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HM Revenue and Customs Brief 01/09

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HM Revenue and Customs -Tax Authorities

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Issued 12 Janaury 2009

Advance Thin Capitalisation Agreements - Frequently Asked Questions

Introduction

HM Revenue & Customs (HMRC) recognises the rising importance of international issues for business customers and has established a new Business International directorate with effect from 5 January 2009. The director of Business International is Judith Knott.

The Financial Transfer Pricing Team has been formed within Business International to take responsibility for certain international tax issues previously dealt with by the specialist financial groups within CT & VAT, including thin capitalisation, financial services transfer pricing and attribution of profits, the Investment Manager Exemption, avoidance involving arbitrage and paragraph 13, Schedule 9 Finance Act 1996. Financial Transfer Pricing is led by Andrew Martyn.

This document seeks to answer questions which have come up in the months since the introduction of the process for entering into Advance Thin Capitalisation Agreements ('ATCAs'), as introduced by Statement Of Practice 4 of 2007 (SP04/07). This is likely to be revised or supplemented as experience of the ATCA process develops within and outside HMRC.

What is the scope of the ATCA?

The ATCA process is designed to deal with thin cap forward agreements, and will not be available for issues such as imputation of interest on outward loans and quasi-equity arguments, or for agreeing an appropriate level for guarantee fees. However, if such issues are encountered in the course of exploring the basis of an ATCA, they may be considered and dealt with. Additionally, the specialist financial teams responsible for ATCAs have, on a limited number of occasions in the past, entered into discussions about the level of return appropriate to a group finance or treasury company, and these discussions may continue to take place within the ATCA dialogue, subject to size, complexity, etc.

Can HMRC explain the criteria for qualifying for an ATCA?

No criteria have been set out and none are planned, though guidance will be offered if experience begins to suggest that it would be constructive to do so ie resources start to become overstretched and HMRC is obliged to become selective. The Statement of Practice (04/07) says that situations 'where the financing arrangements in place do not appear to be significant commercial issues for the company' are likely to be unsuitable for pre-return agreements. However, we do not want to be prescriptive unless for practical reasons we have to be. Companies will submit applications based on their own risk assessment and desire for certainty. Smaller cases are more likely to be accepted where the information is comprehensive, clearly presented and accompanied by a draft agreement.

At what point is it appropriate to submit the ATCA application?

ATCAs are not specifically intended as pre-transaction rulings - it is expected that the majority will be submitted after the relevant transactions have taken place but before the return incorporating those transactions is made. However, it is acceptable to make an application once plans are well-enough advanced for there to be every reason to suppose that transactions are about to be carried out as described in the application ie the pieces are all in place. We cannot spare resource to help in fine tuning or in establishing boundaries with a view to optimising tax efficiencies. We are committed to responding to commercial imperatives and to 'real time' working, but with 'real' transactions. SP04/07 also sets out the circumstances in which the ATCA can have retrospective effect (Para 19 onwards)

What are the key differences between ATCAs and the old treaty-linked process?

  • ATCAs are negotiated quite separately from the treaty clearance application process. The treaty clearance and thin cap are now separate issues dealt with in different offices. The treaty clearance application to CAR Residency in Nottingham (formerly the Centre for Non-Residents) no longer presents HMRC with an opportunity to consider the thin cap position. Except where an ATCA application is received, HMRC cannot commence thin cap enquiries until the return encompassing the relevant transactions or indicating a thinly capitalised position is submitted. Similarly, the borrower has no obligation to initiate thin cap discussions with HMRC - or at least not until HMRC exercises the option of enquiring into the return.
  • It remains the case that, where a treaty clearance is required, a certified application to CAR Residency must still be made. Assuming there are no problems with the application, CAR will issue a clearance notice and report the outcome to the payer's Corporation Tax office, rather than (as was the case before) referring the application for consideration and in some instances awaiting the outcome of thin cap enquiries.
  • ATCAs extend the range of potential applications for a thin cap forward agreement to include lending arrangements which involve no treaty claim, such as funding involving quoted Eurobonds, discounted loans and UK/UK transactions.
  • The traditional, occasionally drawn out process of correspondence to establish key facts and obtain relevant documentation is replaced by a requirement to present the necessary information in the initial application. As a consequence, if meetings are needed to increase understanding and advance resolution, these should occur sooner and be more focused than was previously the case; progress should be swifter than under the old system.
  • ATCAs offer the opportunity to introduce a more standardised approach where it is appropriate, using the model ATCA as a basis for the agreement, while recognising that most agreements are to varying degrees customised to fit particular facts and expectations.

