HMRC issue draft guidance on the treatment of interest-free and other non-market loans under New UK GAAP

HMRC issue draft guidance on the treatment of interest-free and other non-market loans under New UK GAAP

Mon 23 Nov 2015

HMRC have issued draft guidance to be incorporated into the corporate finance manual with regards to the accounting implications of interest free and other non-market loans (NMLs) under New UK GAAP (i.e. FRS 101, FRS 102 and Section 1A of FRS 102) and the resulting tax consequences. 

Background

The move from Old UK GAAP (FRS’s, SSAP’s and UITF’s) to New UK GAAP is required to be made by medium and large companies for accounting periods commencing on or after 1 January 2015 and by small companies for accounting periods commencing on or after 1 January 2016.

The specific issues covered by this guidance arise because of the difference in the way in which these loans are treated under New UK GAAP, as compared to Old UK GAAP where FRS 26 had not been applied (the treatment where FRS 26 is applied is broadly consistent with New UK GAAP).

Given the timing of these accounting changes, and the prevalence of interest free and other non-market loans between groups of companies / companies and their shareholders, we can expect to see these issues coming to light in accounts in the near future, and will therefore need to consider the tax implications of them.

It is worth noting that this draft guidance does not reflect the changes to the loan relationship provisions under the Finance (No 2) Act 2015, and in particular:

  • the fact that for loan relationships entered into in an accounting period beginning on or after 1 January 2016, debits and credits charged to equity are not brought into account for tax purposes, and
  • the change to the definition of amortised cost basis of accounting, which is being aligned to the accounting definition.It is stated that the guidance will be updated for these changes in due course.

The accounting implications arising from the change to new UK GAAP

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.

Over the term of the loan, the amount originally credited to equity is released (or debited) to the profit and loss account as an implied ‘finance expense’. The corresponding credit is taken to the liability on the balance sheet.

The result is that, by the end of the term of the loan:

  • the liability on the balance sheet is reinstated back to the face value of the loan at day one,
  • the debits charged to the profit and loss account over the term of the loan will amount to the credit taken to equity on day one.This is referred to as the accretion of the loan.

The tax implications arising from the change to new UK GAAP (for loans entered into prior to accounting periods beginning on or after 1 January 2016)

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 taxable, while the subsequent debits to the profit and loss account in respect of the finance expenses are tax deductible, unless otherwise provided.

The guidance covers the following areas, which are suggested to be the most common circumstance:

  • Interest free and other no-market loans from shareholders – loan first recognised under Old UK GAAP (excluding FRS 26)On the transition from Old UK GAAP to New UK GAAP, there will be an accounting adjustment reducing the carrying value of the loan in the balance sheet, offset by an equal credit to equity (retained earnings), as explained above.  In the example given, the interest free loan of £100,000 is restated on transition to new UK GAAP on 1 January 2015 as a liability of £68,301, with the difference (reflecting the non arm’s length terms) being credited to equity.This accounting adjustment to equity will be brought into account for tax purposes under s316 CTA 2009.  If the loan falls to be repaid after the end of the accounting period, it will be spread over a period of ten years under the COAP Regulations instead of being taxed in Year 1.

    The finance expense shown in the accounts over the period of the loan will be deductible for corporation tax purposes in the year charged. The corresponding credits will be taken to the liability on the balance sheet, so that it accretes to its maturity value of £100,000 by the end of the period.

    Overall, the debits and credits brought into account for tax purposes over the period will be equal, reflecting the fact that neither a profit nor loss arises on the loan.

  • Interest free and other non-market loans from shareholders – loan first recognised under New UK GAAPAs the loan is first recognised under New UK GAAP, the reduced carrying value of the liability will be included in the balance sheet at the time the loan is entered into (‘inception’), with the difference between that and the face value of the loan being credited to equity.  Therefore, there is no transitional adjustment to consider.The amount credited to equity will (under current rules) be brought into account for tax purposes in full at that time, while the finance expense charged over the period of the loan will be deductible for corporation tax purposes in the year charged (Sections 307-308 CTA 2009).

    Again, the overall effect is that the debits and credits brought into account for tax purposes over the period will be equal, reflecting the fact that neither a profit nor loss arises on the loan.

