UK: The Taxation of Corporate Debt - A guide for the non-specialist

Corporate Tax Bulletin January 2000
Last Updated: 16 February 2000

Jonathon Ivinson provides a basic guide to the taxation of corporate debt.

The introduction of a new regime for the taxation of corporate debt in the Finance Act 1996 was the final part of a three stage process designed to streamline the taxation of profits, gains and losses of foreign exchange transactions, financial instruments and what the new rules termed "loan relationships". The Revenue's stated aim in introducing the new legislation was to "move away from a rigid income/capital divide in the way in which taxation was applied to an approach which looked at the overall position, either the return received or total outlay, and taxed or relieved that overall outcome". The combined effect of the three codes is a comprehensive system for the taxation of corporate financings which aligns their tax and accounting treatments. In the past, broadly speaking, cash was king and the receipt of interest or the realisation of a security triggered a tax event. The new rules adopt an accruals approach to profits and losses derived from loan relationships. The tax treatment is driven by the way the debt is accounted for in a company's statutory accounts, generally irrespective of actual receipts or realisations.

The three codes, whilst dealing with different types of finance, share the same revolutionary principle: the capital/revenue distinction is replaced with so called "all income" accruals treatment. Profits, gains or losses attributable to trading transactions are taxed or relieved under Schedule D Case I, whilst those attributable to non-trading transactions are taxed under a new Schedule D Case III.

All three sets of rules operate on the principle that it is the accounting treatment of profits and losses on debts or financial instruments that informs the tax treatment. Thus, profits under a loan relationships are either recognised on an accruals or MTM (mark to market) basis of accounting.

Loan Relationships

A "loan relationship" exists where a company stands (whether by reference to security or otherwise) in the position of the creditor or debtor in respect of a money debt and that debt arises from a transaction involving the lending of money. The concept of "loan relationship" embraces most forms of corporate debt; overdrafts, bank loans, deposits, mortgages, most forms of loan stock and debentures. The definition is straightforward and is intended to be a wide term embracing both simple debts and issued securities which are treated broadly the same way.

Credits and debits

As part of the move away from the capital/income distinction, the new legislation works with "credits" and "debits", which include both capital and income profits, gains and losses, payments received and expenses paid. Credits and debits which are brought into account have to be computed in accordance with an authorised accounting method. This method must fairly represent all profits, gains and losses arising from loan relationships and related transactions along with all interest and charges and expenses incurred under or for the purposes of a company's loan relationships and related transactions. A "related transaction" is a disposal or acquisition of rights or liabilities under a loan relationship.

Authorised accounting methods

How are debits and credits computed? The legislation requires the use of one of two authorised accountancy methods, the accruals basis and the MTM basis. Each method has rules which govern how interest, capital profits and losses and discounts are treated. Where the statutory accounts for the company use one of these methods correctly, that method will in most cases apply for tax purposes without the need for further adjustment.

An authorised accruals basis allocates payments to the periods to which they relate ignoring when payments are actually made and any due and payable dates. The method must contain proper provision for allocating payments under a loan relationship to accounting periods and must assume that every amount due under the loan relationship will be paid in full when due apart from the authorised arrangements for bad debt and in the case of certain government investments. There are three common methods of accruing payments which are spread across more than one accounting period. The straight-line basis simply divides the total return by the number of periods; the economic accrual or actuarial method produces a constant rate of return taking account of other variable factors such as a back-end loaded interest payment profit and the "rule of 78" which is appropriate in cases where there are equal repayments in each period as in, for example, consumer credit transactions. The effect of the "rule of 78" is to ensure that interest charged is proportional to the capital balance outstanding throughout the term of the loan.

