Report on the work of the Technical Committee - May 2003
This article, which appears in the June 2003 issue of Tax Adviser, contains the Inland Revenue‚ s guidance with comments from the CIOT. The CIOT‚ s comments are in italics. The Inland Revenue‚ s original guidance was incorporated in the Inland Revenue Corporate Finance Manual at 6210 to 6228.
The CIOT has been concerned (since it was introduced by FA 1996) about the uncertainty produced for corporate clients and their advisers by the ‚ unallowable purposes‚ rule, a concern which is heightened by the extension of the concept to the areas of foreign exchange and derivative contracts in FA 2002.
There has been considerable correspondence and discussion with Ministers and the Inland Revenue over that time. Based on the whole experience of those discussions, the CIOT offers the following guidance to its members. A copy of this paper has been shown to the Inland Revenue in draft and they have indicated that it does not contain anything with which they would seek to disagree.
Ministers see an important deterrent effect against avoidance in these provisions. In general Ministers believe taxpayers are likely to know if they are engaged in tax avoidance, which is the target of the legislation.
They have also decided against a general clearance procedure (going beyond the provisions of Code of Practice 10) because the resource cost to the Inland Revenue could be prohibitive and advisers would feel obliged to apply for clearance in almost all circumstances on a purely protective basis.
Nevertheless, within the limits set by these parameters, we believe that the Inland Revenue are keen to do what they can to reduce uncertainty for taxpayers engaged in commercial transactions which would be significantly affected if these provisions were to apply.
In appropriate cases guidance can be sought under the provisions of COP 10. For example, the extension of the approach to foreign exchange and derivative contracts is recent and will fall within the ‚ Four Finance Bills rule‚ until at least July 2005. The provisions for guidance to be given in ‚ national importance‚ cases can also be considered.
The Inland Revenue have included guidance in their manuals (which are of course published). We understand that this is based largely on actual cases that have been referred to them.
The cases are not therefore intended to be any more than examples of the application of the rules or in any sense to extend the legislation. For example in CT 12686(e) the example given was based on an actual case and the text presumes that the main purpose of what was planned in that case was to gain a tax advantage. If that is not a main purpose, then the fact that the facts are superficially similar does not of itself mean that the legislation will apply. The example should not be taken to imply that a company with a commercial purpose for the funds which borrows from another company with surplus management expenses (which it can then offset against the interest income arising) would be caught by the legislation simply because of the tax consequences of the transaction.
Nor are the cases selected to cast an adverse implication on other cases that have similarities, but important relevant distinctions. For example, the inclusion of the example of the insolvent company in CT12685 does not imply that any case where liquidation takes longer than expected for entirely commercial reasons gives rise to a problem.
At a number of points the guidance refers to the wider group position as being relevant to whether a company is caught. The Inland Revenue accept that what is important for the application of the legislation is the purpose(s) of the company itself, as distinct from the group. However, tax advantages to other group companies or even third parties are potentially relevant and may indeed provide evidence of what the company‚ s purposes were. Equally, intra-group transactions may be commercial just as third party transactions generally are It is a question of coming to a view on the purpose(s) on the evidence available.
You will note from the Economic Secretary‚ s comments (see CT12673) that paragraph 13: a) will normally apply where UK branches of overseas companies borrow for overseas activities outside the UK tax net; b) will not normally apply where a company borrows to acquire shares in companies, whether in the United Kingdom or overseas, or to pay dividends, provided that the borrowings are not structured in an artificial way. See also CT12687(b) where the company cannot make a pre-tax profit. This approach is not affected by the substantial shareholdings rules; and c) will not normally apply where a company is choosing between different ways of arranging its commercial affairs, if it chooses the course that gives a favourable tax outcome, provided that tax avoidance is not the object, or one of the main objects, of the arrangements.
In CT 12674(b) reference is made to the purchase of shares. This simply reflects the fact that earlier correspondence with the Economic Secretary was concerned with shares, it does not imply that the purchase of other categories of business asset is less worthy or commercial.
Paragraph 13 would not normally apply to loan relationship debits: a) simply because a company is able to obtain relief for the same expenditure or loss on the borrowing to which the debits relate in more than one jurisdiction. However, paragraph 13 would apply where the structure that has been adopted has one or more uncommercial features so that the loan relationship can be said to have an unallowable purpose and/or where, taking account of the overall position as regards the company or group, relief for interest and other finance costs might otherwise be available more than once in the UK in respect of the true economic costs of the borrowing; b) that relate to a borrowing from an exempt body (such as a pension fund), even if that exempt body is connected with the borrower, provided the arrangements are commercial; c) that relate to a straightforward borrowing by a UK Plc in order to fund a repurchase of its shares provided that there are no attempts to structure the arrangement in such a way as to provide a tax advantage for any other person and/or the amount borrowed ‚ the level of gearing up ‚ is dictated by market forces and hence is at arm‚ s length; d) that relate to a third party borrowing undertaken by one group member, that fulfils the commercial borrowing requirements of the group, which it on-lends interest-free (or at a rate not exceeding the costs of the third party borrowing) to other UK-resident group members. In such circumstances, paragraph 13 would not apply, provided that the group gets one and only one deduction for the costs associated with the true economic cost of the borrowing. For example, paragraph 13 will not normally apply where intra-group interest-free loans are made primarily to enable borrowings to be matched with assets within the meaning of the Exchange Gains & Losses (Alternative Method) Regulations, or section 84A FA 1996 (for periods beginning on or after 1 October 2002);or e) where a loan relationship debit in one UK-resident group company is matched by an equal and opposite loan relationship credit, which is fully taxed, in another UK-resident group company in respect of the same loan relationship. On the other hand, paragraph 13 is potentially in point if the main or one of the main purposes of the intra-group funding was to achieve a tax advantage for the group as a whole, in that the loan relationship credit on the intra-group funding is in some way shielded from tax. An example of the loan relationship credit being shielded would be by the soaking up of otherwise stranded surplus expenses of management etc. Where the loan relationships involve cross-border transactions, thin capitalisation and transfer pricing legislation (section.209 ICTA 1988 and Schedule 28AA ICTA 1988) as well as the provisions of the Double Taxation Treaties may be applicable.