How might taxpayers best present information to make the process as efficient as possible?

It is recommended that the information be presented as comprehensively as possible, proportionate to the size and complexity of the case, and may include:

  • A description of financing structure which has been or is in process of being put in place, including dates of transactions;
  • A description of the business and the plans of the principal trading operations, showing how capital is allocated and the relationship between capital and cash flows from operations, indicating any changes relating to the financing transactions;
  • Copies of loan agreements and other relevant documents;
  • A clear statement of the source of the funds (immediate and ultimate), how the funds were applied and the repayment terms;
  • An analysis of the financial strategy of the business, identifying the principal cash flows and the sources of repayment of debt;
  • A group structure covering all relevant companies and clearly setting out any changes to the structure taking place over the course of the transactions;
  • Financial forecasts contemporaneous with the transactions in question, projected as far as is meaningful, including a clear picture of the expected levels of interest cover, gearing or other relevant measures over the forecast period;
  • An analysis supporting the borrower's view of the extent to which the connected party (or supported) debt is considered to be arm's length;
  • A clear proposal for the terms of the agreement, including covenants. This might be in the form of a draft agreement, based where appropriate on the model ATCA.

How can taxpayers present their application to maximize the effectiveness of the case? (Some of the following points are usually more relevant to intra-group funding arrangements which incorporate an element of group reorganisation)

  • Fully explain the commercial motivations/advantages/pressures of the chosen course of action, both from the UK and the wider group perspective;
  • Provide an analysis of the cost of debt and resultant benefits to the business in clear commercial terms;
  • Provide an analysis of the risks to the lender and how the risks are managed, priced, monitored, hedged or secured;
  • Provide an analysis of the risks for the borrower, including the risks of failing to meet the terms of the loan, and the possibility of penalties and their effect;
  • Explain how the borrower intends to repay or otherwise manage the proposed loans, including sources of repayment;
  • Provide copies of applications and responses for any pre-transaction clearances under other specific provisions of the Taxes Acts, where those would be helpful in understanding the proposals.

What is the status and purpose of the Model ATCA?

Para 60 of SP04/07 says:

It is recognised that a model is not obligatory and will not be appropriate in all cases, but HMRC considers that it would cover a significant proportion of cases dealt with in Local Compliance, as well as some of those handled by the Large Business Service.

The Model ATCA is there to help, to act as a guide, particularly in smaller and more straightforward cases. It can serve as an aide-memoire or a check list for the features which HMRC likes to see in agreements, such as the procedure which applies in the event of a breach of one or more of the covenants.

How do ATCA applications fit in with the new arrangements for transfer pricing enquiry governance and the newly formed Transfer Pricing Team?

  • ATCAs are negotiated and concluded under the Advance Pricing Agreement legislation at Sections 85 to 87 Finance Act 1999, and the same statutory provisions will apply as for other APAs, although the terms contained in each agreement are framed by reference to Schedule 28AA ICTA 1988. Because of their APA status, ATCAs fall outside the governance rules recently set out by the Transfer Pricing Group for the conduct of transfer pricing enquiries. Even so, it is envisaged that most ATCA applications will be signed off within 18 months.
  • Thin cap enquiries initiated by HMRC into company tax returns fall within the TP governance procedures in the same way as non-financial transfer pricing cases. An enquiry will only be opened if the risk assessment and business case justify doing so, and the enquiry will be subject to periodic review. How enquiries interact with open ATCA applications is explained below.
  • Applications for ATCAs are typically made before a return falls due for the period in which the transactions occur, but the ATCA application can overlap with HMRC-initiated enquiries. Either the return falls due and is submitted before pre-return ATCA negotiations are concluded, or the ATCA application is not made until after the return has been made (possibly after enquiries into the return have begun). In either case, the ATCA takes precedence, but the enquiry will be tracked under TPG governance procedures.
  • Whichever way the case arises, the work is likely to be carried out by (and will certainly be supervised by) an International Issues Manager or a specialist from the Transfer Pricing Group. The Financial Transfer Pricing Team at Business International will continue to be responsible for operational policy, consistency and best practice, advising and supporting operational colleagues rather than taking case ownership.

We expect that a lot of people at HMRC will get involved in the ATCA process; how will HMRC provide appropriate training for the relevant people and ensure consistency of treatment?

