Global Tax Alert | 5 November 2013

UK announces changes to compensating adjustments

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On 17 September 2013, the UK Government announced that it will withdraw “compensating adjustments” for individuals and other taxpayers within the charge to income tax where the counter party to the transaction is a company.

On 25 October, following a brief consultation period, HMRC released a technical note and draft legislation which together provide more detail on the proposed rule change.

This Alert focuses on the changes to ”excess” interest payments. This is likely to be of interest to those who have made significant loans to companies (either in the form of loan notes or more informal arrangements) including individual shareholders in private equity backed companies.

Compensating adjustments have also been withdrawn for individuals in respect of payments to service companies. This change is as previously announced and is not considered further by this Alert.

The withdrawal of compensating adjustments became effective from 25 October.

Compensating adjustments

Transfer pricing provisions apply where individuals participating in a company make loans which are not on arm's length terms. Prior to the changes, where the interest payable by the company was in excess of an arm's length rate, the amount which the company could deduct in calculating its profits was restricted. A compensating adjustment could then be claimed by the lender so that his or her position mirrored that of the borrower.

Example 1 (old rules)

An individual makes a loan to a company on which interest of £110 per annum is due. The arm's length rate of interest would be £100. In calculating its profits, the company is restricted in the amount of interest which it can deduct to £100 (even though it pays £110). To compensate for this, prior to the changes, the individual would have claimed a compensating adjustment of £10 –so that in effect he or she was only taxable on £100 of interest.

Changes to compensating adjustments

With effect from 25 October, the company will continue to be restricted in respect of the level of reduction but the individual will no longer be able to claim a compensating adjustment to mirror this restriction.

However, following feedback from EY and others during the informal consultation period, there have been some further amendments:

  • Compensating adjustments will remain available in respect of interest accrued as at 25 October.
  • Interest received by individuals over and above the arm's length rate will be treated as distributions and taxed as though they were dividends.

Example 2 (new rules)

As example 1 above, an individual has made a loan to a company on which interest of £110 per annum is due. The arm's length rate of interest would be £100. The interest is payable annually and, as at 25 October, half of this amount has accrued.

There will be no change to the way that the company calculates its profits and it will remain restricted to a deduction of £100. The individual will receive a compensating adjustment for the amount of excess interest which had accrued as at 25 October (half, or £5 in this example). The remaining £5 excess interest which he receives will be re-characterized as a distribution and will be taxed in the individual's hands as a net dividend with a 10% tax credit.

Accurate records of the interest accrued as at 25 October will be vital as this may have a significant impact on an individual's tax position.

For additional information with respect to this Alert, please contact the following:

Ernst & Young LLP (United Kingdom), Manchester
  • Sarah Teshome
    +44 161 333 2905
  • Martin Portnoy
    +44 161 333 3275
Ernst & Young LLP (United Kingdom), London
  • Jo Quelch
    +44 20 7951 2451
  • Gary Mills
    +44 20 7951 1608

EYG no. CM3936