In CT 12686(a) reference is made to a loan having an uncommercial feature. The Inland Revenue do not contend that a single uncommercial feature will necessarily taint the loan. Again, it is a question of what evidence any uncommercial feature(s) provide(s) of the company's purpose(s) in respect of the loan.
CT12686 refers to cases where only one deduction for interest is claimed in the UK. We understand that cases where only one net deduction is obtained in the UK (e.g. where borrowing by one company is on-lent at interest and at a ‚ turn‚ to another group company) are viewed similarly by the Inland Revenue.
Paragraph 13 would normally apply to loan relationship debits: a) that, subject to the comments at CT12686(d) and (e), relate to the write-off of loans where the purpose of the loans was not amongst the business or other commercial purposes of a company. An example of a loan of this nature would be an interest-free loan made by a company, whose business consists in operating a widgets retail outlet, which had lent the money to a football club supported by one of the directors of the company for the purpose of providing financial support to the football club. Furthermore, if the company borrowed to make the loan to the football club, then paragraph 13 would normally also apply to disallow the loan relationship debits relating to the interest or other finance costs on that borrowing; b) that, subject to the comments at CT12686(d) and (e), relate to a borrowing the proceeds of which are used in such a way that the company cannot or does not expect to make an overall pre-tax profit. An example would be where a company borrows at interest and on lends at a rate of interest that is less than the rate of interest on the borrowings; or c) where a company or a group of companies enters into one or more transactions or arrangements which have the main purpose or one of the main purposes of securing loan relationship debits for repayments of loan principal, in addition to payments of interest, on the true economic commercial borrowing to the company or group. An example of this would be where one group company undertakes a borrowing of ¬£20 million at 8.4% for 5 years from a third party and at the same time a second group company pays that third party ¬£13 million for preference shares of ¬£20 million in the first group company to be delivered 5 years later. The effect of this is that, economically, the group borrows ¬£7 million on an amortising basis at 8.4% but for tax purposes the group claims relief as loan relationship debits for both the interest of ¬£1.4 million on the group amortised borrowing of ¬£7 million and the repayment of the ¬£7 million loan principal. In such circumstances paragraph 13 is likely to apply to disallow the amounts equivalent to repayments of principal.
In CT 12687(a) the application of the provision to writing off directors‚ loans is considered. We believe that this would normally be relevant only to close companies. If the director was taxed on the write-off it may be that there is no tax advantage or it is not sufficient to be a plausible main purpose. Equally, if the company derives some benefit from the transaction (e.g. advertising benefit), then either the provision may not apply or a ‚ just and reasonable apportionment‚ would fall to be made.
In CT 12687(c) whether a loan can be linked with a particular investment is a question of fact. Similarly with the tax scheme facilitator‚ s purpose in raising funds (CT 12688).
We would expect that the Inland Revenue will publish more guidance reflecting experience with foreign exchange or derivatives in due course.
The area of most difficulty of interpretation is where there is not a pre-tax benefit from a transaction. The Inland Revenue have been consistent about their views as expressed in CT 12687(b). Our view is that the Kleinwort Benson case [45 TC369] has some relevance here. The Inland Revenue do not apply their interpretation aggressively in innocent cases. For example, if a company borrows to invest in ordinary shares (which may produce a capital gain in due course on disposal, albeit the gain may be exempt for tax purposes under the substantial shareholdings rules) the Inland Revenue will accept that potential pre-tax benefit as being relevant to the test required by the legislation, even though there may be a pre-tax funding cost in excess of any dividend income over the period over which the investment is held. It is also unlikely that the legislation would be applied to absolutely plain vanilla finance leasing financed by intra-group debt. However there are areas of difficulty here, for example in relation to preference share investments. The Inland Revenue's principal target is preference shares where any capital appreciation in the value of the shares will be limited.
There are circumstances in which the definition of tax avoidance purpose in paragraph 13(5) ‚ a ‚purpose that consists in securing a tax advantage (whether for the company or any other person)‚Äù ‚ will mean that paragraph 13 will apply to loan relationship debits of facilitators of tax avoidance schemes. The type of circumstance is where a person (the facilitator) enters into a loan relationship with a view to participating in a transaction or a series of transactions which are designed to secure a tax advantage for another person ‚ then paragraph 13 will apply to that loan relationship.
Paragraph 13 applies to borrowings taken in order to provide funds which the borrower is to apply for the purpose of participating in a tax avoidance scheme even though the tax avoidance does not result directly from any relief obtained in respect of the borrowing.
This information has been provided for you by the Technical Department of the CIOT. Please address any queries to Bianca Marsden on tel 020 7235 9381.