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Where Taxpayers and Advisers Meet

Interest free loan UK to UK and transfer pricing

simplytax
Posts:86
Joined:Wed Aug 06, 2008 3:34 pm
Interest free loan UK to UK and transfer pricing

Postby simplytax » Tue Feb 09, 2010 12:11 pm

If UK parent funds the set up of its UK sub and there is a large intercompany balance with no interest applied then one would expect there to be an imputation of interest ( where SME thresholds exceeded ) for transfer pricing on the parent as lender and the sub can claim a compensating adjustment.

However what is the position if an arms length lender would not have advanced the monies/met bills for the sub. treating the sub. as a stand alone company and start up? s1A(2) sch 28AA ICTA states that account be taken of the question of whether the loan would have been made at all and the amount of the loan if it were a 3rd party. Does this mean that there would be no imputation of interest on the parent company as lender ?

If so how does this reconcile with HMRC manuals INTM503010 http://www.hmrc.gov.uk/manuals/intmanual/INTM503010.htm

Here it refers to a loan performing an equity function and that if agreed imputation of interest is correct that the parent company loan should not be repaid in a later period. if part of the loan were deemed equity and part not then presumably there will be imputation of interest on part of the loan and the remainder of the loan HMRC would say should not be repaid.

How does this work in practice given it is UK to UK ? Both parent and sub. are likely to commercially regard the loan in their accounts and potentially repayable at some point if the sub, is successful. If so should there be a transfer pricing adjustment in the tax returns for imputation of interest on the parent based on the full amount of the loan even although the sub could not have borrowed the funds from a 3rd party ?

If both parent and sub are loss making then any compensating TP adjustment in sub. may simply become a LR deficit to carry forward which may not obtain relief for a number of years given it is start up. The parent however may be profitable in next couple of years and will be taxed on any TP imputation so no fiscal group neutrality for the year in question.

Anyone with experience of above TP adjustment to be made and HMRC ?

Incredulum
Posts:2795
Joined:Thu Dec 03, 2009 5:35 pm

Re: Interest free loan UK to UK and transfer pricing

Postby Incredulum » Tue Feb 09, 2010 6:49 pm

I spend something like a fortnight a year on TP of my intercompany balances. (cool!)

You state that the loan to which you refer would not be lent by a third party. It is therefore equity in function when first lent in. Therefore no interest need be imputed - in fact, you must NOT impute interest. (But see my final paragraph.)

The alternative method would be for sub to issue shares to give it equity and then if you were to lend down further cash (subject to suitable debt:equity ratios and other covenants), interest should be charged.

And then there is the media via which is probably your set of circumstances. Part of the loan is equity, the other part debt.

Why not just get sub to issue shares, and then there is no non-equity function? You can always reduce share cap in due course if you need to.

Incredulum
Posts:2795
Joined:Thu Dec 03, 2009 5:35 pm

Re: Interest free loan UK to UK and transfer pricing

Postby Incredulum » Tue Feb 09, 2010 7:04 pm

For "see my final paragraph", please see my penultimate paragraph!

simplytax
Posts:86
Joined:Wed Aug 06, 2008 3:34 pm

Re: Interest free loan UK to UK and transfer pricing

Postby simplytax » Tue Feb 09, 2010 7:33 pm

Thanks for your comments.

How do you generally go about supporting the arms length amount of loan and interest to satisfy HMRC? Its not that long ago that banks were falling over themselves to lend and now they won't lend !

If sub set up with small equity and not forecasting profits for several years may not have been able to borrow much. I suspect parent co thought loan was more flexible on getting repaid than awaiting distributable reserves for dividends.

Any downsides with capitalising loan now and locking in capital ?

If actual interest were paid on the loan as recorded by the companies would that then require TP adjustment in sub to reduce to interest on arms length amount of loan - possibly nil and corresponding adjustment to parent to reduce taxable interest received to nil ?

If no interest paid but simply imputed interest at a commercial rate for simplicity would HMRC care if potentially fiscally neutral over time given UK to UK?

If loan is providing equity function but companies continue to show loans in their accounts and loan is repaid in future what is ramification of this from HMRC ? expect interest to then be imputed and if it has been then no concern or what ?

Incredulum
Posts:2795
Joined:Thu Dec 03, 2009 5:35 pm

Re: Interest free loan UK to UK and transfer pricing

Postby Incredulum » Wed Feb 10, 2010 11:28 am

I hasten to point out I am not a transfer pricing expert.

>How do you generally go about supporting the arms length amount of loan and interest to satisfy HMRC?

