DEBT and EQUITY

1
DEBT and EQUITY

• Interest treated as a deduction in arriving at
  taxable profits unless prohibited
• Dividends are a payment out of profits ie not
  deductible
• Interest received is generally taxable
• Dividends received by one UK company from another
  are Franked Investment Income (and not taxable) -
  credit no longer repayable

2
s208 UK company distributions not generally
chargeable to corporation tax Except as
otherwise provided by the Corporation Tax Acts,
corporation tax shall not be chargeable on
dividends and other distributions of a company
resident in the United Kingdom, nor shall any
such dividends or distributions be taken into
account in computing income for corporation tax.
3
DISTRIBUTIONS

• any dividend paid by a company, including a
  capital dividend, is a distribution
• treated as paid when it becomes due and payable
• J Paterson (Motors) Ltd v IRC 1978 STC 59 held
  that where the accounts showed a capital
  distribution and a directors indebtedness no
  longer appeared, the dividend had been paid for
  tax purposes
• includes a distribution out of the assets whether
  in cash or otherwise

4
EXCEPTIONS

• so much as represents a repayment of share
  capital or an amount of new consideration
  received by the company
• distributions made in course of a winding up
• certain purchases of own shares by unquoted
  trading companies
• certain demerger transactions

5
PREFERENCE SHARE FINANCING

• If company will not pay tax in forseeable future
• but has distributable reserves
• may find it cheaper to issue preference shares
  than borrow
• may be problems over security

6
PREFERENCE SHARE FINANCING

• overdraft interest deductible in hands of
  borrower, taxable in hands of lender
• but deduction for borrower may be considerably
  deferred
• dividends not deductible and, for UK corporate
  shareholders not taxable

7
BORROWER Loss before finance costs (1,000) (1,
000) Interest (100) Preference share
dividend (90) Loss after finance
costs (1,100) (1,090) LENDER Interest/dividen
d income 100 90 Tax
(30) After tax income 70 90
8
LOAN RELATIONSHIPS

• Replaces mixture of differing treatments of
  interest
• previously depended on short v annual, bank v
  other, paid v accrued, deep discount etc etc
• now simplified and based on accounting treatment
• interaction with CGT is handled by classifying
  LRs as QCBs (ie outwith CGT)
• ST D1.7
• Revenue Manual (CFM 5050)

9
LOAN RELATIONSHIPS

• Comprehensive code for corporate taxation of debt
  and interest
• General move from cash to accounts basis
• Loan relationship widely defined to catch money
  debts arising from lending money
• Applies to debits/credits arising from loan
  relationships
• If debt is not a loan relationship the rules
  apply to the interest and exchange differences
  (by assuming it to be paid under a LR) but not to
  the other debits/credits (FA 1996 s100(1))

10
CONSEQUENTIAL CHANGES

• New Case III (for companies only)
• Abolition of Schedule C
• Abolition of Schedule D Case IV for companies
• Loan relationships within Case V switched to I or
  III as appropriate
• Repeal of accrued income scheme for companies
• Repeal of deep discount and deep gain legislation

11
81 Meaning of loan relationship etc
(1) Subject to the following provisions of
this section, a company has a loan relationship
for the purposes of the Corporation Tax Acts
wherever  
(a) the company stands (whether by reference
to a security or otherwise) in the position of a
creditor or debtor as respects any money debt
and (b) that debt is one arising from a
transaction for the lending of money
and
references to a loan relationship and to a
company's being a party to a loan relationship
shall be construed accordingly.
12
DEFINITIONFA 1996 s81A company has a loan
relationship if it is a debtor or creditor in
respect of any money debt and that debt has
arisen from the lending of money.
13
MONEY DEBTs81(2)Is a debt which falls to be
settled by the payment of money or by the
transfer of a right to settlement under a debt
which is itself a money debt.Extended by s81(3)
to catch securities issued for a money debt
14
INCLUDES

• overdrafts
• bank loans
• bank deposits
• building society deposits
• mortgages
• company securities
• government gilts
• bills of exchange
• perpetual debt
• related exchange gains/losses (from FA 2002)

