive gross payments following registration with Specialist PT International. Further information on the Non-Resident Landlords Scheme can be found at INTM370000.