CFM35175 - Loan relationships: connected companies: hybrid capital instruments: tax rules - eliminating tax mismatches

CTA09/S352B

Tax mismatches can arise in situations where a company borrows externally and then lends the funds raised to fellow group companies. CTA09/S349 requires a loan relationship between connected companies to be taxed on an amortised cost basis. If the linked external loan relationship is accounted for at fair value a tax mismatch would arise.

The internal loan relationship, despite potentially being accounted for at fair value, would be taxed on an amortised cost basis under CTA09/S349 (see CFM35030). If the external loan is accounted for at fair value that loan relationship would be taxed on fair value movements. This results in a tax mismatch which has the potential to give rise to large taxable debits or credits that do not reflect the underlying economic reality, creating tax volatility.

CTA09/S352B was introduced to address this type of situation.

Conditions

This section applies if all the following conditions are satisfied:

  • a company lends money under a loan relationship with a connected company that is taxed on an amortised cost basis under CTA09/S349 (the internal loan)
  • the company borrows under a loan relationship which is accounted for on the basis of fair value accounting and which is not a connected company relationship to which CTA09/S349 applies (the external loan)
  • there is a qualifying link between the external loan relationship and one or more internal loan relationships

Effect

Where the conditions are met, the external loan relationship is to be taxed on an amortised cost basis.

A qualifying link arises if the capital raised is wholly or mainly used to fund loan relationships between connected companies. HMRC accept that what is wholly or mainly will depend on the circumstances.

Where the funding structure of the group changes, it will be necessary to reassess whether a qualifying link exists between internal and external loan relationships. The company will need to demonstrate a qualifying link between the funds obtained under the external instrument and the provision of funds under the internal instruments.

A company’s intention in undertaking a financial transaction is expressed through the intentions of its directors, although in many cases decisions will be delegated to a lower level of management. Particularly in large companies, the board of directors (or the group board) is likely to have set out a detailed policy on funding requirements. Where the link between an external and internal financial transaction is evidenced through documentation such as the detailed policy and that policy is implemented in practice that should be sufficient evidence of a “qualifying link”.

Fair value hedging

CTA09/S352B(4) applies where the external loan relationship is also subject to a hedging relationship in relation to a derivative contract. This is not expected to be a common situation.

In these circumstances, in applying the amortised cost basis of accounting in accordance with s352B(3), it is to be assumed that the hedging instrument has been designated for accounting purposes as a fair value hedge. In practice, this means that the carrying value of the loan relationship should be adjusted for the fair value movements in the value of the risk being hedged.

Application to MREL instruments

CTA09/S352B is likely to have particular relevance for banks which are required to issue MREL instruments,

Example

The Bank of England directs a bank to issue internal MREL (see glossary) with terms that give it, as resolution authority (see glossary) the right to release or convert the instrument. Under IFRS 9, these terms may require the instrument to be accounted for at fair value. The intra-group instrument is funded by an externally issued instrument also accounted for at fair value. As the internal loan relationship would be taxed on an amortised cost basis, there is a tax mismatch. The effect of the legislation is that both loan relationships will be taxed on an amortised cost basis.

Commencement and transitional rules

CTA09/S352B applies for accounting periods beginning on or after 1 January 2019.

If a company has an accounting period that straddles this date, this is to be split into two separate deemed accounting periods - one ending on 31 December 2018 and one starting on 1 January 2019.

An adjustment may be needed when a loan relationship comes into the rules on 1 January 2019. The amount to be brought into account is the difference between the tax-adjusted carrying value of the instrument at the end of an accounting period ended on 31 December 2018 and the tax adjusted carrying value of that instrument at the beginning of the 2019 period.