Taxation of loan relationships

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1 Taxation of loan relationships Produced by Tolley in partnership with Sue Mainwaring Reed Elsevier (UK) Limited trading as LexisNexis. Registered office 1-3 Strand London WC2N 5JR Registered in England number VAT Registered No. GB LexisNexis and the Knowledge Burst logo are trademarks of Reed Elsevier Properties Inc. LexisNexis The information in this document is current as of DATE and is subject to change without notice.

2 Taxation of loan relationships Produced by Tolley in partnership with Sue Mainwaring This guidance note explains how companies are taxed in respect of their loan relationships and relevant non-lending relationships (RNLR) under CTA 2009, Parts 5 and 6. In particular, it considers the computational and charging provisions in Chapter 3 of Part 5. For information on which items fail to be taxed under the loan relationship regime, see the Loan relationships - scope and definitions guidance note. There are other rules relating to the taxation of corporate debt which must also be considered. For an overview of these rules and links to further guidance, see the Overview of provisions relating to corporate debt guidance note. HMRC s own guidance on the loan relationship rules is set out in some detail at CFM30000 onwards. Introduction Companies are generally taxable on the debits and credits that are recognised in their statutory accounts in respect of their loan relationships and related transactions. The legislation is specific about the debits and credits that are taxable, and the basis of the accounts that they are drawn from. These concepts are discussed further below. The term loan relationship is closely defined and is discussed in detail in the Loan relationships - scope and definitions guidance note. It includes relevant non-lending relationships and certain other financing arrangements which are deemed to be loan relationships for tax purposes, but in these cases only certain debits and credits are within the scope to tax. The term related transaction is defined in CTA 2009, s 304 as a disposal or acquisition (in whole or in part) of rights or liabilities under a loan relationship. This includes, but is not necessarily restricted to, instances where rights or liabilities are transferred or extinguished by any sale, gift, exchange, surrender, redemption or release. Profits arising from a company s loan relationships are taxed as income (CTA 2009, s 295), either as part of the company s trading profit or as non-trading income. The distinction between trading and non-trading is discussed further below. Some exceptions to the general principles regarding taxation of loan relationships are listed at the end of this guidance note. It is important to note that the loan relationships regime generally takes precedence over other statutes unless there is an express provision to the contrary (CTA 2009, s 464). In addition to adjustments under the regime itself, the amounts charged to tax are subject to the transfer pricing, thin capitalisation and debt cap provisions. But an amount which is denied relief under these rules is not generally deductible elsewhere. It may be useful to consider the taxation of loan relationships by looking at the Flowchart - tax treatment of loan relationships. Acceptable accounts The loan relationship rules operate by reference to amounts recognised by companies for accounting purposes. Those accounts must be prepared under generally recognised accounting practice (GAAP), including UK and International Accounting Standards (CTA 2010, s 1127). It should be noted that UK GAAP is changing for accounting periods beginning on or after 1 January In 2012 and 2013, the Financial Reporting Council (FRC) revised financial reporting standards for the UK and Republic of Ireland. The revision has resulted in the replacement of almost all extant standards with just three Financial Reporting Standards: > > FRS Application of Financial Reporting Standards - which sets out the overall financial reporting framework > > FRS Reduced Disclosure Framework - which addresses the requirements and disclosure exemptions for the entity financial statements of subsidiaries that otherwise apply EU-adopted IFRS > > FRS The Financial Reporting Standard applicable in the UK and Republic of Ireland - a single standard that applies to the financial statements of entities that are not applying EU-adopted IFRS, FRS 101 or the FRSSE (the financial reporting standard applicable to smaller entities) As these standards form New UK GAAP, the tax rules applicable to loan relationships can continue to follow the accounting treatment without interruption or amendment. It is possible, however, that companies which are required to change their basis of accounting on introduction of these new standards may have transitional adjustments which will, for better or worse, fall to be taxed. For further guidance on New UK GAAP, see the Trading income - general principles guidance note. If the accounts are not GAAP compliant then the relevant amounts must be restated on an acceptable basis for tax purposes.

