Thin Capitalisation Rules (part of transfer pricing rules in the UK) are the main area of concern to parent companies when provision of finance is involved.
In many countries, it may be advantageous to provide additional funding to a subsidiary by way of a loan rather than acquiring additional equity capital. The subsidiary can repatriate more of its profits by way of interest, thus leaving lower profits in the local country – otherwise the profits would be repatriated via a dividend.
The UK thin capitalisation rules in the past have helped to ensure that inward investors do not finance their UK sub groups with amounts and/or terms of debt that give rise to excessive interest deductions. The rules require that investors do not use debt that is in excess of arm’s length standard by reference to both the amount and terms of the debt.
Transfer pricing rule
The basic transfer pricing rules applies where a provision has been made between two persons by means of a transaction or services of transactions and one of the person controls the other or both are controlled by the same person or persons. Once control has been established, the rules require that the actual provision be compared to the arm’s length provision (ie one which would have been made between independent enterprises).
If an actual provision confers a tax advantage on one or both of the affected persons, an adjustment is to be made to the taxable profits of the tax advantaged persons.

The comparison exercise can be complex and requires adjustments to be made by both the business and HMRC.

The process will frequently produce a range of figures more or less equally reliable than a single correct answer.

Achieving certainty

HMRC recognises that thin capitalisation is a difficult area and one in which the majority of customers want to get the right result when their returns are filed. Usually a taxpayer makes a self-assessment, files the return and then waits to see if HMRC open an enquiry within the statutory time limit. This may not happen for nearly two years after the end of an accounting period and so perhaps the best part of three years from when a particular lending transaction took place. Over this sort of timescale there is plenty of scope for key personnel to have moved on, making subsequent reviews more time consuming. Therefore the treatment of particular financing arrangements for future tax returns has habitually been dealt with in advance of the enquiry framework through the procedures associated with the operation of the UK’s double taxation treaties (‘the treaty route’). In recognition of the benefits of this advance process, HMRC have agreed to widen the scope of the Advance Thin Capitalisation Agreement (ATCA) process by making it available to those for whom the treaty process would not be available.

Who can apply for ATCA clearance?

• Any UK business or company in the UK
• Partnership
• Private equity companies

When should you think about applying for ATCA?

• Intra-group funding outside the scope of treaty applications, eg involving a quoted Eurobond or discounted bond;
• Financing arrangements brought into schedule 28AA by the “acting together” rules in paragraph 4A, schedule 28AA;
• Financing arrangements previously dealt with under the treaty route.

Fixed term

An ATCA will be operative for a specified period from the date set out in the agreement. The current guidance is that thin capitalisation agreements negotiated under the treaty route should not be entered into for more than five years. It is therefore intended that the vast majority of ATCA’s will last for between three and five years.

While an ATCA will normally operate prospectively in relation to chargeable periods beginning after the time the application is made, it is possible that a chargeable period to which the agreement relates may have ended before the agreement is reached. It is possible for the agreement to be effective for that chargeable period and the agreement may set out any adjustments to be made for tax purposes as a consequence of the agreement.

In addition, although a particular agreement does not relate to earlier periods, the conclusions reached in negotiating the agreement may be relevant to a return for an earlier period, or to the resolution of thin capitalisation enquiries raised for earlier periods, if the particular facts and circumstances surrounding those years are substantially the same. Consequently, in such circumstances, the company applying for an ATCA and HMRC may jointly agree to consider a “roll-back” of the ATCA as an appropriate means for amending a self assessment return and of resolving outstanding transfer pricing issues in earlier years.

Except where “roll-back” is being considered, the request for an ATCA in respect of future years will not in itself affect any transfer pricing enquiry into earlier years. However, to the extent such an approach is appropriate and feasible, HMRC will coordinate the request in respect of future years with any transfer pricing enquiry in respect of prior years in order to improve overall efficiency and reduce duplication of enquiries.
Agreement
An ATCA will cease to have effect if its terms are not observed such that the provision leading to revocation, nullification, revision or mutual agreement override the information disclosed to HMRC when making the application. It will therefore be important that the agreement with HMRC contain provisions relating to its monitoring. The ATCA may include reporting requirements to show that agreed covenants have been satisfied in the corporation tax computation for the relevant years.

Withholding taxes
An application for an ATCA is made by a UK resident, whereas a Double Tax Treaty (DTT) application to pay interest in accordance with the treaty is made by a non-UK resident. The two applications are entirely distinct.
An ATCA cannot remove the withholding tax obligation and income tax must be deducted at the basic rate by the person making the payment unless they have obtained clearance from HMRC to pay the interest gross.
Revised procedures for DTT application were announced in 2007 and can be found at www.HMRC.gov.uk/CNR1clearance-processes.htm. As the ATCA and DTT application route are substantially similar means of reaching an arm’s length agreement, HMRC expects that the streamlining of the treaty process, will result in all future thin capitalisation agreements being negotiated.
An application for treaty clearance could be made subject to the application meeting the appropriate criteria, a treaty clearance notice would be issued enabling the non-resident to access the appropriate treaty benefits. The UK company could then negotiate an ATCA under the statement of practice.

The option of entering into a thin capitalisation agreement under the double tax treaty route is still available. There may well be good reasons for continuing the UK treaty route, the associated beneficial owner of the interest should via, this DTT application, notify the Charities Assets and Residence group of HMRC of the intention to use the treaty route.

In summary, forward agreements on thin capitalisation could be reached either:

1.through the treaty route once the overseas parent company had made the relevant application or

2.via an ATCA regardless of whether or not the overseas parent had applied for treaty relief.

Nullifying and revoking ATCAs

• HMRC has the power to nullify a pre-return agreement as if it had never been made where the business had fraudulently and negligently provided false or misleading information in relation with the pre-return agreement application.
• HMRC may withdraw from the ATCA if the business is not cooperating in providing the necessary information to consider the application properly.

Penalties

• Tax geared penalties will apply where a business has acted fraudulently or negligently in making an incorrect return and tax has been lost as a result.
• A penalty not exceeding £10,000 may be imposed where false or misleading information is supplied fraudulently or negligently.

Summary

It is anticipated that UK companies involved in cross border financing will take advantage of the ATCA process such that thin capitalisation issues are resolved at an early stage, thus avoiding the risk of an enquiry at a much later stage.

How can we help?

We have assisted a number of UK companies in this area and will be able to share our expertise and knowledge in this respect.

For more information contact:
Les Secular, Abbas Sadak