15
EXCLUDES

• Trade debts (not lending money but interest
  caught by s100)
• HP and finance leases (not lending of money)
• Intercompany and directors loan accounts unless
  arising from lending money
• Shares
• Capital contributions
• Interest treated as a distribution by s209

16
LATE OR DEFERRED CONSIDERATION

• Simply left unpaid - it is a money debt but there
  is no loan relationship. Any interest will be
  within the rules because of s100
• Consideration not due until later date - not a
  money debt until co has legal right to sue for
  the interest
• Unascertainable deferred consideration - not a
  money debt until ascertained and due and payable

17
GRANTS

• If agreement provides for the money to be repaid
  unless certain specified events occur it is
  probably a loan relationship
• If it provides for a grant which is only to be
  repaid if certain conditions are not met this is
  unlikely to be a loan relationship
• Smart v Lincolnshire Sugar Co 20 TC 643

18
Smart v Lincolnshire Sugar Co

• company received subsidies which they argued were
  a loan as in certain circumstances they were
  repayable and if taxable should only be taxed
  when the possible repayment events had expired
• Inland Revenue argued they were not loans but
  grants taxable at time of receipt
• held on balance that they were grants taxable on
  receipt

19
DEBITS/CREDITS UNDER LRs

• The amounts to be brought into account for tax
  are those brought into the accounts under GAAP
• If company has not prepared accounts under GAAP
  tax accounts recalculated
• If loan relationship is for purposes of a trade
  carried on by the company all debits/credits go
  into Case I computation
• If not they go into a Case III pot (giving eg bad
  debt relief for non trade debts)

20
CASE III DEFICIT

• group relief
• set-off against current year profits
• carry-back against non-trading loan relationships
  income
• carried forward and set against non-trading
  profits for succeeding accounting periods

21
SPECIFIED TREATMENTSThere are special rules for

• bad debts (impairment)
• connected persons
• capitalised interest
• late payment of interest
• transactions not at arms length

22
International Accounting Standards

• From January 2005 all UK companies (except small
  companies) must use either IAS 32 and 39 or FRS
  25 and 26
• Proposal that small companies will implement from
  January 2007
• No longer any need for tax legislation to define
  acceptable accounting method - it is in the
  standards
• FA1996 ss85 and 86 repealed replaced by ss85A and
  B

