1. Clause 85 ensures that, with effect from 21 March 2000, companies are able to obtain relief for interest on certain loans where the interest rate falls as business results improve or vice versa (‘ratchet loans’). It also aligns the definition of these loans for the purposes of the group relief anti-avoidance rules.

2. This will bring the tax treatment of these loans into line with most other commercial loans. Parallel changes are being made in clause 130 to the provisions defining exempt loan capital for stamp duty purposes.

3. Subsection (1) amends section 209 of the Taxes Act 1988, which defines those payments made by a company that are to be treated as a distribution of profit for tax purposes. It introduces a new subsection (3B) narrowing the scope of subsection (2)(e)(iii), which deals with interest which is dependent on business results.

4. The new subsection provides that, from 21 March 2000, payments of interest will no longer be treated as a distribution solely by virtue of the fact that, under the terms of the loan, the rate of interest is inversely linked to business results — that is, the rate decreases as results improve or increases as results deteriorate. (Loans of this type are commonly known as ‘ratchet loans’.)

5. The effect is that companies will be able to claim relief for interest on ratchet loans under the loan relationships rules in Finance Act 1996 where the lender is outside the charge to UK corporation tax as well as where the lender is a UK company. Relief can be claimed for interest accruing on existing loans where that interest is paid on or after 21 March 2000.

6. Subsection (2) amends the definition of ‘normal commercial loan’ for the purposes of the group relief anti-avoidance rules in Schedule 18 to the Taxes Act 1988. It aligns the existing provision for ratchet loans in paragraph 1(5E) of Schedule 18 with the amended section 209. This ensures that, with effect from 21 March 2000, ratchet loans will generally be treated as normal commercial loans.

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7. Companies are generally able to claim tax relief for interest expenditure under the loan relationships rules (Finance Act 1996, sections 80-105 and Schedules 8-15). But where the creditor is not within the charge to UK corporation tax, interest on certain loans is treated as a distribution of profit. Relief is not available under the loan relationships rules for amounts which, when paid, are treated as distributions (Finance Act 1996, paragraph 1 of Schedule 9). These rules prevent equity investment being artificially characterised as a loan in order to obtain interest relief.

8. The current rules apply to loans where the amount of interest is to any extent dependent on business results. This ensures that interest relief is not available where the interest effectively represents a share in profits. But ratchet loans, where the interest rate reduces as business results improve (or vice versa), also come within the scope of these rules even though there is no question of sharing in any increase in the profits. This may make ratchet loans unattractive to borrowers.

9. The group relief rules allow losses and certain other amounts incurred by one company to be set against the profits of another company in the same group. Two companies are members of the same group if one is a 75% subsidiary of the other, or if both are 75% subsidiaries of a third company.

10. There is anti-avoidance legislation to prevent the percentages being manipulated in order to create artificial group relationships (section 413(7) and Schedule 18 to the Taxes Act 1988), and this legislation includes rules to distinguish between equity capital and normal commercial loans (paragraph 1 of Schedule 18). There is special provision for ratchet loans, so that they qualify as normal commercial loans. But the current definition of ratchet loans does not include loans where the rate of interest increases as business results deteriorate or as the value of an asset decreases.

11. Transfers of most loan capital are exempt from Stamp Duty and Stamp Duty Reserve Tax, but ratchet loans are currently unable to benefit from this exemption. Clause 130 amends the definition of exempt loan capital so that transfers of ratchet loans on or after 21 March 2000 will qualify for exemption.

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