UK: Transfer Pricing and Private Equity - Guidance Issued

Originally published September 2005

The March 2005 announcement that the transfer pricing legislation would be widened to catch more private equity transactions has caused concern and uncertainty in the private equity industry. The legislation was finally enacted in July in the post-election Finance Act and HM Revenue & Customs have now issued some draft guidance on the practical application of the new rules.

Transfer pricing will apply to a loan made to a company if it can be said that the loan is not made on arm's length terms because:

• the loan would not have been made at all but for a special relationship between the parties; or

• the amount lent exceeds what would have been lent but for a special relationship between the parties; or

• the interest rate or other terms differ from what would have been agreed between independent parties.

If a loan is caught by transfer pricing, a tax deduction will not be available for interest on the loan to the extent that the loan is not made on arm's length terms.

Before the changes the transfer pricing rules only applied to loans made to a company by a person who controlled that company or to a loan made to a joint venture company by one of the joint venture parties where there were two joint venture parties who had at least a 40% interest in the joint venture company. Limited partnerships were treated as transparent in applying the control test (although HMRC were trying to change their practice on this). In the past therefore, transfer pricing was not usually a major issue on private equity transactions.

Under the new rules, transfer pricing also applies where the company is controlled by persons ‘acting together’ in relation to the financing of the company, and those persons collectively would be capable of controlling the company. The new rules potentially catch most private equity transactions as they can apply where the private equity investment is made through a number of separate funds operated by the same private equity house or where the investment is made by two or more independent private equity houses as in each case they will be acting together. There was also a concern when the rules were announced that they could apply to banks providing mezzanine finance.

In broad terms, the new rules apply to loans made on or after 4 March 2005 . They will also apply to existing loans from 1 April 2007 - or sooner if the terms of the loan agreement are varied. Draft guidance has also been issued on the application of the transitional rules.

The draft guidance identifies several factors which, depending upon the precise circumstances, suggest that a transaction may not be made on an arm's length basis so that transfer pricing may be an issue. The circumstances identified by the guidance are:

• Co-ordinated or linked transactions - the way a transaction is co-ordinated or linked with other transactions could make it feasible that it may not be on arm's length terms. This could be relevant where several shareholders lend on similar terms;

• Common interest in both sides of the transaction - if the same person has a similar beneficial interest in both sides of the transaction (for example where the lender and borrower companies are owned by the same person(s)), it could be on non-arm's length terms;

• Involvement of other parties - if other parties are involved, perhaps in giving a guarantee. Involvement of others will only be a relevant factor if the other party's involvement changes the fundamentals of the transaction, such as the risk or anticipated return for either party.

• Mezzanine finance - The guidance deals with the situation where one or more banks negotiate with management to provide senior and mezzanine debt to fund a management buy out and the mezzanine finance includes equity warrants giving the bank the right to obtain a small shareholding. HMRC’s guidance states that although the deal involves others (management), is co-ordinated with the acquisition of the company and (through the equity warrants) the bank will have an interest in both sides of the transaction, these factors do not create a risk that the lending will be otherwise than on arm's length term. The rationale for this being that the involvement of others and the co-ordination will not affect the bank's decision to lend and the bank's interest in the borrower through the equity warrants is disproportionate to the bank's risk as a lender.

• Bank holding shares in its trading book as trading stock - Where the bank is lending to a company and holds shares in the company as trading stock these can generally be disregarded as they will not usually be a factor in the bank's lending decisions

• Syndicated loans - The guidance clarifies that there should not be a transfer pricing risk if several lenders coordinate their lending through loan syndication.

• Several private equity houses/ several funds managed by same private equity house - The guidance confirms that where several separate private equity houses invest in a company with each owning a percentage of the shares and providing an equivalent percentage of the loans to the company there will be a risk that the borrowing will be on non-arm's length terms. This would seem to apply where several funds managed by the same private equity house invest as well as where several independent private equity houses invest.

• Disproportionate investor loans - The guidance indicates that if several shareholders lend to the company but one shareholder lends a greater amount which is not proportionate to its shareholding, whilst part of the lending of the shareholder who lends a greater amount may be on a non-arm's basis, it will not necessarily all be on a non-arm's length basis.

Loans made under a contract entered into before 4 March 2005 will not come within the new rules until 1 April 2007 unless there is a variation to the loan contract. HMRC guidance makes it clear that any changes to the interest rate, repayment terms, amount borrowed, or currency of the loan, no matter how minor, will cause the loan to come within the new rules unless the change is provided for in the original contract or is made to correct errors in the loan documentation. Other changes which may or may not be regarded as a change in the terms of the debtor relationship, depending upon the precise facts, include:

• changes to intercreditor agreements;

• changes to the provision of security; and

• assumptions of loans by a new debtor.

Companies with pre-4 March 2005 loans from private equity investors will need to take great care that any refinancing of their bank debt does not cause their shareholder loans to fall within the new rules.