by Jonathan S. Schwarz

This material must be read in conjunction with the Responsibility Statement

CONTENTS

INTRODUCTION

The difference between Schedule 28AA and the previous transfer pricing legislation
How are the terms of an arm’s length loan determined?
What is the proper rate of interest?
Guarantees from associated persons
Property value fluctuation after the loan is made
Refinancing
Mortgages on UK property


Introduction
The first substantive transfer pricing area that has received attention from the Inland Revenue in print is in relation to UK let property. The first inkling of this was in the Inland Revenue Non-Residents Newsletter No.4.It pointed out that under the new legislation, the whole of any arrangements between connected persons must be what would be found between parties acting at arm’s length rather than just the price. This has particular relevance to non-resident landlords who purchase property in the UK for letting and finance the purchase by way of loans. The Revenue Newsletter noted that in the past, such loans have often totalled 100% of the purchase price and the whole of the resultant interest has been set against the rental income. The Revenue warns that for 1999-2000, the landlord will only be able to claim the amount of interest that would have been payable if loans had been obtained from lenders acting entirely at arm’s length and having regard only to the assets of the company. The Newsletter continues to say that if the assets consist only of the UK let property, a third party lender is only likely to lend a percentage of the purchase price. This, they say, is typically 65% to 80%, depending on the situation of property and market conditions.

These comments were followed up in more detail in the Inland Revenue Tax Bulletin Issue 46 of April 2000. The Tax Bulletin article indicates that the Revenue has received a considerable number of queries specifically in connection with interest paid and rents received by non-residents letting property in the UK and the article attempts to address some of the points raised.

The difference between Schedule 28AA and the previous transfer pricing legislation
The Revenue emphasise that all aspects of a ‘provision’ between related parties must be on the same basis as between independent enterprises acting entirely at arm’s length. This does not simply refer to price. In the context of loan interest, this refers particularly to determining the amount of the loan, as well as the rate of interest.

How are the terms of an arm’s length loan determined?
The Revenue accept that this varies with the facts and circumstances of each case. The Revenue approach is that a third party lender will determine the amount by looking at the assets and the income of the prospective borrower. They again refer to the 65% to 80% range under current conditions. They also indicate that this range is applicable if there is a satisfactory projected income stream. In reviewing projected rental streams, a third party lender would have regard to both the quality of the tenant and the duration of the leases. They also indicate that lending decisions are as a result of the valuation of a number of general economic and specific commercial factors.

What is the proper rate of interest?
The Tax Bulletin gives limited guidance on this issue. It only refers to the frequent question as to what would happen if a bank had lent a 100% of the purchase price. It is often argued that this would reflect a higher interest rate in light of the increased risk. The Inland Revenue concede that a higher risk may well justify a higher interest rate. In this particular context, they express the view that 100% loans are not normally the case today. In addition, a prospective borrower would not necessarily take up such a loan if they considered the price would not give an adequate return. It is implicit in this answer that there may well be specific circumstances where loans outside the 65% to 80% range may well reflect arm’s length dealings. Other than the concession that the interest rate does reflect risks, the matter is not taken much further.

One of the frequently raised concerns in transfer pricing generally is in relation to the availability of arm’s length comparables. Financing property is an area where there is a great deal of information available since funding of property investment is available from a wide range of lenders. Other issues such as the term of the loan and whether it is a fixed or floating rate will typically be relevant.

Guarantees from associated persons
One of the more controversial areas in relation to the financing of UK rental property arises in the context of loans made to a non-resident landlord by a bank or other unrelated lender. It is not uncommon for lenders in these circumstances to require a guarantee from an associate, typically a parent company or other associated shareholder. There are two transactions involved, namely the loan and the guarantee. The view stated by the Inland Revenue is that consequently, there is a provision which has been made between associates by means of a series of transactions and this is therefore within the scope of Schedule 28AA. They argue that if the interest arising is more than would have been obtained without the guarantee, then the amount claimed should be recalculated as if no guarantee had been given. An example of this is where the principal loan is more than would have been the case in the absence of the guarantee.