  • The Transfer Pricing Group (TPG) was launched on 1 April 2008, bringing together the existing international tax specialists, Local Compliance, the LBS and SCI, alongside supporting specialists such as economists and sector experts. Teams of transfer pricing specialists have been established in Local Compliance and the Large Business Service and an intensive training programme is well advanced to provide expertise for every transfer pricing and thin cap enquiry. The Financial Transfer Pricing Team at Business International will continue their monitoring and supervising role in relation to ATCAs, but with the expansion of the work and the increasing expertise available in the TPG, the central teams will be concentrating on training, updating guidance, and providing a high level strategic and support role, taking on a more active role in only the largest and most complex cases, or those with novel features.
  • The work of the TPG is ensuring the creation of a core of well-trained specialists able to carry out, monitor and supervise transfer pricing work throughout HMRC.
  • Training and guidance extends to material on topics such as economics and commercial awareness.
  • Written guidance to transfer pricing specialists and the wider HMRC is being brought up-to-date.

How are ATCA applications being handled?

The Statement of Practice says that ATCA applications should be sent to Miles Nelson at Business International, 3rd Floor, 100 Parliament Street, London, SW1A 2BQ but it would be helpful if they were also copied to the office where the borrower's Corporation Tax affairs are dealt with. In order to provide a more efficient service, it has been decided that Danny Berry (at the same address) should receive the applications relating to private equity leveraged buy-outs.

You may if you wish submit applications by email:

'Mainstream' ATCAs should be sent to Miles Nelson and copied to borrower's CT office

Private equity ATCAs (preferably marked as such) should be sent to Danny Berry and copied to borrower's CT office

If you are happy to submit electronically, please also copy both types of application to Mike Bowen, who has an administrative role in relation to ATCA submissions.

We hope soon to establish and publicise a central electronic mailbox to which ATCAs can be sent, leaving their processing less dependent on the presence of any individual.

HMRC's ability to conduct email correspondence is subject to data security rules, but it would be helpful if applicants or their representatives could indicate whether you are comfortable to exchange emails with HMRC on the matter of the ATCA. Please indicate any restrictions - by way of content, for example - that you would wish to place on such exchanges.

Applications are in most cases allocated either to a member of the Transfer Pricing Group or an International Issues Manager within Local Compliance or the Large Business Service. This will depend on the complexity of the case and the availability and location of the relevant expertise. The Statement of Practice says at Para 26 that: 'HMRC will endeavour to respond to the initial contact within 28 working days'. This may not amount to a definitive answer, but should take the matter on to the next stage: a request for further information or a meeting request.'

When might HMRC withdraw from considering an ATCA application any further?

It is expected that the majority of cases will be seen through to a successful conclusion with co-operation from groups and their advisors but HMRC may withdraw from considering an ATCA application:

  • If negotiations reach a stage where there appears to be no possibility of agreement as to arm's length terms;
  • When responses to requests for further information are unsatisfactory or inconsistent so that insufficient information is provided to allow a proper understanding and assessment of the situation and reasonable warning of withdrawal has been given;
  • Where expected resource commitment appears disproportionate to the apparent risk or uncertainty.

What happens if the two sides fail to reach an agreement?

As Para 46 of SP04/07 states, if HMRC decides to withdraw from the ATCA process, it will issue a statement setting out the reasons. If agreement cannot be reached, both sides walk away, and the thin cap issue reverts to an annual self assessment exercise. If risk assessment suggests that further enquiry is appropriate, a CTSA enquiry may be opened, if there is a business case for doing so.

Who is entitled to sign off an ATCA on behalf of HMRC?

Subject to local management arrangements, ATCAs may be authorised by a Local Compliance or LBS International Issues Manager, a member of the Transfer Pricing Group or the relevant LBS Customer Relationship Manager, as well as members of the Financial Transfer Pricing Team at Business International.

One of the valuable elements of an APA is the bilateral nature. Is there any intention of extending the ATCA process to provide for agreement in the country of the lender as to the treatment of any part of the debt on which interest is denied in the UK?

There are no plans to make the ATCA process multilateral. An application for a bilateral agreement involving any sort of transfer pricing must be made via the mainstream transfer pricing APA programme overseen by Ian Wood at Business International , and will be considered in accordance with that programme's criteria regarding complexity, etc. Thin cap aspects of APA and Advance Agreement Unit cases are in practice usually referred to the Financial Transfer Pricing Team for consideration on a unilateral basis. There is difficulty in finding compatibility with overseas territories' thin cap rules, particularly where 'safe harbour' regulations are in place.

Does the ATCA process cover the anti-arbitrage rules or the unallowable purpose rules at Para 13 Schedule 9 Finance Act 1996?

