Misplaced Misgivings

The Revenue's policy with regard to non-resident landlords' interest paid on United Kingdom properties is suspect, says Peter Vaines FCA, ATII, TEP, barrister.
The transfer pricing legislation was substantially amended in 1998, and is now found in Schedule 28AA to the Taxes Act 1988. One of the more significant changes was to extend the principle of self assessment to transfer pricing, placing a much heavier burden on the taxpayer in determining transfer pricing issues.
The application of the transfer pricing legislation to non-resident landlords in connection with borrowings for the acquisition of United Kingdom investment properties is a matter of increasing controversy. The Inland Revenue has expressed its views widely in correspondence; they were also largely set out in Tax Bulletin 46, and appear to be settled policy on which it is suggested that the Revenue will not move without a very serious challenge. I hope that this is not the case and that the Revenue will be persuaded to reconsider its position.
Interest claimable
Let us look at a typical situation where a foreign company wishes to buy an investment property in the United Kingdom. The company borrows 90 per cent of the purchase price from a bank, supported by a guarantee from its major shareholder, or perhaps its parent company. The company lets the property commercially and claims a deduction for the interest paid against the rents.
The Revenue says that the company should only be able to claim the amount of interest which would have been payable if the loan had been acquired by the company acting entirely at arm's length and having regard only to the assets of the company. It suggests that a third party lender would normally lend only 65 per cent to 80 per cent depending upon the quality of the rental stream and a number of other commercial factors. This is its interpretation of how the transfer pricing legislation should be applied and accordingly, in the above example, the company would be denied relief for a significant part of its interest paid.
A loan by any other name
I have the greatest difficulty in seeing how this can possibly be right on a number of grounds. For a start, how can it be said that a loan from a clearing bank could be other than a loan from a third party? The Revenue says:
'the loan granted by the bank is one transaction, but there is also another transaction involved, i.e. the associate giving a guarantee to the bank. So there is a provision of funding which has been made between associates by means of a series of transactions and this is therefore within the scope of Schedule 28AA. If the interest arising is more than would have been obtained without the guarantee, e.g. because the principal loan is more, then the amount claimed should be re-calculated as if no guarantee had been given.'
This passage covers a number of points but the crucial element in the Revenue's argument seems to be that the loan from the bank is not really a loan from the bank at all, but the provision of funding from its major shareholder because of the existence of the guarantee. With respect, this is barely tenable. All that has happened is that the shareholder has guaranteed the loan. It is the bank which has lent the money and the terms of the loan are commercial.
The best that can be said is that there is another transaction, one which has taken place between associates, to which the transfer pricing legislation should apply that is the provision of the guarantee. A fee would have been paid for the provision of a guarantee if it had been provided by an independent third party, and if a transfer pricing adjustment is to be made it should be to reduce the profits of the company by an amount equal to such a fee.
The second part of the above extract suggests that the interest on the loan is more than would have been obtained without the guarantee. But this is surely the wrong way round. The amount of interest which would have been paid if no guarantee had been given would have been much higher. The existence of the guarantee enabled the loan to be obtained at a lower and more acceptable rate of interest. The transfer pricing legislation (if it applies at all) would operate to substitute the much higher interest which would have been paid on such a loan between independent enterprises acting entirely at arm's length. It does not entitle the Revenue to pretend that an entirely different loan was made between different parties at a different rate of interest; that self evidently goes too far.
Not excessive, just higher
The Revenue's argument has another strand. It is not that the rate of interest is excessive, it is that the amount of interest paid is higher than it should be because a larger loan was able to be secured by reason of the guarantee. That may be right in some cases, but it does not necessarily follow. In any event, even if a larger loan were able to be secured, why should it be ignored? The whole idea is to look at the transaction which has taken place and to substitute arm's length terms not to substitute an entirely different transaction.
The Revenue does not even attempt to deal with the point that if a bank had lent 100 per cent of the purchase price, this would have been at a greater interest rate to reflect the increased risk. It says:
'It is true that a higher risk may well justify a higher interest rate. However, the arm's length price is a bargain arrived at between two parties acting independently. Even if a 100 per cent loan were on offer from a bank, which in our experience is not nowadays normally the case, a prospective borrower would not necessarily take this up if it considered the price would not give an adequate return.'
Unfortunately, this just avoids the question, which is a pity because it is possibly the crucial question. It cannot be right for the Revenue to say that it does not want to consider this point, so it will ignore what has happened and address its comments to some other transaction which did not take place but which fits more neatly into its thinking.
Interest rate fits the risk
More importantly perhaps, the underlying assumption that a third party lender would not lend 100 per cent of the purchase price of the property must surely be incorrect: it depends upon the rate of interest. Realistically, such a lender would not lend 100 per cent of the value of the property at the same rate which would apply to a smaller loan, as the smaller loan would entail less risk; the lender would demand a much higher rate. How much higher does not really matter.
It also appears to be incorrect to consider how much another bank would lend against a particular property. Banks and lenders might well approach the matter in different ways, all of which would be acceptable, but what matters is the interest rate and other terms which should apply to the loan in question not some other loan. It seems inescapable that the interest would be much higher without the shareholders' support so that if Schedule 28AA is to apply to the transaction, the tax deduction ought to be much more than the amount of interest actually paid.
The Revenue defends its general approach by saying that Schedule 28AA must be construed in line with the Organisation for Economic Co-operation and Development's transfer pricing guidelines. This is clearly correct having regard to paragraph 2 of Schedule 28AA. The Revenue highlights part of the guidelines relating to thin capitalisation which suggest that in some cases:
'it might be appropriate for a tax administration to characterise the investment in accordance with its economic substance with the result that the loan may be treated as a subscription of capital.'
Unfortunately whatever the merits of this statement, it clearly has nothing to do with the issue under consideration.
No grounds for challenge
There seems to be no reason to challenge the nature of such arrangements, as third party loans supported by shareholder guarantees must be one of the most common form of bona fide commercial transactions. As suggested above, a strict application of the transfer pricing rules would not be to cause any disallowance of the interest paid but to allow a deduction in respect of the provision of the guarantee. Indeed, the best answer may be to sidestep the issue completely and arrange for the shareholder to charge an arm's length fee for the guarantee, because then there would be no part of the transaction or series of transactions to which the transfer pricing rules could apply.
Peter Vaines is a partner with Haarmann Hemmelrath.

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