From a tax perspective, these are uncertain times for individuals investing through loans and those who are members of investment partnerships or trading LLPs. In addition to the anti-avoidance provisions for partnerships outlined in our blog here, a Discussion Note rushed out by the Government during the Liberal Democrat conference is likely to result in a substantial increase in the rate of tax suffered on interest on shareholder loans to companies where the companies’ total borrowings exceed the amount which could have been borrowed from unconnected lenders. The effective tax rate could increase to as much as 68% if the lender pays tax at the 45% rate. While the main target of the proposals appears to be companies controlled by a small number of individuals, the proposals would have a major impact on private equity financing in general and have been the subject of extensive representations by the BVCA.
The problem has arisen as a result of the disparity between the rates at which income is taxed in the hands of individuals (up to 45%) and those of companies (up to 23%). Generally where interest or other tax deductible payments are made by a company to an individual shareholder, the company can claim a deduction from its profits taxed at 23% whereas the individual is taxed on the receipt at rates of up to 45%. However, if the payments would not have been made, or the amounts would have been different, if the parties had not been connected with each other, the UK transfer pricing rules substitute an arm’s length amount. Where the company has borrowed from its shareholders because it has exhausted its capacity for external borrowing, the transfer pricing rules generally deem there to be no interest paid on the shareholder loans as the loans would not have been made at all if the lenders were not also the company’s shareholders. This results in disallowance of any tax deduction for the company, balanced by a “corresponding adjustment” for the lender who is treated as not receiving any taxable interest. If the lenders are UK resident individuals, the transfer pricing adjustment is beneficial as it achieves tax free receipts for individuals (worth up to 45p in the Pound) at the expense of the loss of the company’s tax deduction (worth only 23p in the Pound), an example of a tax avoidance provision being used to save tax.
The Government is concerned that some individuals have been deliberately bringing their dealings within the scope of the transfer pricing rules to save tax. The examples given in the Discussion Note are:
- the use of service companies owned by partnerships: the partnership pays the service company less than the full market rate for supplies of staff or other services by the service company, so a greater amount of cash remains within the partnership for distribution to partners, while the transfer pricing rules give the partners a tax deduction at up to 45% [or 47% if NICs payable too] for the higher arm’s length price; the service company is taxed on the higher price but at a rate of only 23%;
- a loan to a company from its sole shareholder, an individual: as the company has already taken out the maximum amount of third party debt which it is able to raise, current law disallows any deduction for interest paid by the company on loans from the individual shareholder on the basis that the company would not have been able to borrow those amounts from an unconnected lender. The individual claims a “corresponding adjustment” so the interest received by the individual is not taxable. If the individual pays tax at the top rate, these arrangements potentially allow the individual to receive value from the company free of tax with the effective tax borne by the company at only 23%.
The Government proposes that in cases of this sort, the individuals should no longer be able to claim a corresponding adjustment. It would follow that the individuals would be taxed on income received from the company at the full rate of up to 45% even though the company’s tax deduction has been disallowed. The effective rate of tax could therefore be as high as 68% (23% + 45%). This is punitive by any measure and goes far beyond correcting the perceived tax avoidance. It is also inconsistent with internationally recognised transfer pricing principles.
The aim of the transfer pricing legislation is to create symmetry, so tax free receipts for the recipient balance the disallowance of the tax deduction for the payer. It is only the disparity between the effective rates of tax for companies and individuals which has created the perceived scope for avoidance. The more obvious way of counteracting this perceived avoidance in the case of shareholder loans (and the suggestion put forward by the BVCA) would be for the individuals to be taxed on the excess interest as if it were a dividend rather than interest, resulting in an overall effective rate of tax of around 50% taking into account the absence of a tax deduction for the company. This would correspond with the commercial reality that junior levels of debt often perform a quasi-equity function and would be consistent with other provisions of the tax code which treat interest with equity characteristics as if it were a distribution.
The example quoted in the Government’s discussion note is over-simplified. In practice it is far less clear to what extent subordinated debt would be subject to transfer pricing adjustments and may vary from year to year. Within the private equity industry, such loans are not merely made by individuals but often by private equity investment funds consisting primarily of institutional investors with a small proportion of individual co-investment. Often individual managers co-invest in the investee companies and in some cases the managers’ loans are subordinated to those of the fund with the result that they are the most likely to benefit from corresponding adjustments.
The Government has not specified when the new rules would come into effect, but the consultation period has been short and the likelihood is that a further announcement will come soon, possibly in or before the Autumn Statement. There is no indication yet that existing arrangements will be “grandfathered” and remain unaffected by the proposed changes. It would be particularly harsh if the new rules were to apply to interest accrued before the new rules come into force as interest on junior debt commonly rolls up for several years pending repayment of senior debt. It may be advisable to consider paying accrued interest in cash or in the form of PIK notes before the new rules come into force if the company’s finances and tax status permit and the necessary consents from senior lenders can be obtained, subject to taking appropriate advice.
The Discussion Note can be found by clicking here.