UK: New Anti-Avoidance Rules on Transfer Pricing - Affects Loans Made From 4 March Onwards

The Inland Revenue has announced new anti-avoidance legislation aimed at attacking structures used in private equity transactions to avoid the application of the transfer pricing rules. These rules prevent a company claiming tax relief for interest paid on certain loans to connected parties.

We have not yet seen the draft legislation (it should be in the draft Finance Bill) and the exact extent of the changes will not become clear until then. However it appears that the legislation will not just hit structures put in place deliberately to avoid the rules but will also hit many structures where we would not have expected the transfer pricing rules would apply - including many joint venture arrangements outside the private equity sector. The Inland Revenue also announced changes to the circumstances in which a corporation tax deduction will be allowed for interest only when it is paid rather than when it accrues. This will again hit the private equity industry.

1. Currently the transfer pricing rules only apply to loans made to a company by a person who controls that company or to a loan made to a joint venture company by one of the joint venture parties where there are two joint venture parties who have at least a 40% interest in the joint venture company. Under the new rules the transfer pricing rules will also apply where the company is controlled by persons acting together in relation to the financing arrangements of a business and those persons collectively would be capable of controlling the company. This is intended to attack arrangements where a private equity investor deliberately splits up his holding for instance by using parallel companies or partnerships to avoid the rules. However the application is much wider - it does not appear to be limited to circumstances where there is a tax avoidance motive. It would for instance appear to catch a situation where a private equity investment was made through a number of separate funds operated by the same private equity investor or where the investment was made by two private equity investors acting together. It is likely that most private equity companies and many other joint venture arrangements will be caught by these new rules.
2. The transfer pricing rules will now apply when a loan is put in place before there is the necessary connection between the company and the lender. This is intended to attack arrangements where private equity investors made any loan investment into the company before taking an equity stake to try and avoid the transfer pricing rules.
3. New rules were announced affecting when a corporation tax deduction is allowed on rolled up interest or a premium (for example on zero coupon debt). In general tax relief is allowed on an accruals basis for all interest and premiums. However where a loan is made to a close company a deduction is only allowed when the interest or premium is paid if the loan is made by a party which is a shareholder in (or in some circumstances loan creditor of) the company. A special exemption to these rules was introduced where the loan is made by a CIS Limited partnership (a limited partnership which is a collective investment scheme) . This meant most private equity transactions would be exempt from the rules. Under the new rules the exemption will only apply if the company is a small or medium sized enterprise and the creditor is not resident in a tax haven. This again will hit private equity transactions.

The new rules apply with immediate effect to loans made on or after 4 March 2005. They will also apply to existing loan relationships from 1 April 2007 or sooner if the terms of the loan are changed.