IR46 29 November 1994 PAYMENTS OF INTEREST AND SIMILAR SUMS BETWEEN CONNECTED COMPANIES - THIN CAPITALISATION The Chancellor proposes in his Budget to amend the legislation which applies to certain payments of interest and other similar sums between connected companies. The measure will apply to payments made on or after today except payments in respect of some existing securities to which the measure will apply with effect from 1 April 1995. The Chancellor's intentions in amending the existing provisions are to mitigate their effect in some circumstances and also to remove any grounds for uncertainty about their application. For most companies the amendments will in practice lead to no change. In certain cases where the legislation will make a difference, its application will be deferred to give companies an opportunity to review their position. DETAILS 1. At present payments of interest and similar sums to certain non-resident connected companies are, for the purposes of United Kingdom domestic law, treated in the same way as distributions. This means that the paying company is not entitled to deduct the payment in calculating its profits for tax purposes and is obliged to make a payment of advance corporation tax at, or around, the time of the payment. These rules have enabled the Inland Revenue to challenge "thin capitalisation". "Thin capitalisation" is the process of financing subsidiaries with greater amounts of debt in comparison with equity than would be normal in an arm's length funding arrangement. Such a funding structure may be intended to reduce or eliminate the company's liability to corporation tax by loading it with "excessive" interest payments. 2. This domestic treatment is modified by the terms of agreements between the governments of the United Kingdom and certain overseas countries for the elimination of double taxation. The precise wording of such agreements varies but, for the majority of companies, the effect is to limit the amount of a payment to be treated as if it were a distribution to only the part which exceeds what would have been paid between unconnected companies. 3. The proposed measures will amend the rules for identifying the connected companies to which the legislation applies. They will deal with relevant payments between such companies on a consistent basis no matter where in the world the companies are resident and will follow the approach of most of the United Kingdom's recent double taxation agreements by only treating the "excessive" part of such payments as if they were distributions. 4. The new provisions will leave most companies in the same position as at present - after taking account of the interaction of current domestic law and the relevant existing double taxation agreement. Where there is no such agreement or where it varies from the current norm, a minority will find their position altered. To assist companies (and their advisers) in establishing whether and how the new measures will affect them, a draft of the Finance Bill clause has been issued today. A copy is annexed to this Press Release. 5. The new measures respond to representations about the harshness of the current rules in a few cases. The Government has also taken the opportunity to remove any uncertainty for taxpayers which recent speculation about the application of the existing rules following a European Court of Justice decision may have caused. 6. The Chancellor intends the new provisions to apply generally to payments made on or after today. Where the payment relates to a security in respect of which the Inland Revenue, after consideration, have issued a notice authorising payments to be made either free of, or with a reduced rate of, withholding tax, this date will not apply. In such cases only payments made after 31 March 1995 will be affected. This will give the majority of holders of such notices time to satisfy themselves that the new measures leave their position unchanged. It will also provide the smaller number of companies whose position would be affected with an opportunity to reconsider their funding arrangements. 7. The Government intends to keep this legislation - and its effectiveness in achieving its purpose - under review. NOTES FOR EDITORS 1. The new provision is intended to replace subsections 209(2)(e)(iv) and (v) of the Income and Corporation Taxes Act 1988 which treat interest paid to non-resident companies with whom the payer is in a direct, or indirect, 75 per cent shareholding relationship as a distribution. 2. The new legislation will treat as a distribution only that part (which might be the whole) of any payment which would be regarded as "excessive" when measured against an arm's length standard and will no longer distinguish between payments made to resident and non-resident companies. 3. At present the relevant Double Taxation Agreements usually have the effect of limiting the application of the domestic provision to this "excess". Consequently, the majority of companies will be unaffected by the new approach. 4. In the few cases where no Double Taxation Agreement applies, or where the agreement does not restrict the domestic legislation (eg those with Ireland and Italy) the new provision will have the effect of allowing the paying company a deduction in calculating its profits where none was previously due. In other cases where the Double Taxation Agreement prevents the United Kingdom domestic legislation applying (eg those with Germany or Japan) the new legislation may have the effect of restricting the extent of the deduction in calculating a company's profits. 5. As a further point, there has been some speculation about the possible relevance for the existing provisions of a recent European Court of Justice decision involving a Netherlands company (Halliburton Services BV). The Government intends the new provision to remove any possible doubt this may have caused. Compliance Cost Assessment Assessments of the compliance costs affecting businesses are now available. A copy of the Compliance Cost Assessment for this proposal can be obtained by writing to: Danny Connor Inland Revenue Deregulation Unit Room F7 New Wing Somerset House London WC2R 1LB. ANNEX - DRAFT CLAUSE PAYMENTS OF INTEREST TO BE TREATED AS DISTRIBUTIONS (1) In subsection (2) of section 209 of the Taxes Act 1988 (meaning of "distribution" for the purposes of the Corporation Tax Acts), after paragraph (d) there shall be inserted the following paragraph- "(da) any interest or other distribution out of assets of the company (''the issuing company'') in respect of securities issued by that company which are held by another company where - (i) the issuing company is a 75 per cent. subsidiary of the other company or