Arbitrage - the 2005 anti-arbitrage legislation falls outside the ATCA regime and outside the governance processes of the Transfer Pricing Group. It is subject to its own clearance process controlled by the arbitrage specialists within Business International. However, where a company has made an arbitrage clearance application alongside an ATCA application, so that the company is asking for a set of transactions to be reviewed from both perspectives, HMRC will endeavour to deal with them in as coordinated a way as it can.

Para 13 - ATCAs between a taxpayer and HMRC are entered into under the Advanced Pricing Agreements (APA) legislation in Sections 85-87 FA 1999. In the context of inter-company financing, the only matters that can be the subject of an agreement under the APA legislation are matters relating to transfer pricing governed by Schedule 28AA ICTA 1988. Therefore, a clearance that Para 13 will not apply to a particular loan cannot be given as part of the ATCA procedure.

Under the new procedures for Non-Statutory Business Clearances, HMRC will provide clearances in relation to legislation not contained in the last four Finance Acts, including Paragraph 13, where there is material uncertainty around the tax outcome of a real issue of commercial significance to the business itself. However, any clearance that HMRC can give will be limited to conditions that existed at the time of the transaction and cannot provide any form of comfort that Para 13 will not apply to a loan in subsequent periods. One reason is that purpose can change with time and the purpose test in Para 13 is an annual one which is highly fact-sensitive. It would not be possible to create objective rules to define how long it takes for one purpose to be displaced by another.

As regards the interaction of computational adjustments under Schedule 28AA and Para 13, Schedule 28AA applies where there is a potential tax advantage, but a disallowance under Para 13 will serve to reduce or nullify that advantage ie if there were a Para 13 adjustment, it would be applied first and Schedule 28AA would then be considered in relation to the profits or losses as adjusted. In some cases where there is a potential Para 13 application, a thin cap solution alone may serve to satisfy HMRC's concerns over a company's financial position, so the Sch 28AA adjustment obviates the requirement for a Para 13 adjustment.

Any compensating adjustments will be based on the transfer pricing adjustment only.

What is HMRC's position on safe harbours and netting?

Questions are regularly asked about these issues:

  • Safe harbours - HMRC does not operate any type of 'safe harbour', nor does Tax Bulletin 17 say that it does. The paragraph usually quoted in support of the existence of safe harbours actually concludes: '…there are no hard and fast rules in this area and each case has to be considered on its own facts.' However, the starting point of a thin cap negotiation is often the consideration of debt- and earnings-based ratios.
  • Whether net debt or interest is acceptable in a thin cap agreement - over the years there have been discussions about HMRC's attitude towards using net interest or net debt as a suitable measure in a thin cap agreement. The debate has often been simply whether HMRC accepts netting or does not accept netting. The answer is that HMRC is prepared to examine the arguments for employing a net position, looking at issues such as the security, consistency and durability of the offsetting source, but will not accept netting without being satisfied that it is appropriate. HMRC sees instances of UK sub-groups of multinational enterprises which are subject to group pressure from outside the UK to retain borrowed funds that no longer serve their original purpose, do not form part of the company's working capital, and which the UK grouping is unable to exploit to its own advantage.

Can you clarify which entities are taken into account when measuring a borrower's ability to borrow, following the repeal of s209 (2)(da) and (8A) ie what is the thin cap 'borrowing unit' after 1 April 2004?

The UK borrowing unit

This is the largest grouping whose assets and liabilities are considered in assessing whether or not thin capitalisation is present or not, and which is encompassed in a thin cap agreement.

The position before 1 April 2004

Before 1 April 2004, the borrowing unit for thin cap purposes was defined at ICTA88/S209(8A) and consisted of the ultimate UK parent company and all 51 per cent subsidiaries, wherever situated in the world. If, in addition to such a grouping, there were also within the same global group:

  • any singleton UK companies held directly from overseas, or
  • any sub-groups (other UK groups) held directly from overseas

then each of these would constitute a separate borrowing unit in its own right, and could not be consolidated with any other UK grouping. In other words, if a US-owned group had three trading divisions, and for its European operations it had three different UK parent companies, each heading up one of those divisions, then each of those sub-groups of the US parent would have to be kept separate and considered in isolation from each other. Potentially there could have been two thinly-capitalised sub-groups and one adequately-capitalised sub-group with no consolidation or set-off of any kind between them.