The authorised MTM basis of accounting measures the fluctuations in value of a loan relationship between two points in time, known as "accounting dates". Under MTM, income items (i.e. interest accrued/due) will be taxable but also positive and negative movements in the value of assets have to be brought into account as at the accounting date. MTM is also used to measure the net present value of receivables and payables arising under foreign exchange and financial instruments contracts and dealing operations of banks. These loan relationships are generally traded by banks and financial institutions. The overall effect is that the recognition of profits and losses is accelerated but the rationale is that MTM accounting gives a more accurate view of the profits of such operations (where the business is a dealer) than an accrual of profits and losses over the life of the instruments or contracts in question.

An MTM basis of accounting must use a fair value for all loan relationships and bring that fair value into account in each accounting period. Fair value is given a statutory definition in section 85(6) of the Finance Act 1996. Where the company is the creditor in the loan relationship the fair value is the amount which the company would obtain from an independent person for all of the rights under the loan relationship in respect of future amounts. Where the company is the debtor, the fair value is the amount it would have to pay to an independent person for them to assume the liabilities for future amounts due and payable under that relationship.

There are two types of MTM, the so-called "dirty" and "clean" mark to market. The "dirty" MTM value of a loan relationship reflects accrued interest on a security on the date of valuation. Interest is accounted for on a strict due and payable basis. This is the authorised MTM basis. "Clean" mark to market valuations do not reflect accrued interest. Interest is calculated on an accruals basis rather than a due and payable basis. This basis equates with the authorised MTM method where the value of the loan relationship in question does not reflect accrued interest or where the credits and debits produced by this method give the same result as the application of "dirty" MTM.

The use of MTM accounting is not permitted between connected parties. The definition of connection is considered below.


The new rules introduced a radical change in the way in which interest was treated in the taxation of companies. The rules prior to FA 1996 were complicated. Where interest was not payable by a trading company to a UK bank it fell under the special "charges on income" regime. Additionally, the deep discount and deep gain legislation operated to limit deductibility in certain circumstances. Two authorised accounting treatments are permitted, an accruals basis or an MTM basis. The accruals method brings interest into account on an accruals basis. The MTM basis brings interest into account on a due and payable basis.

The new rules are also broader in scope. They apply to all interest paid by or to companies. Interest on trade debts is now incorporated even though trade debts are not loan relationships.

Allowable expenditure

Section 84(3) and (4) set out the circumstances in which expenses can be taken into account in calculating the profits and gains arising under a loan relationship. Allowable expenses must be incurred directly in:

  • bringing or attempting to bring a loan relationship into existence; or
  • entering into or giving effect to a related transaction; or
  • making a payment under a loan relationship or a related transaction; or
  • pursuing payments due under a loan relationship or a related transaction.

In the case of most loan relationships, the appropriate accounting treatment of allowable expenses would be to accrue the expense over the lifetime of the loan relationship. Where this is the case for accounting purposes, this treatment should be followed for tax purposes. Allowable expenses would include arrangement fees with banks, payments for the variation of loan relationships, the fees of a solicitor or debt collector in pursuing a debt defaulter and early redemption penalties. The Revenue's initial view was that guarantee fees incurred in connection with loan relationships were not allowable under section 84 as they did not relate directly to a loan relationship or related transaction. It was pointed out to the Revenue that in the real world it was very often the case that loans would not be advanced at all without the provision of a guarantee. Thus in Tax Bulletin 26 (December 1996) they confirmed that they accepted that fees paid by a debtor in respect of such a guarantee would relate directly to the bringing into existence of the loan and accordingly relief was available. The definition therefore also covers fees or commissions paid by the debtor in respect of the provision of a loan guarantee.

Bad and doubtful debts

Bad debt relief is available only for companies which are creditors in respect of loan relationships and which utilise an authorised accruals method of accounting. FA 1996, section 85(3)(c) states that, where an accruals basis is used, the creditor in a loan relationship is required to assume that all amounts payable under that relationship will be paid in full as they become due. This assumption is, however, subject to authorised arrangements for bad debt as set out in FA 1996, Schedule 5 paragraph 9. This schedule sets out a list of specific circumstances in which a departure from the assumption of payment in full is allowed. However, the Schedule does not apply in all circumstances where a creditor uses an accruals basis. It will not apply where the creditor is connected with the debtor (see below).