23
D1.721 Amortised cost accounting treatment IAS
39 and FRS 26 each define the amortised cost of a
financial asset or a financial liability (which
will include creditor and debtor loan
relationships respectively) as the amount at
which the financial asset or financial liability
is measured at initial recognition plus or minus
principal repayments, plus or minus the
cumulative amortisation using the effective
interest method of any difference between that
initial amount and the maturity amount, and minus
any reduction for impairment or uncollectibility.
The effective interest rate is the rate of
interest which exactly discounts the estimated
future cash payments or receipts through the
expected life of the financial asset or financial
liability or, where appropriate, a shorter
period, to its initial carrying value. Under IAS
39 or FRS 26, where a company accounts for a
creditor or debtor loan relationship on an
amortised cost basis, any expenses incurred in
connection with the acquisition or issue of that
loan relationship are generally required to be
added to (or in the case of a debtor loan
relationship, deducted from) the initial carrying
value of the loan relationship and will be taken
into account in determining the effective
interest rate1. The loan relationships
legislation also defines an amortised cost basis.
This definition will be relevant where a company
is required to follow an amortised cost basis for
tax purposes, for example because it is connected
with the other party to the loan relationship
(see D1.720). Under the statutory definition an
amortised cost basis of accounting is defined as
a basis of accounting under which an asset or a
liability representing the loan relationship is
shown in the company's accounts at cost adjusted
for cumulative amortisation and any impairment,
repayment or release2. Where a company accounts
for a creditor loan relationship using an
amortised cost basis of accounting, the company
is not permitted to claim relief for any debits
arising as a result of a revaluation of an asset
except where such debits arise from an impairment
loss or the release by the company of all or part
of an amount due under the terms of that loan
relationship. Nor does this provision apply to
deny relief for debits arising as a result of
exchange movements. A revaluation is defined as
including any case where a provision or allowance
is made by the company which has the effect of
reducing the carrying value of an asset or a
group of assets, including the asset in
question3. Where relief is denied for a debit
under this provision, any credits arising from
the subsequent reversal of that debit will be
left out of account for tax purposes. Similarly,
where a company was denied relief for a bad debt
provision in a period of account beginning before
1 January 20054 the subsequent reversal of the
debit will be disregarded for the purposes of the
loan relationships legislation5. 1 IAS 39
paras 43, 46(a), (b) and FRS 26 paras 43, 46(a),
(b). 2 FA 1996, s 103(1). 3 FA 1996 Sch
9 para 6D(1), (3), (4), as inserted by FA 2005
Sch 4 para 16. 4 Under either FA 1996 Sch 9
para 5(1) or TA 1988 s 74 (1)(j) FA 1996 Sch 9
para 6D(2)(b), as inserted by FA 2005 Sch 4 para
16. 5 FA 1996 Sch 9 para 6D(2), as inserted
by FA 2005 Sch 4 para 16.        IAS 39 paras
43, 46(a), (b) and FRS 26 paras 43, 46(a),
(b).      FA 1996, s 103(1).
24
At the start of year ended 31 December 2006, a
company makes a 5-year 10 million loan to an
overseas subsidiary. The loan bears no interest
for the first two years, but 8 interest is
charged for the final three years. It is agreed
with HMRC that, overall, the loan is on arms
length terms. The accounts to 31 December 2006 do
not bring in any interest on the loan. In
discussions with HMRC, the company agrees that
this is incorrect and GAAP requires an effective
interest rate method to be used to spread the
interest receivable over the period of the loan.
Regardless of the credits (or lack of them) in
the accounts, the companys tax return must be on
the basis that the effective interest rate method
had been used, and must bring in the appropriate
amount of interest as a loan relationship credit
for the year. CFM5149a
25
It is agreed that, on the basis of a computation
of the effective interest rate, the company will
bring in interest of 458,000 in year 1
479,000 in year 2 501,000 in year 3, 488,000
in year 4 and 473,000 in year 5. In drawing up
its accounts to 31 December 2007, the company
starts to use an effective interest method,
spreading the interest receivable in years 2 to
4 over the remaining period of the loan. The
accounts show an interest credit of 600,000. But
FA96 s84A(3) ensures that the company is only
taxable on 479,000, not 600,000, even if the
2007 accounts are in accordance with GAAP.
26
Bad debts (impairment relief)

• if under IAS 39 and FRS 26 company is accounting
  for a loan relationship using an amortised cost
  basis
• it is required to determine at the end of each
  accounting period whether there is any objective
  evidence of impairment
• if provision not justified in respect of
  particular loan relationship but it forms part of
  a pool of assets with similar credit
  characteristics must consider whether a provision
  is required for that particular pool

27
Impairment - example A bank has statistical
evidence, based on data gathered over a number of
years, that a rise in mortgage rates correlates
with an increase in credit card default by
customers with a poor credit history. In 2007,
mortgage rates increase, and the bank recognises
an impairment loss calculated in accordance
with the statistical data on its portfolio of
credit card debts owed by this customer group.
The impairment loss provided it is correctly
calculated - accords with IAS 39, even though it
cant be identified with individual amounts owed
by individual customers, and it will be allowable
for tax purposes. CFM5153a
28
IMPAIRMENT LOSSES

• 'impairment losses' introduced in place of
  references to 'bad' and 'doubtful debts' for
  periods of account beginning on or after 1
  January 2005
• reflects international accounting terminology
• if company accounts for a loan relationship on an
  amortised cost basis
• able to claim relief for any impairment losses
  arising in respect of the loan relationship on
  accounts basis
• If parties are connected both parties must use
  amortised cost basis

