A development of interest in the financial world

On 27th March HMRC released a consultation document entitled ‘Possible changes to Income Tax rules on interest’. This drearily-named paper proposes a series of anti-avoidance measures aimed at removing exemptions for withholding tax at source on interest payments. Whilst this may all seem rather insignificant, together they amount to a minor assault on common methods of company financing.

The three main proposals are:

  1. Quoted Eurobond exemption
  2. Funding bonds
  3. Yearly interest

Quoted Eurobond exemption

Eurobonds, not to be confused with the proposed Euro-area government bonds of the same name, are international bonds denominated in currencies other than that of their country of issue. In 1984 an exemption was introduced in the UK for quoted Eurobonds, allowing their interest to be paid gross. This was in response to similar exemptions in tax havens, and discouraged offshore tax avoidance whilst promoting the growth of the UK Eurobond market. However, in recent years groups have issued Eurobonds in territories such as the Channel Islands and Cayman Islands for intra-group financing to take advantage of this exemption. Despite being quoted these bonds are not actually traded, and “enable companies to make gross payments of interest out of the UK to fellow group companies, where otherwise deduction of tax would be required.”

HMRC wish to halt this avoidance of tax on the interest on inter-company debt, and therefore propose to remove the exemption “where the Eurobond is issued to a fellow group company, and listed on a stock exchange on which there is no substantial or regular trading in the Eurobond.” This shouldn’t affect third party financing arrangements, but groups using Eurobonds as part of their intra-group financing may find their existing arrangements will be hit as no mention is made of grandfathering.

Funding bonds

Funding bonds are those where interest payments are made in kind, rather than cash. These payments may take the form of shares or loan notes, and are often used when a company has insufficient liquidity to pay in cash. Currently HMRC is obliged to accept such payments in kind when they collect 20% withholding tax on interest payments. The consultation document proposes that companies will have to pay the withholding tax to HMRC in cash. Whilst this will make HMRC’s job easier it could put undue strain on struggling companies, and may have knock-on effects in private equity where such bonds are sometimes used to take advantage of late interest rules.

Yearly interest

Loans which pay ‘short’ rather than ‘yearly’ interest do not suffer withholding tax on interest; these are typically loans which are under one year in duration. HMRC considers this “somewhat archaic” and wishes to strike the term ‘yearly interest’ from the statutes, thereby disregarding loan duration. Whilst this may seem to them to be a reasonable simplification of the tax code, as Allen & Overy point out HMRC appear to have failed to consider the effect this would have on the colossal commercial paper market. It could also have a significant impact on private equity where short term bridging loans are common.

Other proposals

  • For tax on interest to be withheld, the debt must have “arisen in the UK”. Some have argued that if the physical evidence for the debt resides offshore, then it cannot be said to have arisen in the UK. HMRC dispute this, and wish to have their interpretation written into law.
  • HMRC are proposing that the interest element of compensation payments be subject to withholding tax in cases where this is currently disputed.
  • The extending of ‘disguised interest’ anti-avoidance measures to cover individuals in addition to companies.

Conclusion

These proposals will likely have an adverse impact on corporate financing, especially private equity. However, the consultation is open until 22nd June so if you feel your company would be affected by the changes there is still time to make your voice heard.

Striking off companies

The death of a company

When a solvent company comes to the end of its life, it can either be wound up or struck off. Winding up is the formal process, involving the appointment of a liquidator to sell assets and pay off debts, and distribute the remainder to shareholders. This surplus is then subject to capital gains tax. The disadvantage of liquidation is cost. According to HMRC, winding up “a small business with straightforward affairs” typically costs around £7,500.

The alternative is striking off. This is a simpler process, but has less attractive legal consequences. Distributions to shareholders are treated as dividends, with potentially disadvantageous tax implications. Historically, however, extra-statutory concession C16 has allowed distributions to be treated as capital in the hands of shareholders in the same way as a formal liquidation.

The death of a concession

Extra-statutory concessions (ESCs) are just what they sound like – concessions to the law made by HMRC. However, in 2005 the House of Lords ruled that HMRC should not be making new laws, but administering existing ones. Since then there has been a programme to abolish ESCs and where appropriate codify them in law.

