Taxation implications of financing U.K. subsidiaries.
One of the idiosyncrasies of the U.K. system is that it draws a distinction between annual interest and "short" interest. This distinction applies in determining deductibility; only short interest, other than annual interest paid to a U.K. bank, may be deducted, on an accrual basis, as a trading expense. Annual interest generally is allowed only when paid as "a charge on income." Charges on income can offset income and gains within the year, and may be surrenderable within a U.K. group. They may also be carried forward as part of a trading loss, but only if the borrowing is for the purposes of the trade (for example, borrowing to acquire the stock of another corporation will not qualify). An investment company can carry forward charges on income as excess management expenses.
The first task is therefore to determine whether the terms of the financing are such that any interest will be regarded as "short" rather than "annual."
Interest on a loan or advance that is expected to remain outstanding for more than a year is "annual." Interest on advances of a genuinely short-term nature (which would include demand loans and fluctuating advances) is "short." The substance of the borrowing must be considered. Even if an advance from a group member is constructed so that it is legally repayable on demand, the U.K. Revenue may challenge a contention that interest is "short." When the debtor company clearly needs funding and cannot continue to trade without the financial support provided by the group, the reality is that the debt is expected to exceed one year. Repaying debt before the year-end and readvancing the money afterwards may be treated as an admission that the interest is annual.
Even when it is clear that the advance will be fully repaid within a year, it is generally unwise to structure financing advances as "short." If the borrower is not a trading company (or is not borrowing to finance its trade), the interest will not be deductible.
The most common situation in which short interest will arise is when intercompany balances have arisen as a result of trading transactions, such as the purchase of goods or services.
Essentially the only issue that should arise here is whether any interest charge is made on an arm's length basis. Unfortunately it is not quite as simple as that. Any payment of interest to an overseas resident associated company (based on a 75% common control) is a distribution. This means that not only is the interest not deductible but also that advance corporation tax (ACT) has to be accounted for. In practice, the U.K. Revenue in its negotiations has tended to agree to a disallowance of the interest in whole or in part without requiring ACT payments. While the U.K. Revenue uses the threat of ACT to force a settlement, the further consequences (for example, the refund provided for under the U.S.-U.K. double tax treaty) also has to be considered, and settlements often do not lead to a strict application of all U.K. tax rules. The likely position in the United States, particularly given the competent authority provisions of the U.S.-U.K. treaty, needs to be examined when agreeing to any particular settlement with the U.K. Revenue. Additionally, the U.K. Revenue may argue that an arm's length supplier would not have traded with a thinly capitalized customer and that the "trade debt" is really a means of funding the subsidiary.
While in an extreme case this may be an issue, the more common issues are whether interest can automatically be charged on balances outstanding beyond a particular period (90 days or 180 days, for example) and whether retroactive charging of interest is permissible. In principle the charging of interest on long outstanding payables is "arm's length." However, if the period of free credit granted is unusually short there may be a problem. More particularly, the overall terms of trade need to be considered, as the credit allowed (or expected by custom) is factored by suppliers into their prices.
Generally, the U.K. Revenue is not unduly aggressive in investigating whether the original terms of trade allowed interest to be charged, but it would be prudent to define the position in advance. Otherwise, if a charge is made retroactively (which may occur when it is realized that Sec. 482 exposure exists), the U.K. Revenue could argue that, if the parties were at arm's length, the creditor could only specify that interest charges would run from the date when it announced such a charge. Any counterargument either has to be based on what bargaining power would exist in an uncontrolled situation or on a competent authority position. Fortunately, if it is clear that the adjustment is made because of a need to avoid a Sec. 482 adjustment, the U.K. Revenue is unlikely to insist on the competent authority route.
Although U.K. tax law does not contain a general rule attacking thinly capitalized companies, the blanket disallowance of interest payments to nonresident affiliates enables the U.K. Revenue to introduce this concept by the back door. Most of the U.K.'s double tax treaties contain provisions overriding this provision. However, all such treaties limit the protection to an arm's length amount of interest if there is a "special relationship" between the borrower and the lender. Historically, treaties referred only to an arm's length rate, but newer treaties employ different language, many following the wording of the U.S. treaty that restricts protection when "the amount of the interest paid exceeds for whatever reason the amount which would have been paid in the absence of such [special] relationship."
Following a decision of the Special Commissioners that such wording only permitted the U.K. Revenue to attack interest paid at an excessive rate, legislation has been enacted to codify this position.
The special relationship provisions of any treaty must be construed as
requiring account to be taken of an factors, including:
(a) The question of whether the loan would have been made at all in the absence of the relationship,
(b) The amount which the loan would have been in the absence of the relationship, and
(c) The rate of interest and other terms which would have been agreed in the absence of the relationship.
Furthemore, the provision is to be construed as requiring the taxpayer to show the amount of interest that would have been paid in the absence of the special relationship. This is likely in practice to impose, however subtly, a greater conservatism in loan structures and to put pressure on groups to accept the Revenue's informal "safe harbor" of a 1:1 debt to equity ratio.
While other factors (such as interest cover, fixed asset cover and cash flow) may be relevant, the Revenue has principally focused on the debt to equity ratio. In applying this test, the Revenue will be flexible and will, for example, consider assets, such as goodwill, not recognized in the financial statements of the borrower (or valued at lower, historical cost figures). It will also consider the position of a U.K. subgroup as a whole.
While more aggressive positions may be achieved in practice, the delay and uncertainty in obtaining the Revenue's agreement has to be factored into the decision as to how aggressive a position to adopt. While a particular division of the Revenue, the Inspector of Foreign Dividends, issues authorities to pay interest gross to the United States, its authority win be given only after a review by the local office dealing with the borrower. For larger loans, the local office may be required to consult with the International Division. As a practical matter, arguments about thin capitalization arise early and, while in principle the argument could be revisited when the borrower's tax return is reviewed, the granting of an authority to pay interest gross will almost certainly ensure that the Revenue will accept that the interest may be deducted when paid. If, because of a change in conditions, the Revenue wishes to review its position, it win probably withdraw the authority to pay the interest gross and negotiate on a revised basis for future payments only.
The provisions treating interest on "equity notes" as distributions are understood to have been framed in conjunction with advice obtained from the IRS, so that any "debt" in which the creditor could take a position that it represents equity for U.S. filing purposes will be treated similarly in the United Kingdom. However, this has not been explicitly drafted into the U.K. rules. In broad terms, any debt that is framed so that it could remain outstanding for more than 50 years will be caught by these provisions and treated as equity.
Other approaches to funding a U.K. subsidiary can be considered; even long-term interest-free debt could have a place. Providing it is treated as equity for U.S. purposes there should be no tax disadvantage, yet it retains much greater flexibility than share capital. Alternatively, bank borrowing with or without a parent's guarantee may be an answer. If the borrowing is from a U.K. bank there is no thin capitalization issue under present law, even if the debt is backed by a parent's guarantee. The universal rule is to consider all the options and understand the consequences on both sides of the Atlantic.
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|Publication:||The Tax Adviser|
|Date:||Apr 1, 1993|
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