Thin capitalisation refers to the situation where a company is said to be excessively geared through connected party loan finance. Interest is generally tax deductible, whereas dividends are not; as a result, thin capitalisation is a focus for tax authorities.
Unlike many tax authorities around the world, HM Revenue & Customs (HMRC) does not operate a separate thin-cap regime. Instead it relies on the general transfer pricing provisions contained under Part 4 Taxation (International And Other Provisions) 2010.
Whereas many thin-cap regimes operate prescribed formulae and safe harbours in relation to interest deductibility (ie allowing interest deduction up to a preset limit), the UK regime is based solely on the arm’s-length principle, which is in effect a test of whether a company could and would have borrowed the same amount from an independent party without the support of parental or cross guarantee.
The UK regime is considered to be among the more complex of the developed thin-cap regimes, which in turn gives rise to greater uncertainty for UK taxpayers. This uncertainty has, in the past, been exacerbated by the time limits associated with the UK Corporate Tax Self Assessment (CTSA) regime, which allows for a window of enquiry of generally up to 12 months after the submission of the relevant CTSA return. In practice, this has left companies dealing with thin-cap enquiries several years after the loan finance was introduced.
For many years HMRC has offered UK taxpayers the opportunity to apply for an advance agreement in relation to the deductibility of loan interest arising from intra-group funding arrangements through the tax treaty application procedure, whereby taxpayers would invoke the terms of a bilateral treaty to reduce or eliminate a withholding tax obligation on payments of interest to an overseas lender.
However, this route was not open for certain intra-group funding situations including those that were not subject to the UK withholding regime, such as listed Eurobonds, loans provided by lenders in non-treaty locations and loans taken on by private equity-backed portfolio companies that were the target of the ‘acting together’ rules.
In recognition of the difficulties and uncertainties faced by UK taxpayers in relation to complying with the UK thin-cap regime, in April 2007, through its Statement of Practice 04/07 (SOP 04/07), HMRC introduced the Advance Thin Capitalisation Agreement (ATCA) programme.
The aim was to assist UK taxpayers in achieving certainty in relation to the application of the transfer pricing provisions relating to intra-group funding arrangements. For most companies this has included agreeing on the amounts borrowed and the applicable interest rates, but it has also included agreeing an appropriate margin or spread for UK finance and treasury companies.
Although the statutory basis for an ATCA is exactly the same as for a non-financing advance pricing agreement (APA), the HMRC administration of the ATCA programme is separate to that of an APA (other than HMRC’s head office financial transfer pricing specialists, who are the overall managers of the programme and an initial point of contact).
The HMRC personnel involved in the ATCA programme are typically international issues managers – corporate tax specialists who deal with transfer pricing and similar issues – and the individuals allocated to an ATCA are typically determined on the basis of geography.
Applications from companies dealt with in HMRC’s large business service section may also be submitted through the customer relationship manager, and those dealt with by local compliance offices – typically smaller companies – can be submitted to a transfer pricing cluster leader, whose responsibilities are broken down on the basis of geographic regions.
The ATCA programme does not exclude potential applicants by reference to size or complexity of the transaction. Rather, the threshold is whether the loan finance represents significant ‘commercial issues for the company’.
Since the introduction of the ATCA programme approximately 500 applications have been processed by HMRC. To date, we understand that about two-thirds have been in respect of private equity-backed portfolio companies where, needless to say, gaining certainty over interest deductibility represents a key shareholder issue.
ATCAs are typically agreed on a prospective basis, although they can be rolled back and used on a pre-transactional basis. HMRC has stressed that ATCAs should not be used as a tax planning tool, and only transactions that are either ‘very likely’ to occur or are ‘well in the process’ will be considered at a pre-transaction stage. Our experience has been that leveraged buy-outs are the transactions most likely to be subject to a pre-transactional ATCA.