both are 75 per cent. subsidiaries of a third company, and (ii) the whole or any part of the distribution represents an amount which would not have fallen to be paid to the other company if the companies had been companies between whom there was (apart from in respect of the securities in question) no relationship, arrangements or other connection (whether formal or informal), except so much, if any, of any such distribution as does not represent such an amount or as is a distribution by virtue of paragraph (d) above or an amount representing the principal secured by the securities;". (2) In paragraph (e) of that subsection- (a) for "paragraph (d)" there shall be substituted "paragraph (d) or (da)"; and (b) sub-paragraphs (iv) and (v) (distribution in respect of securities of subsidiaries of non-resident companies etc.) shall be omitted; and, in subsection (3) of that section, for "subsection (2)(d)" there shall be substituted "subsection (2)(d), (da)". (3) After subsection (8) of that section there shall be inserted the following subsections- "(8A) For the purposes of paragraph (da) of subsection (2) above subsections (2) to (4) of section 808A shall apply as they apply for the purposes of a special relationship provision such as is mentioned in that section but as if- (a) the references in those subsections to the relationship in question were references to any relationship, arrangements or other connection between the issuing company and the other company mentioned in sub-paragraph (ii) of that paragraph; and (b) the provision in question required no account to be taken, in the determination of any of the matters mentioned in subsection (8B) below, of (or of any inference capable of being drawn from) any other relationship, arrangements or connection (whether formal or informal) between the issuing company and any person, except where that person- (i) has no relevant connection with the issuing company, or (ii) is a company that is a member of the same UK grouping as the issuing company. (8B) The matters mentioned in subsection (8A)(b) above are the following- (a) the appropriate level or extent of the issuing company's overall indebtedness; (b) whether it might be expected that the issuing company and a particular person would have become parties to a transaction involving the issue of a security by the issuing company or the making of a loan, or a loan of a particular amount, to that company; and (c) the rate of interest and other terms that might be expected to be applicable in any particular case to such a transaction. (8C) For the purposes of subsection (8A) above a person has a relevant connection with the issuing company if he is connected with it within the terms of section 839 or that person (without being so connected to the issuing company) is- (a) an effective 51 per cent. subsidiary of the issuing company; or (b) a company of which the issuing company is an effective 51 per cent subsidiary. (8D) For the purposes of subsection (8A) above any question as to what constitutes the UK grouping of which the issuing company is a member or as to the other members of that grouping shall be determined as follows- (a) where the issuing company has no effective 51 per cent. subsidiaries and is not an effective 51 per cent. subsidiary of a company resident in the United Kingdom, the issuing company shall be taken to be a member of a UK grouping of which it is itself the only member; (b) where the issuing company has one or more effective 51 per cent. subsidiaries and is not an effective 51 per cent. subsidiary of a company resident in the United Kingdom, the issuing company shall be taken to be a member of a UK grouping of which the only members are the issuing company and its effective 51 per cent. subsidiaries; and (c) where the issuing company is an effective 51 per cent. subsidiary of a company resident in the United Kingdom (''the UK holding company''), the issuing company shall be taken to be a member of a UK grouping of which the only members are- (i) the UK holding company or, if there is more than one company resident in the United Kingdom of which the issuing company is an effective 51 per cent. subsidiary, such one of them as is not itself an effective 51 per cent. subsidiary of any of the others, and (ii) the effective 51 per cent. subsidiaries of the company which is a member of that grouping by virtue of sub-paragraph (i) above. (8E) For the purposes of subsections (8C) and (8D) above section 170(7) of the 1992 Act shall apply for determining whether a company is an effective 51 per cent. subsidiary of another company but shall so apply as if the question whether the effective 51 per cent subsidiaries of a company resident in the United Kingdom (''the putative holding company'') include either- (a) the issuing company, or (b) a company of which the issuing company is an effective 51 per cent subsidiary, were to be determined without regard to any beneficial entitlement of the putative holding company to any profits or assets of any company resident outside the United Kingdom. (8F) References in subsections (8D) and (8E) above to a company that is resident in the United Kingdom shall not include references to a company which is a dual resident company for the purposes of section 404." (4) In section 212 of that Act (exceptions from the definition of a "distribution" for certain interest and other payments)- (a) in subsection (1), in paragraph (b), after "within" there shall be inserted "paragraph (da) of section 209(2) or"; and (b) in subsection (3), at the end there shall be inserted "and does not apply in relation to any interest or distribution falling within section 209(2)(da) if that interest or distribution is otherwise outside the matters in respect of which that company is within the charge to corporation tax." (5) In section 710(3)(a) of that Act (meaning of securities), for "section 209(2)(e)(iv) or (v)" there shall be substituted "section 209(2)(da)". (6) In paragraph 5(5) of Schedule 4 to that Act (deep discount securities), for "section 209(2)(d)" there shall be substituted "section 209(2)(d), (da)". (7) This section has effect, subject to subsection (8) below, in relation to any interest or other distribution paid on or after 29th November 1994. (8) This section shall not have effect in relation to any interest or other distribution paid before 1st April 1995 in respect of any security if the security is one in the case of which a notice given before 29th November 1994 under Regulation 2(2) of the Double Taxation Relief (Taxes on Income) (General) Regulations 1970 was in force immediately before 29th November 1994 as regards payments of interest or other distributions made in respect of that security.