On the 1st March 2012, ESC C16 succumbed to this fate. The old extra-statutory concession was enacted in law under The Enactment of Extra Statutory Concessions Order 2012, but not in its original form. Concerned with tax avoidance, the Government has put a £25,000 cap on distributions that are subject to capital gains tax. If distributions exceed this amount, all payments will be treated as dividends, not just the excess over £25,000.

Capital gains vs income tax

This creates a powerful incentive to conduct a formal winding up of a company if distributions will exceed £25,000. The tax treatment of capital gains is typically more favourable than dividends, with a maximum rate of 28% instead of 42.5% for dividends (dropping to 37.5% next year) and an annual tax-free allowance of £10,600 (2011/12). Distributions may even be subject to Entrepreneurs’ Relief, meaning a 10% rate of tax. However, for those with very little income the tax liability on dividends may be more favourable, so each case must be judged on its own merits.

Winding up vs striking off

If distributions are under £25,000 then striking off should be the cheaper option. For amounts over this, winding up is increasingly likely to be more favourable depending on commercial considerations, the tax position of the shareholders and the costs of liquidation.

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Simplifying income tax for small businesses

Credit to Ayla87 @ sxc.hu

This was trailed in the 2012 Budget and proposed details were issued last week in a consultation document. The simplified tax system for businesses with a turnover of up to £77,000 p.a. could find its way into next years’ Finance Act.

Qualifying businesses

The proposal only applies to unincorporated ‘nano’ businesses of which there are currently some 3.5m in the UK. Some will be excluded from participating such as authors, financial traders, property businesses and limited liability partnerships.

Cash is king

The system will work on a simple ‘cash in cash out’ basis with some actual expenses being replaced by a flat rate allowance (e.g. use of home/car for business). Once an election has been made to use the system it will not be necessary to exit it until turnover exceeds a surprisingly high £150,000.

The choice is yours

The new system is voluntary so it will be possible to calculate whether the simplified cash basis will be advantageous. Once a business has opted in it is not yet clear how opting out will work. The year in which a business switches regimes may be challenging as new transitional rules will need to be respected.

Simplicity itself?

The cash basis will still involve some calculations. Non business use of assets will need to be adjusted for as will disallowed or ‘excessive’ expenditures and the costs of ‘more durable’ assets. Perhaps confusingly those registered for VAT are to have receipts and expenditures included in the ‘cash in cash out’ tax calculation. It will only be possible to carry forward losses under the cash basis which may not suit many, for example those who are starting self-employment for the first time or others wishing to use sideways loss relief.

Existing businesses opting into the cash basis will need to examine the difference between accrual and cash accounting for at least the first year of cash operation and make the correct adjustments.

What are the ‘fixed allowances’ to be?

The proposal includes fixed mileage for cars (45p per mile etc.) to replace the costs of vehicle ownership, a flat rate of between £8 and £24 per month for use of home rather than actual costs and flat rate disallowances (e.g. £500 per month for two persons) for personal use of business premises.

Simplified systems in other countries

Many other countries, such as Germany and Austria, have simplified systems for smaller businesses, which allow cash accounting for tax purposes at far higher levels of turnover. South Africa introduced a new system in 2009 but it has only had a take up of 10% indicating that design is crucial.

Will it be worth it?

Whether a business will benefit from the system is down to its individual circumstances. It will be necessary to determine which system will be cheaper, taking into account administration savings. The irony, of course, is that this process itself will add to the administration burden of nano businesses.

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Transfer Pricing shifts East

Controversy over “tax dodging”

Transfer pricing is a controversial area, and is accused of being open to exploitation (pdf) with the victims often being poorer countries whose tax authorities do not have the resources to tackle abuse. The traditional forum for the discussion of transfer pricing rules has long been the OECD, whose Transfer Pricing Guidelines underpin national legislation. However, it has only 34 member countries, taken largely from the developed world.

An unbalanced system

Increasingly, poorer countries are demanding a say in how transfer pricing rules are formulated. The OECD recently held its first Global Forum on Transfer Pricing which included tax officials from over 90 countries. There it acknowledged that it “need[s] to take into account the views of all countries to ensure that the rules will be applied in a globally consistent manner” and the forum agreed that transfer pricing rules needed to be “more robust”.