3 Debits and credits CTA 2009, ss 307(3) and (4) are very precise about the nature of the debits and credits which a company must bring into account. They are the amounts that together fairly represent: > > all profits or losses from its loan relationships > > interest arising from its loan relationships > > expenses incurred by the company for the purpose of its loan relationships and related transactions as long as they are incurred directly in: > > bringing any of its loan relationships into existence > > entering into or giving effect to any of its related transactions > > making a payment under any of its loan relationships or related transactions > > collecting amounts due under any of its loan relationships or a related transaction In order to secure relief under CTA 2009, s 307(4), it is important to ensure that expenses are booked to the company which is a party to the transaction which has given rise to them and that they are relevant to that transaction. For example, this can often be an issue in practice when a new group structure is being created in order to acquire another company or group. Various financing arrangements may be entered into by different members of the new group with a variety of lenders (such as bank loans, the issue of loan notes, private equity financing, etc). It is important that the costs relating to each separate financing arrangement are recorded accurately. The term directly can be applied differently in different scenarios. For example: > > incidental expenses incurred by the party to the loan rather than another party (eg parent company) and recharged - the first are incurred directly and the latter are probably not > > consulting fees incurred on a cash flow statement made available to a finance provider versus a report on the pros and cons of raising debt or equity funding - the first are incurred directly whereas the latter are probably not, even if the company goes on to raise debt funding A wide range of expenses are deductible under these rules. CFM33060 includes a useful table of the type of expenses which HMRC considers allowable. CTA 2009, s 308 ensures that debits and credits are in charge to tax wherever they are booked, including: > > the profit and loss account, income statement or statement of comprehensive income > > the company s statement of recognised gains and losses, or statement of changes in equity > > any other statement of items brought into account in computing the company s profits and losses for the period It is important to note that: > > CTA 2009, s 307(3) makes it clear that the term fairly represents overrides the accounting condition > > CTA 2009, s 312 provides for adjustments to be made when amounts are not fully recognised in the accounts under GAAP > > CTA 2009, s 313 contains rules specifying the use of amortised cost or fair value accounting for tax purposes in certain cases Foreign exchange movements For the avoidance of doubt CTA 2009, s 328 makes it clear that foreign exchange movements generally form part of the taxable debits and credits, but it also specifies that they are not to be brought into account when they are booked directly to a reserve. This rule is vital to the tax-efficient treatment of arrangements to hedge the net investment in overseas subsidiaries and is helpful in the treatment of long term funding of overseas subsidiaries. See the Hedging overseas investments and the Foreign exchange issues guidance notes (both subscription sensitive). There are also a number of anti-avoidance measures pertaining to foreign exchange movements and these are also discussed in the above guidance note. Interest and amounts treated as interest As the loan relationship rules tax all profits and losses arising on a company s loan relationships, it is not usually necessary to determine whether a particular interest expense constitutes interest. However, some money debts will only be relevant non-lending relationships if they give rise to interest, and certain anti-avoidance measures (eg governing late interest) only apply to interest. The Tax Acts do not contain a definition of interest and so the question of what constitutes interest relies on case law. HMRC guidance contains useful discussion and highlights key principles from case law at CFM Several cases have highlighted the characteristic of interest as the compensation for the use of money over a period of time, see Bennett v Ogston 15 T C 374, Wigmore v Thomas Summerson 9 T C 577 Willingale v International Commercial Bank 52 T C 242. Certain amounts which are not interest are treated as such for the purpose of the loan relationship rules including returns on repossessions and alternative finance arrangements (ie funding under Sharia Law). See the Loan relationships - scope and definitions guidance note for more information. See Example 1.