By finding comparatives. It's obviously a very difficult area, and it's an art not a science. Provided you have evidence, and have it documented, then you are fine - from a penalties perspective - in an inquiry.

>Any downsides with capitalising loan now and locking in capital ?

They can be somewhat reluctant if you change the status of a loan purely to change the TP situation. If e.g. (example is a property company with a good asset, hence low interest rate) you put long term debt in at libor +1% five years ago, which was then 6% but is now 1.5% and you want to achieve a higher interest deduction, then you might think: repay loan and refinance - it would probably cost you libor +4% today. BUT the refinancing is only to change the tax position, has no commerciality, so doesn't "work".

A bit different, I guess, in your situation.

>>If sub set up with small equity and not forecasting profits for several years may not have been able to borrow much.

Yes and no. If set up with £100 equity, a bank might lend it, say, £200. However, if Parentco were to lend it £3m then effectively £1m is equity, £2m is debt. So impute interest on £2m only. (And if you are charging interest on the full £3m, then you have to "unimpute" interest on £1m - the equity element - in the way you describe.)

> would HMRC care if potentially fiscally neutral over time given UK to UK?


Much as I would like to say they wouldn't care, UK-UK TP is a statutory requirement. And there can be interest and penalties if you get it wrong - under the draconian new penalty regime.





Yes and no. If set up with £100 equity, a bank might lend it, say, £200. However, if Parentco were to lend it £3m then effectively £1m is equity, £2m is debt. So impute interest on £2m only. (And if you are

Incredulum
Posts:2795
Joined:Thu Dec 03, 2009 5:35 pm

Re: Interest free loan UK to UK and transfer pricing

Postby Incredulum » Wed Feb 10, 2010 11:34 am

...continued.

>>If loan is providing equity function but companies continue to show loans in their accounts and loan is
>>repaid in future what is ramification of this from HMRC ?

You don't need to think of it like that. Consider it on a year by year basis

In my earlier example set up with an acceptable debt equity ratio of 2:1. There is £3m of debt, of which £1m is being treated as equity. If co makes a £1m loss in year 1, by the end of year 1, the company's equity is (1m). So of that £3m loan, £1m is covering the negative equity. The remaining £2m represents £0.667m of equity and 1.333m of debt.

If you then make £2m profit in year 2, by the end, there is equity of £1m, and surplus cash of £1m is repaid. So the remaining loan is 100% debt - the company having £1m of equity.

Year 3 make 3m of profit, repay all the debt and the company has £2m of equity left. You want an interest deduction, so divi it up and lend it back down.

simplytax
Posts:86
Joined:Wed Aug 06, 2008 3:34 pm

Re: Interest free loan UK to UK and transfer pricing

Postby simplytax » Mon Mar 01, 2010 7:53 pm

On contacting HMRC TP unit to discuss their general approach in UK to UK interest free loans, if when the loan is made the two companies document the long term nature and equity function it is performing and no interest is to be charged then that should suffice. The position should be reviewed periodically every few years. Should the subsidiary later be in a position to repay part of the loan that was regarded as long term "equity funding" then that need not be a problem and imputation of interest would not be sought for earlier years. If the loan then is regarded as no longer long term "equity" then interest could be charged in future or a TP adjustment for imputed interest.

Given it is UK to UK it is unlikely to be challenged if no blatant abuse and loan documented at outset as interest free and providing equity function with no short term repayment required.

Incredulum
Posts:2795
Joined:Thu Dec 03, 2009 5:35 pm

Re: Interest free loan UK to UK and transfer pricing

Postby Incredulum » Tue Mar 02, 2010 11:03 am

Yes, indeed. You might wish to contrast that with my example - where the loan is really a short-term, non-equity loan, but in certain years becomes equity on account of the company's thinly capitalised situation.


I'm sure you know this but beware that if the net assets of the company drop below nil, you cannot then capitalise the loan into shares and claim a capital loss. This because buying shares with negative value cannot give you base cost.

simplytax
Posts:86
Joined:Wed Aug 06, 2008 3:34 pm

Re: Interest free loan UK to UK and transfer pricing

Postby simplytax » Tue Mar 02, 2010 11:43 am

Thanks for your comments Incredulum. These issues as like a lot in tax can get very convoluted in theory with uncertainty on how practical HMRC will be in practice.

Any loss in the shares, whether or not the loan is capitalised if between two trading companies I expect would fall under SSE provisions such that if no gain would be taxed then no loss would be available. If no loss relief for connected party loans then probably does not matter whether capitalise loans or leave loans as long term "equity" and disclose as such in balance sheet beneath shareholder funds rather than deducted from assets to arrive at net assets.


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