Funding UK Subsidiaries: Debt or Equity?
By Christopher Flood
Foreign companies setting up subsidiaries or intermediate holding companies in the United Kingdom would do better to capitalize them with debt rather than all equity.
There is no simple rule of thumb—for example, three
parts debt to two parts equity—in terms of how much debt
will be respected by the UK tax authorities. The rules are more complicated.
Recent NewsWire articles have explained how the UK tax system has adapted to encourage inward investment. This article considers the form investment may take and, in particular, the differences between long-term debt and equity finance under UK rules.
The taxation of an equity investment in ordinary UK shares is relatively straightforward. No capital duty is payable on the issue of new shares, stamp duty is chargeable on the acquisition of existing shares at 0.5% of the purchase price, and profits may be distributed without the imposition of withholding tax on share dividends.
On an eventual sale of the shares, a foreign investor would not be liable for UK tax on any capital gain unless, unusually, the shares had been held in a UK branch.
The treatment of the UK company that pays the dividends is also straightforward, although unattractive, in that dividends are not deductible in calculating the taxable profits of the distributing company.
By contrast, the taxation of long-term debt may prove more problematic in part because the ease with which what is actually an equity investment may be dressed-up as an interest-bearing loan.
As with shares, no capital duty is payable on the issue of debt and nor is stamp duty payable on subsequent transfers unless the debt is effectively disguised equity: for example, if the amount of interest payable is determined by reference to the issuer’s earnings. Nor would a foreign investor usually be taxed on the eventual disposal, which again is similar to an equity disposal.
The major difference from the investor’s perspective is that withholding tax of 20% may potentially apply on interest payable to a non-UK lender. However, there are structuring methods by which the withholding may legitimately be avoided or reduced, and then debt will often be preferable to equity because interest is potentially deductible for tax purposes.
The key is to focus on the avoidance of UK withholding tax and the availability of tax relief for interest expenditure.
Avoiding UK Withholding Tax
A UK company that is neither a bank nor other financial institution is required to withhold income tax equal to 20% of each interest payment made to a non-UK lender unless either the recipient qualifies for relief under a double tax treaty or the European Union legislation, the debt is in the form of a “quoted Eurobond” or the principal is required to be repaid within a year.
The UK is party to more than 100 double tax treaties the majority of which can reduce the required rate of withholding tax, often to 0%. The basic requirements for treaty relief are that the recipient of interest should be resident in the treaty partner state and not a mere branch lender, does not book the advance in a UK “permanent establishment,” and is the beneficial owner of the interest. It is this last requirement that has caused some difficulty in recent years.
Since the 2006 IndoFood case, HM Revenue & Customs or “HMRC” has actively applied an “international fiscal meaning” to the “beneficial ownership” requirement. This may be a particular concern where the treaty recipient is an intermediate lender. Where a lender is contractually obliged to pass interest on to another party—for example, its parent or a joint-venturer—HMRC may question whether the immediate lender is the beneficial owner of the interest that it receives. HMRC may be expected to look particularly closely at any claim for relief where the recipient is effectively a conduit for a party that would not itself have been entitled to receive gross payment from a UK borrower. An example is where the ultimate lender is based in a tax haven. Until HMRC is satisfied that the treaty requirements are met and issues a gross payment direction, all interest payments should be paid subject to deduction of tax.
Where the immediate lender is not resident in a treaty state or there is doubt about its “beneficial ownership,” then consideration may be given to issuing the debt as “quoted Eurobonds,” which will require the bonds to be listed on a recognized stock exchange. A significant benefit of the Eurobond exemption is that interest can be paid gross simply by virtue of the nature of the debt obligations so there is no requirement to apply for relief from HMRC. The Eurobond exemption is particularly useful where the debt is likely to be sold on a secondary market or in a securitization structure.
Protecting the Deduction
Since the introduction of the corporate loan relationship regime in 1996, the basic entitlement of a UK corporate borrower to treat interest as a tax deductible expense has been linked to the correct accountancy treatment of the expense and, hence, has been fairly straightforward.
However, the potential to reduce taxable profits by paying interest has inevitably attracted the attention of tax planners and the UK legislation has developed a complicated web of anti-avoidance provisions to deny relief where the investment is disguised equity or where the debt has been structured artificially to reduce the borrower’s profits.