A similar approach has been taken by the Inland Revenue in relation to inward investment into the UK by loans generally (see Tax Bulletin Issue 37 October 1998 Page 581). In that Bulletin, they say that a provision may be made by means of a series of transactions where a related party provides a guarantee to a bank which then on the strength of this makes a loan or an additional part of a loan available to a UK borrower. They regard this as similarly being within the transfer pricing legislation. In the writer’s view, these interpretations of Schedule 28AA by the Inland Revenue are misplaced and reflect an erroneous understanding of how the legislation works in respect of a series of transactions as contemplated by the Schedule. Furthermore, neither Tax Bulletins acknowledge the fact that where a guarantee is given, that an unrelated party would make a charge for the giving of this service, which the borrower under application of the arm’s length principle would be entitled to deduct.

The Revenue indicates that its approach is the same if the loan has been advanced because of a backing deposit, etc. from an associate, a letter of comfort or similar arrangement. They do, however, concede that if the effect of the guarantee is solely to reduce the rate of interest being charged and the UK borrower is not thinly capitalised, the legislation will not apply since no tax advantage is being conferred. This area is one that is likely to give rise to disputes, given the position taken by the Inland Revenue. In view of the doubtful legal foundation for their claim, advisers should not be quick to concede on these issues.

Property value fluctuation after the loan is made
The question is posed as to what the position would be if a loan provided by an associate was 100% of the original purchase price but the value of the property has risen, so that the loan now represents say only 65%.

The Revenue notes that in considering whether the interest payable would have arisen at arm’s length in any particular year, the question must be determined by reference to the date when the loan was made at the time of the property purchase. The Revenue also recognises that as a result of this principle, where the value of a property has declined from the date it was purchased, then an original loan to finance the purchase would still give rise to deductible interest if it was made on arm’s length terms at that time.

It may also be added that the Revenue position expresses only its understanding of domestic transfer pricing law and not the effect that the associated enterprises rule that any applicable tax treaty might have.

Refinancing
A frequent question is what happens where a loan originally made by an unrelated lender is replaced by one made by an associated person. The Inland Revenue observes that where the refinancing reflects what would have happened between parties at arm’s length, then no adjustment under Schedule 28AA is required. Thus, if the refinancing is because a better deal is available on interest rates and the replacement loan otherwise reflects what would have been agreed at arm’s length, no adjustment is necessary.

Particular issues arise where the refinancing is in connection with an increase in the amount borrowed. This is often because of an increase in value in the property. Again, for transfer pricing purposes, the usual arm’s length criteria apply. It should be remembered that in addition to this, the tests for deductibility for Schedule A will also need to be considered and, in particular, the purpose of the additional borrowing.

Refinancing on terms worse than the original loan may give rise to difficulties. If the refinancing is based on interest rates which have risen since the original loan was made, the borrower will have to demonstrate that such a refinancing would nonetheless have taken place in an arm’s length context. Normally, the Revenue says in the absence of other considerations, the arm’s length provision would be based on a refinancing at the previous rate or on a discount by the lender of the principal to reflect the new higher interest rate. In both cases, the net interest payable would remain the same.

Mortgages on UK property
The Tax Bulletin article contains a helpful acknowledgement in relation to security over UK property. In arm’s length circumstances, where a bank or other institutional lender makes a loan, they would often take a charge over the property. The expression ‘provision’ referred to paragraph 1 of Schedule 28AA is interpreted to refer to all of the terms and conditions of a transaction. The question arises whether the effect of this must mean that a loan directly or indirectly provided by an associate is also deemed to involve a charge over the property. The Revenue indicates that when considering the amount which would have been advanced and the rate of interest, then arm’s length lenders would insist on a charge. This does not, however, mean that for other tax purposes, there is deemed to be a charge over the property. This might be a factor in considering whether the interest is from a UK source. Unfortunately, the article does not indicate the effect on the amount of loan and the interest rate for transfer pricing purposes where no such charge is actually put in place.


© Jonathan Schwarz 2001