The new rules represented an extension of the availability of bad debt relief in that they applied to loan relationships to which the creditor was a party for non-trading purposes as well as trading purposes. Previously, apart from one or two specific circumstances, bad debt was not available on loans, profits on the sale of which would not have been brought into account as trading receipts. Relief is available for creditor companies where and to the extent that:

  • a debt is a bad debt
  • a doubtful debt is estimated to be bad
  • a liability to pay any amount as release.

A debt that is written-off as bad, provided against as doubtful or released will generate a debit in the profit and loss account. This "clawback" will be brought into account in the computation of the company and will be taken into account under Schedule D Case I or Case III as appropriate. Credits arising through the reduction of a provision or a subsequent recovery will similarly be brought into account.

Connected parties

FA 1996 section 87 describes the circumstances in which one company will be treated as connected with another for the purposes of the rules. Connection has important consequences. These are:

  • the accruals basis (as opposed to MTM) always applies between connected parties
  • no relief for bad debt
  • releases or waivers of intra-group debt are neither taxed nor relieved
  • interest which is paid late is accounted for an a receipts basis
  • there are special rules governing the taxation of "relevant discounted securities" which in certain circumstances penalise some forms of intra-group finance

Connection can arise if:

  • one party to a loan relationship controls the other; or
  • the two parties are under common control; or
  • one party is a close company and the other party is a participator or an associate of a participator in that company.

If any of these characteristics apply at any time during the current accounting period of a company or at any time during the preceding two calendar years then for the for purposes of section 87 it will be treated as connected with the other party.

The interaction of the rules on connection and the consequent restrictions on bad debt relief led to representations from the British Banking Association and the British Venture Capital Association among others. It was pointed out to the Revenue that bad relief would not be available if a bank exchanged debt for shares in a troubled company as this would create a connection for the purposes of the corporate debt rules, creating an economic disincentive to corporate rescue initiatives of this nature. Legislation was introduced allowing for the deductibility of loses where a creditor takes shares or becomes entitled to shares which are "ordinary share capital" of the debtor company in satisfaction of its liability and makes a loss in circumstances where prior to the debt for equity swap the two companies were not connected. These provisions are contained in paragraph 6(4) of Schedule 9 FA 1996.

For venture capital funds paragraph 6(4) did not go far enough. The investment vehicles of venture capital funds are generally limited partnerships, the partners of which, taken together, may have control of the investee company. A close company and a participator in it fall within the statutory definition of connection whereas a loan creditor will not, in itself, be treated as a participator. It is very common therefore to find that venture capital funds have a connection with investee companies. The Revenue responded to this with an extra statutory concession which, in certain tightly drawn circumstances, disregards the rights of partners in order to ensure that, for example, the general partner in a venture capital company will not be automatically treated as connected with the company in which the partnership is investing. Loans made by venture capital investment vehicles in the ordinary course of their business of providing finance will not be taken into account in determining whether the creditor and the debtor have a connection. Thus in certain circumstances bad debt relief is capable of being obtained in respect of what are strictly connected party loan relationships.

The consequences of connection

Companies are obliged to use the authorised accruals method of accounting in respect of any loan relationship in which they are connected with the other party to the relationship. As mentioned above, the authorised accruals method does not permit any departure from the assumption that all amounts due and payable under a loan relationship should be paid in full. This means that, subject to the statutory and concessionary relief available in the case of debt for equity swaps, bad debt relief is not available in respect of connected party loan relationships. This is a provision designed to prevent abuse of bad debt relief as, without such provisions, judicious inter-company financing arrangements could allow multiple bad debt relief claims in respect of the same advance. The corollary of there being no bad debt relief between connected parties is that the release or waiver of intra-group debt does not trigger a tax charge. This should be contrasted with the position where there is a release between unconnected parties. If Company A owes a bank £1,000 but comes to an arrangement with the bank that the bank will accept £500 in full and final settlement of Company A's obligations, this waiver by the bank of its right to £500 will produce a taxable credit of £500 for Company A. The unconnected creditor will be entitled to bad debt relief in respect of the amount waived.

