IFM40820 - Overseas property business: loan relationships and derivative contracts

FA22/SCH2/PARA52

Where a QAHC has an overseas property business, the profits of which are QAHC overseas property profits taxable in a foreign jurisdiction, PARA 52(1) provides that no liability to UK corporation tax arises (IFM40810).

A QAHC will often be party to a loan relationship or derivative contract for the purposes of its overseas property business – for example, it may borrow to fund its investment in overseas property, or it may enter into a derivative contract to hedge certain exposures.

The profits which arise from such loan relationships and derivative contracts will be exempt from corporation tax by virtue of PARA 52(4), but only to the extent (apportioned on a just and reasonable basis) that those profits relate to the QAHC overseas property profits which are exempt from corporation tax as a result of PARA 52(1).

Example 1

A QAHC has an overseas property business, and the resulting profits are QAHC overseas property profits which are taxable in a foreign jurisdiction. The profits are therefore exempt from UK corporation tax liability under PARA 52(1).

The QAHC has a GBP functional currency and receives rental income in a foreign currency. As such, it is therefore exposed to fluctuations in exchange rates: for example, if rents are received in Euro and GBP weakens relative to the Euro, then the QAHC will receive less income (expressed in GBP).

To hedge such exposure, the QAHC enters into a derivative (such as a currency swap) to convert it to GBP at a fixed rate. The rates move and at the end of the accounting period, the derivative is in-the-money. Therefore, a credit arises in the QAHC on the derivative contract.

The resulting credits in respect of the derivative contract that the QAHC is party to for the purposes of its overseas property business are exempt from UK corporation tax liability in accordance with PARA 52(4) to the extent (apportioned on a just and reasonable basis) that the credits relate to the QAHC overseas property profits which are exempt from corporation tax as a result of PARA 52(1).

The same principle would apply to loan relationship debits in respect of a loan taken out to fund the property acquisition. Interest arising in respect of such a loan will not be taken into account in computing UK corporation tax liability to the extent (apportioned on a just and reasonable basis) that the interest relates to QAHC overseas property profits which are exempt from corporation tax as a result of PARA 52(1).

Example 2

A QAHC has an overseas property business which consists of 8 properties in Jurisdiction A and 2 properties in Jurisdiction B.

Jurisdiction A has a corporate tax rate of 10 percent and it is accepted that this tax is charged on income and corresponds to UK corporation tax, while Jurisdiction B has a corporate tax rate of 0 percent.

The QAHC overseas property profits of this overseas property business is £100,000. These profits are attributable as follows: £70,000 to Jurisdiction A; £30,000 to Jurisdiction B.

In accordance with PARA 52(1) and PARA 52(3), the £70,000 QAHC overseas property profits which are taxable in Jurisdiction A are exempt from UK corporation tax.

The £30,000 QAHC overseas property profits attributable to Jurisdiction B do not meet the criteria in PARA 52(3) as they are chargeable at a nil rate. They will not be exempt from UK corporation tax in accordance with PARA 52(1), and therefore will be chargeable to UK corporation tax under CTA09/PT4/CH3.

The QAHC took out a loan of £1,000,000 to fund the acquisition of these 10 properties, with the 8 properties in Jurisdiction A costing £600,000 and the 2 properties in Jurisdiction B costing £400,000. Loan interest is payable at 5 percent, so is £50,000 per annum.

In line with PARA 52(4), loan relationship debits arising in respect of a loan taken out to fund the acquisition of property will not be taken into account in computing the corporation tax liability to the extent, apportioned on a just and reasonable basis, that the interest relates to QAHC overseas property profits which are exempt from corporation tax as a result of PARA 52(1).

In this example, the loan relationship debit of £50,000 will need to be apportioned on a just and reasonable basis between Jurisdiction A (profits exempt from UK corporation tax by virtue of PARA 52(1)) and Jurisdiction B (profits are not exempt under PARA 52(1)).

It would be just and reasonable to apportion 60 percent of the interest expense (£30,000) to Jurisdiction A, given that 60 percent of the loan was used to fund the 8 properties in that jurisdiction. This £30,000 would therefore be disregarded as it relates to the exempt overseas property profits, while the remaining 40 percent of the interest expense (£20,000) will not be prevented by PARA 52(1) from being allowable as a loan relationship debit as it relates to the overseas property profits which are chargeable to corporation tax under CTA09/PT4/CH3. (But other tax rules, such as unallowable purpose at CTA09/S441 may need to be considered.)

PARA 52(5) provides that where a QAHC is party to a loan relationship or derivative contract partly for the purposes of an overseas property business and partly for another purpose, PARA 52(4) will only apply to the proportion of the profits from such a relationship or contract that are attributable to the overseas property business. Any such apportionment must be on a just and reasonable basis.

Example 3

PARA 52(5) provides that where a QAHC is party to a loan relationship or derivative contract partly for the purposes of an overseas property business and partly for another purpose, PARA 52(4) will only apply to the proportion of the profits from such a relationship or contract that are attributable to the overseas property business. Any such apportionment must be on a just and reasonable basis.

For example, a QAHC takes out a loan of £1,000,000 to fund the acquisition of a rental property (for which funding of £800,000 was required) for use in the QAHC overseas property business and to meet business expenses in connection with profits derived from activities outside its QAHC overseas property business (£200,000 required).

The whole of the QAHC overseas property profits is taxable in the foreign jurisdiction in accordance with PARA 52(3) and therefore no corporation tax liability arises in respect of these profits (PARA 52(1)).

Loan interest at 5 percent p.a. is £50,000 and these debits must be apportioned on a just and reasonable basis between the QAHC overseas property business and the non-QAHC overseas property business. A just and reasonable apportionment would see £40,000 of the loan relationship debits attributed to the QAHC overseas property business, and as the QAHC overseas property business profits are exempt by virtue of PARA 52(1), the loan relationship debits will not be allowable. The £10,000 loan relationship debits attributed to the non-QAHC overseas property business will not be prevented by PARA 52(1) from being allowable for UK tax purposes (although other rules, such as the unallowable purpose rules at CTA09/S441 would need to be considered).