The UN as an alternative to the OECD

The OECD is not the only intergovernmental body involved in transfer pricing, with the 193 member UN recently releasing its Model Double Taxation Convention. The Convention’s transfer pricing recommendations are currently based on the OECD’s guidelines, but has been heavily criticised by India (pdf), which stated that the “Guidelines on transfer pricing only reflect the agreements amongst… members of the OECD and accordingly tend to take care of interest of only developed countries.” Despite this criticism, the India is pressing for the UN to upgrade the its Committee of Experts on International Cooperation in Tax Matters to an intergovernmental commission.

NGOs add pressure

There are other players pushing the agenda of developing countries. Transfer Pricing Week magazine recently voted ActionAid one of their five leading forces in transfer pricing for their report on SABMiller’s tax practices in Africa. Also on the list was the Taskforce on Financial Integrity and Economic Development, which campaigns for improved transparency and accountability in the global financial system.

Conclusion

The pressure is mounting on the current OECD-dominated system. With the global transfer of economic power from West to East, it can only be a matter of time before transfer pricing rules face a similar seismic shift.

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An introduction to Transfer Pricing

Background

When two companies do business, their transactions are generally thought of as being priced by the market. However, when two entities are linked the laws of supply and demand don’t apply. Companies can allocate costs and revenues across divisions, subsidiaries, fellow group members and joint ventures as they see fit. This distribution can be done in a way that produces a tax advantage, for example by allocating profits to a lower-tax jurisdiction.

This is where the transfer pricing rules come in.

Arm’s length provision

The fundamental principle behind transfer pricing is that of the ‘arm’s length’ provision. Transactions which meet the ‘participation condition’ are compared to those which would have been made between independent entities. For example

Companies A and B are both owned by the same parent. A sells a component to B for £100, but the open market price would be £150. This means that A’s profit is £50 lower than it would have been had the transaction occurred at arm’s length. As a lower taxable profit (or higher allowable loss) will give rise to a lower tax liability, company A is considered an ‘advantaged person’. The corollary to this is that company B will have a higher taxable profit, so is a ‘disadvantaged person’.

Whilst entities are free to conduct the actual transaction at whatever price they choose, a transfer pricing adjustment must be made for tax purposes to reflect the arm’s length provision. In the UK this is reported by way of self-assessment when filing tax returns. It should be noted, though, that an adjustment can only be made to reduce a tax advantage, unless the entity is a ‘disadvantaged person’ making an adjustment in conjunction with an ‘advantaged person’.

In reality, arm’s length prices can be open to interpretation, particularly with intangibles such as royalties and management charges. A company may wish to negotiate advance pricing agreements with HMRC and other tax authorities to provide clarity and certainty.

Definition of participation condition, transaction and provision

Participation condition

The participation condition is met when one entity “directly or indirectly participat[es] in the management, control or capital of the other”, or they are under equivalent common control. The transfer pricing rules define control more broadly than normal tax legislation. Effectively, control exists where one party has the power to determine the actions of another, and this definition is not confined to majority ownership. Specifically:

  • Joint venture companies are controlled by parties which have an interest of at least 40%.
  • Relationships can be tracked through multiple levels to determine whether control exists.

Transactions

Transactions are defined broadly, and include arrangements, understandings and mutual practices, whether or not they are legally enforceable.

Provision

The overall value of a transaction (including terms and conditions) to is known in UK legislation as its ‘provision’, which is analogous to the phrase “conditions made or imposed” in Article 9 of the OECD Model Tax Convention.

Burden of proof

The burden of proving that transaction provisions are at arm’s length falls on the taxpayer. However, it is up to HMRC to prove negligence or carelessness where they wish to impose penalties.

Scope

Transfer pricing is inherently transnational, and the UK legislation is part of an international framework based on the OECD Transfer Pricing Guidelines. However, since April 2004 it has also applied to UK-to-UK transactions.

SMEs (as defined under European law) are largely exempt from the transfer pricing rules, unless they elect not to be. Exceptions to the exemption include transactions involving entities in tax havens, and where HMRC suspects aggressive avoidance.

Conclusion

Transfer pricing is a simple concept, but the devil is in the detail. Larger groups, even those without international operations, will need to be aware of it. For multinationals, advance pricing agreements are a necessity and can be time consuming to negotiate. On top of this, fundamental changes are on the horizon, driven by the rise of developing nations. We explore this in our next article on the future of transfer pricing »

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