  • Interest free and non-market loans from shareholder  – impact of transfer pricing provisions where borrower is not thinly capitalisedThe example given is of an interest free loan made by a UK shareholder at a time when New UK GAAP is already being applied (so no transitional adjustment to consider here).

The UK transfer pricing provisions treat the accounts as if they were re-written to reflect what the arm’s length position would have been. 

In these cases, the UK lender will have interest imputed upon them under the transfer pricing provisions, to reflect an arm’s length rate of interest. 

Assuming the borrower claims a compensating adjustment in their tax computation, they are treated as paying an arm’s length rate of interest. It will thus be necessary to make additional deductions for tax purposes to ‘top up’ the finance expense (as included in the accounts) to the arm’s length amount.

Note: as the new GAAP accounts are effectively ignored for tax purposes, the credit to reserves on inception of the loan is not taxable.  Assuming a compensating adjustment is claimed, the borrower obtains tax relief on the arm’s length rate of interest, although this will be given through the implied finance expenses being tax allowable, plus a further deduction to bring the total tax allowable expense up to the arm’s length rate.

  • Interest free loans and non market loans from shareholder where borrower is thinly capitalisedA related party lender may advance a loan of an amount greater than a third party would have been prepared to.  Where the borrower is thinly capitalised, there will be a disallowance in respect of interest reflecting both that the rate of interest and the quantum of the loan advanced are not at arm’s length.  The example given is of a loan made of £100,000 to a UK company, B Ltd, at 10% by an overseas shareholder at a time when Old UK GAAP applied.  However, had the arrangements been at arm’s length, B Ltd would have only been able to borrow £60,000 and the interest rate would have been 15%.  The loan is restated in B’s balance sheet on transition to new UK GAAP to £85,725, so there is a transitional adjustment of £14,275 (£100,000 – £85,725).  This is spread over a period of ten years under the COAP Regulations, giving rise to a taxable credit each year of £1,473.

    The overall effect is that the borrower will receive tax relief for the arm’s length interest expense over the term of the loan.  This is achieved by a thin capitalisation restriction being made, under which the net debit (arising from the finance expense less any credit under the COAP regulations) is restricted to the arm’s length interest expense.

    However, the term of the loan in this example is for less than ten years.  Once the loan has been repaid, the transfer pricing issues it created clearly fall away, so there are no further transfer pricing adjustments to be made.  Nevertheless, there is still the remainder of the ten years’ worth of credits to be brought in under the COAP regulations.  However, it is not necessary to tax these remaining credits under the COAP Regulations if these do not exceed the amount of debits that have previously been disallowed under the transfer pricing rules.

     

  • Interest free and non-market loans subject to the connected company provisionsSo far we have considered loans made from shareholders rather than between connected companies.  Connected companies are required by s349 CTA 2009 to account for their loan relationships on the amortised cost basis of accounting, that is, they should be represented at ‘cost’, adjusted for cumulative amortisation and any impairment, repayment or release  (s313(4) CTA 2009).  ‘Cost’ for this purpose will usually be the cash lent, but it will not be as straightforward where the arrangements are more complex than simply borrowing money (e.g. if there are linked transactions or an element of non-monetary consideration involved). 

    As such, any adjustments to the carrying value of the liability on the balance sheet under New UK GAAP (either on initial recognition of the liability or on transition to New UK GAAP) are ignored for tax purposes, so the loan will continue to be treated at its original ‘cost’.  In other words, transitional adjustments on the change to New UK GAAP are not taxed under the COAP Regulations and the amount taken to the income statement in respect of the accretion of the loan to its maturity value is similarly ignored for tax purposes.

    The effect of this is that the connected companies will be taxed on their loan relationships in the same way under New UK GAAP as they would be under Old UK GAAP.  Adjustments may, however, may required in respect of transfer pricing.

  • Group continuity – notional carrying valueWhere section 340 CTA 2009 applies on the transfer of a loan between group companies (for the transfer to be treated as taking place at notional carrying value (‘NCV’)), the transferee is deemed to have acquired the loan at NCV, while the actual consideration paid and the actual present fair value/fair value of the loan on initial recognition in the accounts of that company are ignored for tax purposes.This has the purpose of ensuring continuity of treatment of the loan, by ensuring that the transferee measures the loan on acquisition at the same value as the transferor did immediately before the disposal.

Comments

Leave a Reply

Your email address will not be published. Required fields are marked *