The following is an overview of the main provisions that need to be considered when a UK company is debt funded by a parent or other interested party from outside the UK.
Generally, the borrower’s entitlement to tax relief for interest should mirror the treatment in its properly prepared accounts as to both timing and quantum. If the UK borrower is connected with the lender, it will be required to use an amortized costs basis of accounting for the purposes of calculating relief. Usually this will mean that the time at which interest is actually paid has no bearing on the period in which it is accrued for tax purposes. However, if the connected lender is resident in a jurisdiction that has not entered in to a double tax treaty with the UK that includes a non-discrimination article, or if the lender is managed from a jurisdiction where it is not subject to tax by reason of residence, domicile or place of management, then tax relief may be delayed until the interest is actually paid. For example, if a Cayman Island parent provides a loan to its UK subsidiary that then fails to pay interest within the 12-month period following the accounting period in which it is accrued in the borrower’s accounts, then the tax deduction is deferred until the period in which payment is eventually made.
Tax relief for interest may be also be denied or restricted where, in broad terms, the interest has certain characteristics of a return on equity and, in such cases, all or a part of the interest may be deemed to be a distribution of profits.
If the interest represents more than a commercial return for the use of the principal because, for example, the amount due exceeds what would be payable on market terms, then the excess is treated as a non-deductible dividend. (In such circumstances, it would be cold comfort that at least no withholding tax would apply!)Or, if the interest or other consideration given for the loan depends, to any extent, on the whole or any part of the borrower’s business, the tax deduction is denied.
Although the UK now boasts a competitive corporate tax rate of 28% (which will reduce to 24% over the next four years), when rates were higher it was not uncommon for international groups to seek to reduce their UK taxable profits by, for example, paying artificially high rates of interest to an offshore lender subject to a lower tax rate in its jurisdiction. Historically, UK governments have tended to respond to avoidance schemes on a piecemeal basis, so there are now a number of overlapping provisions all aimed at preventing the artificial manipulation of debt liabilities designed to reduce taxable profits.
The loan relationship regime contains a number of targeted anti-avoidance rules.
For example, interest is only deductible to the extent it is “arm’s length,” which the legislation achieves by applying an “independent terms assumption.” In effect, the quantum of interest is deemed to be what it would have been if the lender and borrower had been “knowledgeable and willing parties dealing at arm’s length.” Because of the potential for this provision to overlap the general transfer pricing rules, it is effectively disapplied where that is the case.
Also, the corporate debt regime includes a “targeted anti-avoidance rule.” In a case where a loan has an “unallowable purpose,” the borrower will be denied a tax deduction to the extent that interest is “on a just and reasonable apportionment” attributable to the unallowable purpose.
In addition to targeted loan relationship rules, the UK also has a general statutory transfer pricing regime that includes thin capitalization restrictions. The combined effect of these potentially overlapping provisions is that the UK corporate borrower may only recognize for tax purposes the funding costs it would have incurred had it borrowed on market terms from an unconnected lender.
The broad objective of the statutes is to prevent the UK company from obtaining tax relief for interest that exceeds what would have been due on an arms-length basis. Accordingly, the rules may bite even where the debt carries only a market rate of interest if, for example, the principal by reference to which the interest is charged exceeds what an independent lender would have been prepared to advance. For these purposes, the borrower’s market standing and credit worthiness are to be ascertained without reference to its position in any group of which it may be a member.
Perhaps the most significant recent legislative change that increased the attractiveness of the UK as a location for intermediate holding companies was the introduction of a “participation exemption.” In most cases, foreign dividends received by UK companies will no longer be taxed in the UK.
However, to limit the opportunities for the exemption to be used for tax avoidance, the UK has also introduced a worldwide “debt cap.” In broad terms, the entitlement of a UK group member to treat interest as deductible is limited by reference to the external debt obligations of the whole group.
The bottom line is that the ease with which withholding tax can be avoided and the potential for interest to be tax deductible means that, solely from a UK tax perspective, debt funding of UK companies is generally preferable to equity investment. But the UK has a mature anti-avoidance environment, which is continuing to evolve, with a “general anti-avoidance rule” currently under consideration. So the scope for structuring interest obligations so as artificially to avoid tax or to replicate a quasi-equity return is extremely limited, and any such structuring should only be undertaken with appropriate professional guidance.