4 Trading vs non-trading Profits arising from a company s loan relationships are taxed as income rather than capital and their classification as trading or non-trading is determined by how the funds are actually used. Generally speaking, where a loan is used to generate income which is taxed as trading profits, it is a trading loan relationship under CTA 2009, s 297. Interest on a loan applied in the acquisition of plant and machinery for use in the company s trade would give rise to trading deductions, whereas a loan used to fund the acquisition of a trading subsidiary would give rise to nontrading deductions. Debits and credits from non-trading loan relationships are pooled together, resulting in either a net credit or a net deficit. A net credit is brought into the company s total taxable profits under CTA 2009, ss 299 and 301. For the treatment of losses and how they may be used, see the Non-trading deficits on loan relationships guidance note. Property or overseas property businesses are not treated as trading for the purpose of loan relationships, under CTA 2009, s 39. For more information see CFM Where a company lends funds to an associate, it will generate non-trading loan relationship income unless lending is an integral part of its trade (CTA 2009, s 298). This will only usually be the case for banks and financial institutions. This is an important point when considering the treatment of: > > loans between two trading companies > > loans from a designated treasury company or special purpose finance vehicle See Example 2. Capitalised interest Under CTA 2009, s 320(2), interest allocated to the carrying value of a fixed capital asset or project is relieved in the period in which it would otherwise have been charged to the income statement under GAAP. Pre-trading financing costs If a company incurs financing costs before it starts to trade, these will always be non-trading debits. Where financing costs would be for the purpose of a trade if the company had commenced to trade, CTA 2009, s 330 provides for the company to elect for the costs to be treated as trading debits arising on the first day of trading. The election is available as long as the trade commences within seven years of the end of the accounting period in which the debit arises and must be made within two years of the end of the accounting period. Relationships between connected parties There are a number of specific rules that must be applied to the debits and credits arising on a company s loan relationship with connected parties. CTA 2009, Part 5, Chapters 4-6 include: > > amortised cost basis of accounting to be used (CTA 2009, s 349(2)) > > restricted relief for debits in respect of impairment losses and releases (CTA 2009, s 353) > > disregard of related transactions (CTA 2009, s 352) > > continuity of treatment on transfers within groups (CTA 2009, s 335) In addition: > > CTA 2009, Part 5, Chapter 7 sets out restrictions to group relief involving impaired consortium debts > > CTA 2009, Part 5, Chapter 8 sets out the cases where interest payable to certain connected parties may only be relieved when it is paid, although these provisions are due to be repealed following announcements made at Autumn Statement Meaning of connected There is a connection between the parties to a loan if they are both companies and the conditions of CTA 2009, s 466 are met. In particular, if the parties are connected at any time in an accounting period, they are held to be connected for the whole of that period. There is a connection if one party controls the other or both fall under the common control of a third person. Control is defined in CTA 2009, s 472, and it is important to note that this definition requires the power of a person to secure that the affairs of a company are conducted in accordance with his wishes. This is to be distinguished from a power of veto. Impairment losses The general rule in CTA 2009, s 354 is that no relief is available for a provision against, or a loss on writing off, a loan receivable from a connected party. Moreover, when parties cease to be connected, the lender may not claim relief for impairment losses booked in any subsequent period (CTA 2009, s 355). This is balanced by CTA 2009, s 358 which provides for a corresponding credit on the release of a connected party debt to be left out of charge to tax. The term release is generally held to take on its formal legal meaning for this purpose. Consequently, to be sure of securing this relief, it is not sufficient simply to write back the amounts in the company s

5 books. Consideration should be given for the release or a deed of release should be drawn up. These provisions are, however, subject to the rules governing the acquisition of creditor rights by a connected company at an undervalue contained in CTA 2009, s 361. Debt equity swaps When shares are issued in settlement of a debt, the accounting treatment may suggest that the debt has been written off to the income statement and a separate amount capitalised in consideration of the shares. CTA 2009, ss 356 and 322(4) ensure that symmetry is maintained. Where the parties are connected, no relief is allowed for any loss, but no income is brought into charge if the consideration is ordinary share capital of the company. Loans for unallowable purposes This is a more general anti-avoidance rule in CTA 2009, ss which is dependent on a motive test. Where a company is a party to a loan relationship that is held to be for an unallowable purpose, all debits, together with foreign exchange credits, on that relationship and its related transactions must be left out of account for tax purposes. A loan has an unallowable purpose where it is used in activities which are outside the charge to tax or where one of the main purposes that the company is party to the relationship, or a related transaction, is the avoidance of tax. HMRC discusses the general application of these rules at CFM38110 and sets out transactions which it believes falls within and outside the scope of these rules at CFM38180 and CFM38190 respectively. Related transactions Where there is a related transaction in respect of a connected party loan, the debits brought in by the lender must not be greater and the credits cannot be smaller than the amounts that the lender would have recognised if the relationship had continued to exist (CTA 2009, s 352). FX movements are excluded from this rule. Continuity of treatment Chapter 4 contains important rules that ensure no debits or credits, other than FX movements up to the transaction date, are recognised when a loan relationship is transferred between two UK members of a capital gains group. The basic rule is that the transfer is deemed to take place at a value that ensures no profit / loss arises, but some precise conditions apply. In particular, the transferee has to become party to equivalent rights and liabilities but the rule will still apply if the original loan is substituted with a replacement loan on equivalent terms. HMRC s guidance on these rules is set out at CFM Anti-avoidance provisions The loan relationship regime contains a number of specific anti-avoidance measures concerned with deeming loan relationships to exist where funding transactions are structured in a way which would otherwise keep income out of charge to tax or tax it as capital (where it may be sheltered by capital losses). These rules are generally only in point where deliberate structuring is being undertaken to mitigate tax and should be looked at closely in those circumstances.

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