1 Unit
CPD technical article
Thin capitalisation refers to the situation where a company is said to be excessively geared through connected party loan finance. Interest is generally tax deductible, whereas dividends are not; as a result, thin capitalisation is a focus for tax authorities.
This article was first published in the September 2011 edition of Accounting and Business magazine.
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Unlike many tax authorities around the world, HM Revenue & Customs (HMRC) does not operate a separate thin-cap regime. Instead it relies on the general transfer pricing provisions contained under Part 4 Taxation (International And Other Provisions) 2010.
Whereas many thin-cap regimes operate prescribed formulae and safe harbours in relation to interest deductibility (i.e. allowing interest deduction up to a pre-set limit), the UK regime is based solely on the arm’s-length principle, which is in effect a test of whether a company could and would have borrowed the same amount from an independent party without the support of parental or cross guarantee.
The UK regime is considered to be among the more complex of the developed thin-cap regimes, which in turn gives rise to greater uncertainty for UK taxpayers. This uncertainty has, in the past, been exacerbated by the time limits associated with the UK Corporate Tax Self Assessment (CTSA) regime, which allows for a window of enquiry of generally up to 12 months after the submission of the relevant CTSA return. In practice, this has left companies dealing with thin-cap enquiries several years after the loan finance was introduced.
For many years HMRC has offered UK taxpayers the opportunity to apply for an advance agreement in relation to the deductibility of loan interest arising from intra-group funding arrangements through the tax treaty application procedure, whereby taxpayers would invoke the terms of a bilateral treaty to reduce or eliminate a withholding tax obligation on payments of interest to an overseas lender.
However, this route was not open for certain intra-group funding situations including those that were not subject to the UK withholding regime, such as listed Eurobonds, loans provided by lenders in non-treaty locations and loans taken on by private equity-backed portfolio companies that were the target of the ‘acting together’ rules.
In recognition of the difficulties and uncertainties faced by UK taxpayers in relation to complying with the UK thin-cap regime, in April 2007, through its Statement of Practice 04/07 (SOP 04/07), HMRC introduced the Advance Thin Capitalisation Agreement (ATCA) programme.
The aim was to assist UK taxpayers in achieving certainty in relation to the application of the transfer pricing provisions relating to intra-group funding arrangements. For most companies this has included agreeing on the amounts borrowed and the applicable interest rates, but it has also included agreeing an appropriate margin or spread for UK finance and treasury companies.
Although the statutory basis for an ATCA is exactly the same as for a non-financing advance pricing agreement (APA), the HMRC administration of the ATCA programme is separate to that of an APA (other than HMRC’s head office financial transfer pricing specialists, who are the overall managers of the programme and an initial point of contact).
The HMRC personnel involved in the ATCA programme are typically international issues managers – corporate tax specialists who deal with transfer pricing and similar issues – and the individuals allocated to an ATCA are typically determined on the basis of geography.
Applications from companies dealt with in HMRC’s large business service section may also be submitted through the customer relationship manager, and those dealt with by local compliance offices – typically smaller companies – can be submitted to a transfer pricing cluster leader, whose responsibilities are broken down on the basis of geographic regions.
The ATCA programme does not exclude potential applicants by reference to size or complexity of the transaction. Rather, the threshold is whether the loan finance represents significant ‘commercial issues for the company’.
Since the introduction of the ATCA programme approximately 500 applications have been processed by HMRC. To date, we understand that about two-thirds have been in respect of private equity-backed portfolio companies where, needless to say, gaining certainty over interest deductibility represents a key shareholder issue.
ATCAs are typically agreed on a prospective basis, although they can be rolled back and used on a pre-transactional basis. HMRC has stressed that ATCAs should not be used as a tax planning tool, and only transactions that are either ‘very likely’ to occur or are ‘well in the process’ will be considered at a pre-transaction stage. Our experience has been that leveraged buy-outs are the transactions most likely to be subject to a pre-transactional ATCA.
Stages of an ACTA
Initial contact
It is up to the taxpayer to approach HMRC in applying for an ATCA. The initial contact must clearly include a statement that agreement under S218 TIOPA 2010 (previously S85 FA99) is being sought from HMRC. The application should include information concerning the company seeking the agreement and the wider group of which it is a part, and the background to the business and industry, along with a financial model that includes projected earnings and cash generation for a prescribed period.
Ultimately, HMRC encourages applicants to consider the information being provided in the context of the materiality of the transaction and tax ‘at risk’.
HMRC has a dedicated financial transfer pricing team which has prime responsibility for dealing with ATCAs.
Review
HMRC will enquire into the issue and undertake a review of the information that has been provided. At this stage HMRC will ask for any additional information that it feels is necessary to form an opinion as to the arm’s-length position.
Negotiation and agreement
The negotiation period typically depends on the complexity of the case. Simple cases can sometimes be resolved through emails, letters and calls, while more complex arrangements may require a number of meetings before an agreement is reached.
Both HMRC and the taxpayer have the right to walk away from the ATCA process if either party feels an agreement cannot be reached. In this instance, the thin-cap issue will revert back to an annual self-assessment exercise.
The ATCA represents a legally binding agreement between HMRC and the taxpayer as to the tax treatment of the financing provision and, as such, CTSA returns submitted that are not in accordance with the terms of the ATCA can leave the taxpayer open to tax-geared penalties.
‘Open for business’
Meeting the requirements of the UK thin-cap regime represents a complex challenge and the introduction of the ATCA programme has been an important step in providing a framework to eliminate much of that uncertainty.
Our experience to date suggests that HMRC are very much ‘open for business’ when it comes to applications for thin-cap advance agreements and that they have been particularly useful to companies and shareholders wrestling with the demands of FIN 48 and tax provisioning, and for those seeking greater clarity in relation to tax payments on account, as well as those wishing to avoid having significant resources tied up in complex and time-consuming HMRC enquiries in relation to their intra-group funding arrangements.
Victoria Horrocks and Steve Morgan are transfer pricing partners at PwC, Greg Forde is a transfer pricing manager at PwC
Questions by David Harrowven, ACCA examiner
1 Unit