There is also an exception to the normal rules for connected parties in the case of late interest. In a loan relationship between unconnected parties, interest would be allowed as a debit when it is accounted for under an authorised basis of accounting irrespective of whether it is actually paid or not. However, interest is only allowed as a debit when paid, as opposed to when it is actually accrued under an authorised accruals basis of accounting where the debtor company is connected to the creditor (and consequently is statutorily obliged to use an authorised accruals basis of accounting), interest treated as accrued in an accounting period of the debtor company is not paid within twelve months of the end of that accounting period and the full amount of that interest is not brought into account as a credit by the creditor.

These provisions need to be carefully considered where, for example, in a venture capital backed buy-out, a non-bank investor also has shares in the acquisition vehicle. It may well be the case that its rights as a loan creditor when aggregated with the rights attaching to its equity interest will result in there being a connection for the purpose of the rule. It is often the case in such transactions that some of the acquisition vehicle's funding costs are deferred, for example, by issuing interest bearing loan stock but allowing interest to be rolled up. Borrowers under such instruments are unaffected provided that the holder of the loan notes brings the interest into account for corporation tax purposes. In these circumstances, the issuing company will be able to claim a tax deduction for the accruing interest. However, if the connected lender is not subject to UK corporation tax on the accruing interest, (e.g. it is a foreign investor) the rules on late interest will have effect and no deduction can be claimed until the interest is paid. It should also be noted that, if the purchaser and lender are connected, no deduction will be able to be claimed in respect of a discount accruing on a relevant discounted security. Notwithstanding this, the holder will be subject to tax on the discount as it accrues.

Schedule 9 paragraph 13(2) - unallowable purposes

FA 1996, Schedule 9 paragraph 13 is an anti-avoidance provision. The effect of the application of this provision is the disallowance of any debits where in an accounting period a loan relationship has what the legislation describes as an "unallowable purpose". An unallowable purpose is a purpose which is not amongst the business or other commercial purposes of the company. Where there is a tax avoidance purpose this will not qualify as being a business or other commercial purpose of the company and so related debits will be disallowed. A tax avoidance purpose is an unallowable purpose if it is the main purpose or one of the main purposes for which the company is (i.e. remains as well as becomes) party to the relationship or is entered into a related transaction by reference to it. That is a question of fact which will depend on all the circumstances of the case. This anti-avoidance provision caused controversy at the time of its introduction on the grounds of its generality. Such was the breadth of the provision that it could have been interpreted as preventing companies from getting tax relief for straightforward lease financing arrangements. The Economic Secretary to the Treasury offered a reassurance at the time that this was not the intention of the legislation. She stated that the paragraph denied tax deductions on loans that were for the purpose of activities outside of the charge to corporation tax. She also confirmed that borrowing by a finance leasing company to acquire assets on the grounds that this was more tax efficient than the lessee investing in the assets directly was not caught. She stated that where a company was choosing between different alternatives of arranging its commercial affairs, it was acceptable for it to choose the course that gave the most favourable tax outcome.


The purpose of this article is to restate the fundamental concepts of the loan relationships regime and this has inevitably involved a great deal of simplification. The legislation has given rise to a number of complex difficulties for practitioners but in most cases the Revenue have been quick to respond where the new rules have created potential economic distortion such as in the case of banks and venture capital funds and bad debt relief. The overall effect of the alignment of tax treatment with accounting treatment has been to replace a plethora of often arbitrary rules with a system that is logical and affords certainty for taxpayers.

This article appears in The Tax Journal, published by Butterworths

This note is intended to provide general information about some recent and anticipated developments which may be of interest. It is not intended to be comprehensive nor to provide any specific legal advice and should not be acted or relied upon as doing so. Professional advice appropriate to the specific situation should always be obtained.

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