29
87 Accounting method where parties have a
connection (1) This section applies in the case
of a loan relationship of a company where for any
accounting period there is a connection between
the company and   (a)     in the case of a
debtor relationship of the company, a person
standing in the position of a creditor as
respects the debt in question or   (b)     in
the case of a creditor relationship of the
company, a person standing in the position of a
debtor as respects that debt. (2) Where this
section applies the debits and credits to be
brought into account for the purposes of this
Chapter as respects the loan relationship must be
determined on an amortised cost basis of
accounting.
30
CHARGES ON INCOME

• TA 1988 s338
• gives deduction from total profits
• s338A gives exclusive definition
• Covers covenanted payments and certain gifts to
  charities
• does not cover loan relationship payments and
  dividends/distributions
• withholding obligation in certain situations
  

31

• 338 Charges on income deducted from total profits
  
• Charges on income are allowed as deductions from
  a companys total profits in computing the
  corporation tax chargeable for an accounting
  period.
• They are deducted from the companys total
  profits for the period as reduced by any other
  relief from tax other than group relief.
• The amount of the deduction is limited to the
  amount that reduces the companys total profits
  for the period to nil.
• Except as otherwise provided, a deduction is
  allowed only in respect of payments made by the
  company in the accounting period concerned.

32

• 338A Meaning of charges on income
• This section defines what payments or other
  amounts are charges on income for the purposes
  of corporation tax.This section has effect
  subject to any express exceptions in the
  Corporation Tax Acts.
• (2) Subject to the following provisions of this
  section, the following (and only the following)
  are charges on income   (b)     qualifying
  donations within the meaning of section 339
  (qualifying donations to charity)   (c)    
  amounts allowed as charges on income under
  section 587B(2)(a)(ii) (gifts of shares etc to
  charity).
• (3) No payment that is deductible in computing
  profits or any description of profits for the
  purposes of corporation tax shall be treated as a
  charge on income.

33
WITHHOLDING TAXES

• ITA 2007 s 874 applies to any yearly interest
  chargeable under Sched D Case III (or which would
  be apart from the LR rules) except bank interest
  (s879)
• obligation is to withhold at basic rate and
  account quarterly under Schedule 16
• not changed by loan relationship rules
• but see also ss929 and 930

34

• 874 Duty to deduct from certain payments of
  yearly interest
• This section applies if a payment of yearly
  interest arising in the United Kingdom is
  made(a)     by a company
• The person by or through whom the payment is
  made must, on making the payment, deduct from it
  a sum representing income tax on it at the
  savings rate in force for the tax year in which
  it is made.

35
879 Interest paid on advances from banks (1) The
duty to deduct a sum representing income tax
under section 874 does not apply to a payment of
interest on an advance from a bank if, at the
time when the payment is made, the person
beneficially entitled to the interest is within
the charge to corporation tax as respects the
interest.
36
929 Overview of Chapter (1) This Chapter makes
provision allowing some payments made by
companies, local authorities and qualifying
partnerships to be paid gross where they would
otherwise be subject to specified duties to
deduct sums representing income tax under this
Part.
37
933 UK resident companies A payment is an
excepted payment if the person beneficially
entitled to the income in respect of which the
payment is made is a UK resident company.
38

• 934 Non-UK resident companies
• A payment is an excepted payment if each of the
  following conditions is met in relation to the
  payment.
• The person beneficially entitled to the income
  in respect of which the payment is made must be a
  non-UK resident company.
• The non-UK resident company must carry on a
  trade in the United Kingdom through a permanent
  establishment.
• The payment must be one that is required to be
  brought into account in calculating the
  chargeable profits (within the meaning given by s
  11(2) of ICTA) of the non-UK resident company.

39
INTERACTIONbetweenLoan Relationships, Charges
on Income and Withholding Obligations
Charges on income exclude all loan relationship
payments therefore all interest (including
presumably interest which is deemed to arise
from a loan relationship under s100(1)) is dealt
with under the loan relationship rules. The
withholding obligation applies to all annual
interest (except between UK tax-paying companies
and that paid to a bank) chargeable under Case
III (or would be chargeable under Case III were
it not for the loan relationship rules - see
Inland Revenue Tax Bulletin 42) end