Finnace Bill 2016: Further Changes to Loan Relationships and Derivatives: Interest Free Loans and other Loans on Non-Market Terms

Finnace Bill 2016: Further Changes to Loan Relationships and Derivatives: Interest Free Loans and other Loans on Non-Market Terms

Fri 18 Dec 2015

One of the changes brought about as a result of the requirements of New UK GAAP is the way interest free loans and other non-market term loans are recognised in a company’s financial statements. 

Under Old UK GAAP (where FRS 26 had not been applied) these loans would have been accounted for at historic cost, and the accounts would not reflect any entry within the profit and loss account at recognition or over the term of the loan.  However, the requirement under New UK GAAP is to initially recognise these liabilities on the balance sheet at the present value of future expected cash flows – this is calculated by discounting the face value of the loan by an applicable rate of interest. The effect of this is that the carrying value of these liabilities on the balance sheet will be reduced, with the difference being credited to equity.  This effectively reflects the fact that the shareholder is contributing value to the company because he/ it has lent the funds at below market rate. 

HMRC produced a draft technical guidance note on how interest free and other non-market loans would be taxed. The tax implications of this change arise due to the debits and credits which are booked to the accounts under New UK GAAP – in board terms, the credit to equity on initial recognition of the liability is currently taxable, while the subsequent debits to the profit and loss account in respect of the finance expenses are tax deductible.

However, three areas have since come to light where the original rules gave rise to unintended consequences, so these are now being addressed by draft clauses in Finance Bill 2016, which will have effect for accounting periods commencing on or after 1 April 2016.  Where a company’s accounting period straddles 1 April 2016, the new rules will apply for that part of the accounting period deemed to start on 1 April 2016. 

Restriction of deductions for notional finance costs

New s446A CTA 2009 (introduced by Clause 23 FB 2016) will apply to interest free and non-market loans made by individuals (or other non-corporates) or corporates resident in non-qualifying territories (in other words situations where there is asymmetry for UK tax purposes).  Where the loan liability is recognised by the borrower at an amount less than the amount actually borrowed, the discount at inception is credited to equity and unwinds over the course of the loan.   A notional finance charge also appears in the financial statements over the course of the loan, which will be tax deductible (subject to other adjustments e.g. under transfer pricing or the worldwide debt cap). 

HMRC have now realised that the changes in Finance (No. 2) Act 2015, under which loan relationships and derivatives will be taxed broadly only on amounts that appear in the profit and loss account, means that such companies could obtain tax relief for the notional finance cost they haven’t actually incurred, and at the same time escape tax on the discount credited to equity. This is therefore a problem in those lending scenarios where both parties are not within the loan relationships rules.  The change made is to restore the position to what it would have been before the accounting changes.  It applies where the lender is an individual or a corporate resident in a ‘non-qualifying’ territory (i.e. a territory other than one has a non-discrimination article in its treaty with the UK).  Where it applies, the borrower’s interest relief will be restricted to the extent that the accounting credit on inception is not taxed.

Reversal of debits previously denied under transfer pricing rules

The next problem identified concerns the situation where finance charges required to be recognised for accounting purposes in respect of non-arm’s length loans subsequently reverse in the financial statements under new UK GAAP.  Whilst the transfer pricing rules would operate to restrict the tax deduction to an arm’s length amount, the transitional credit being recognised over a ten year period would not have been adjusted for transfer pricing (as transfer pricing rules only operate to increase profits and not to decrease them).  New sub-sections 446(8) and 693(6) CTA 2009 are thus being introduced by Clause 24 FB 2016 to ensure that credits will not be taxed to the extent that debits have been restricted by transfer pricing adjustments. 

Exchange gains and losses

A number of provisions in CTA 2009 (sections 447, 448, 449, 451 and 694) restrict the amounts of exchange gains and losses which are brought into account on non-arm’s length loan relationships and derivative contracts.   These result in only the arm’s length proportion of exchange differences being recognised (eg 75%, if only 75% of the loan would have been made at arm’s length).  These provisions will be changed to ensure that these provisions do not apply to the extent that the loan relationship or derivative contract is matched or disregarded under the Disregard Regulations (new s447(4A), 448(3), 449(4A), 451(4A) and 694(3A)).  Hence matched forex differences on non-arm’s length loan relationships and derivatives will remain taxable, and so offset forex differences on the hedged item.  These changes are being introduced to avoid the creation of forex exposure for corporation tax purposes where the position is hedged in the accounts (meaning commercially there is no such forex exposure).  New s475B defines the meaning of ‘matched’.  A loan relationship or derivative contract is matched if and to the extent that:

  • It is in a matching relationship with another loan relationship or derivative contract (meaning that the one is intended to eliminate or substantially reduce the foreign exchange currency exposure of the other); or
  • The exchange gains and losses are excluded by the Disregard Regulations

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