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HMRC internal manual

International Manual

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HM Revenue & Customs
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Thin capitalisation: practical guidance: third-party loan agreements: interest rates and related fees

Third-party loan agreements will typically specify the interest rate charged on a loan, though unless it is a fixed rate loan it will be calculated by reference to a formula. One of the simplest formulae is based on LIBOR (see INTM516035) or other reference rate, plus a margin. But a more complicated formulation may apply over the term of a loan. This will depend on the financial performance of the borrower over the loan period. The “plus” element may also vary for the same reasons. Similarly, some loan agreements, whether third-party or not, contain a penalty clause bringing in a higher interest rate in the event of the borrower’s failure to make loan repayments on time. Typically, the interest rate increases by up to 2%.

Arrangement Fees

In addition to the interest rate charged on a loan, third-party lenders may make an additional charge for arranging a loan, and these fees may also be charged by connected lenders.

Arrangement fees represent items such as legal and other expenses actually incurred by the lender in drawing up loan documents, though it may be no more than a kind of “joining fee”. Arrangement fees should be seen as part of the finance cost incurred by a borrower, and should therefore be added to the interest charge and other similar costs in order to assess whether the total finance cost amounts to an arm’s length price.

Arrangement fees may also be susceptible to challenge under CTA09/S54 as being not wholly and exclusively for the purposes of the trade.

Facility Fees

Another charge levied by third-party lenders, over and above the interest charge, is the facility fees. For example, a lender may grant a loan facility of £100m. If the borrower draws only £60m, a small fee may be payable for continuing to hold the remaining £40m available within the notice period specified by the agreement, even though it is not currently required. Such fees are smaller than the interest rate, and are allowable tax deductions where lender and borrower are not connected, as part of finance costs. If a facility charge is made between connected persons, you should establish whether the charge is justifiable. The same considerations apply as for arrangement fees above, as they do to any other one-off or annual fees of a similar nature (see INTM520020 on connected party facility fees).

Note that if arm’s length borrowing has been agreed at a lower amount than the actual total facility, then the cost of making available anything above that lower amount will be disallowable as it relates to the provision of non-arm’s length debt. For example, if it is agreed the arm’s length amount of the facility should be a maximum of £80m, say (continuing the above example), then it may be reasonable to charge a facility fee on the difference between the drawn amount (£60m) and the agreed maximum (£80m), but not on the £20m from £80m-£100m.

It is in general necessary to consider what the fee was actually for, particularly if it entailed no effort or expense on the part of the connected lender.