The position on or after 1 April 2004

S209(8A) was repealed for transactions on or after 1 April 2004, Thereafter the legislation states that the borrowing company should be considered in isolation from any guarantees from connected companies, in effect on a standalone basis. In reality, any third party lender would take into consideration the assets and liabilities of subsidiaries of the borrowing company, so on that basis the post-April 2004 borrowing unit is (broadly):

Borrower + 51 per cent subsidiaries

The main change from pre-April 2004 is that the borrowing unit is now topped by the borrower, not by the UK parent company. The assets and liabilities of any company 'above' the borrower in the chain of ownership will be excluded; since to include them would in effect mean recognising guarantees which are excluded by Schedule 28AA (1B)(4). The subsidiaries of the borrower are included as, in effect, bundles of assets and liabilities, so it may be necessary to examine critically such issues as whether assets may be regarded as reliable security, or how easily assets could be accessed and realised. If any practical difficulty does arise, it is more likely to involve overseas subsidiaries and overseas assets of UK companies, rather than the domestically-based group, and examination of the 'bundles' is likely to be sparing.

Once it is agreed what constitutes the borrowing unit for a particular borrower, consolidated figures in the form of an accurate schedule (assuming the absence of actual consolidated accounts) for the unit will provide the necessary information for an assessment of the thin cap position. Measures used as covenants in any agreement will be tested by reference to the same consolidated unit.

Compensating adjustments

One significant difference between the Schedule 28AA and former s209 provisions is the arrangement for compensating adjustments in Schedule 28AA by which companies such as those in a parallel sub-groups, as in the example of the three divisions above, or companies within the same sub-group but outside the borrowing unit, may be able to claim a compensating adjustment under Schedule 28AA Para 6D, assuming they have the necessary borrowing capacity. This of course excludes the lender, which cannot guarantee its own loan.

This ability to claim does not require the existence of a formal guarantee, but includes any case where the lender has a reasonable expectation that he will be paid by or out of the assets of the guarantor company. This extends to unwritten guarantees and informal arrangements, which may in practice be inferred by reason of the relationship between the borrower and the claimant to the adjustment.

Will HMRC challenge the manner in which interest disallowed by agreement in an ATCA is allocated in practice, for example between different lenders treated as 'acting together', provided they operate within certain parameters?

In some cases the terms of an ATCA will be such that there is no doubt as to how a disallowance of interest is to be allocated.

However in many cases the terms within the ATCA are not so explicit as it to make it obvious how disallowed interest should be allocated between debt tranches and investors. In these circumstances HMRC would expect to see interest disallowed in accordance with any specific terms and conditions of the underlying financial instruments in priority to any other factors. For instance there may be specific terms and conditions of the instruments entered into as part of the commercial structure of the business which make it clear how a disallowance should be allocated or there may be an order of subordination set out in a loan or inter-creditor agreement.

A proportion of disallowed debt may include instruments which rank pari passu with other instruments and/or instruments with the same terms and conditions held by different investors. HMRC would expect the disallowance to be apportioned pro-rata across these instruments and/or investors.

If after considering these steps the disallowance has not been fully allocated, HMRC's current view is that an allocation of any remaining disallowed interest among debt tranches and investors that is made on the basis of commercial, ie non-tax, considerations would normally be regarded as low risk in the context of considering compliance with s847 ITA 2007.

This does not go as far as giving an answer to all scenarios in existing ATCAs because where tax advantage is a significant motive in determining the basis of the allocation we would naturally wish to reserve our position until the facts have been established and the consequences considered.

We will keep this position under review.

CAR Residency takes this opportunity to offer a few tips for making successful clearance applications:

Common errors in applications which hold up treaty applications at CAR Residency

  • The application has not been certified by the overseas fiscal authorities of the treaty partner state
  • The address is not legible
  • The application has not been signed
  • A copy of the loan documentation has not been provided
  • It is at times overlooked that answers to certain questions on an application form can trigger a requirement to submit supplementary information in support of a claim - for example a list of names and addresses of shareholders as required in certain circumstances for a claim under the US/UK treaty (Section B2, Question 2.8).

It is worth noting that:

All the information provided to CAR Residency is confidential. We are often contacted by UK based agents who have not been nominated on the form (part A) to discuss the tax affairs of the company or permanent establishment but we can only discuss the tax affairs of the company with:

  • an officer of the company and/or
  • an agent (tax adviser) nominated by the applicant company

Use of a syndication manager in the appropriate circumstances streamlines the process and reduces the number of claims to be processed.

Any questions or comments on this paper to

Miles Nelson
Financial Transfer Pricing Team
3rd Floor (03C/01)
100, Parliament Street
London
SW1A 2BQ

Tel: 0207 147 2663


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Article Published/Sorted/Amended on Scopulus 2009-01-12 23:22:56 in Tax Articles

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