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INTM584040 - Thin capitalisation: third-party loan agreements: Interest rates and related fees

How interest rates are defined in third-party loan agreements matters for two reasons. Firstly, if the third-party loan is guaranteed by a party connected to the borrower, then the UK transfer pricing legislation at ICTA88/SCH28AA is in point. Secondly, unguaranteed third-party loans are a potential source of arm’s length data of value in considering loans between connected parties.

Third-party loan agreements will typically specify the interest rate charged on a loan, although it may not be immediately apparent from the text of the agreement, since it may calculated by reference in terms of a formula. The simplest formula is LIBOR (see INTM577035) or other base rate plus a margin, but a more complicated formula may be used. This may depend on the financial strength of the borrower, with a lower rate for a stronger, more secure business - see INTM582030. It may not be immediately possible to calculate the actual interest rate from the information given, and it may be advisable to seek additional information from the borrower before being able to do so. Some loan agreements, whether third-party or not, contain a penalty clause invoking a higher interest rate in the event of failure to make loan repayments on time. Typically, the interest rate increases by up to 2%. Since such clauses are found in agreements for third-party loans which have not been guaranteed by connected parties, it follows that the increased rate is not necessarily excessive, but where connected parties are involved, the reason for the failure will need closer examination.

Arrangement Fee

In addition to the interest rate charged on a loan, third-party lenders may make an additional charge for arranging a loan. Charges of this kind may also be allowable tax deductions for a connected borrower. Care needs to be taken with this point, however. The arrangement fee will probably not represent items such as legal and other expenses incurred by the lender in drawing up loan documents, etc, but something more akin to a “joining fee”. It is part of the way the lender makes profits. As such, it represents part of the cost of financing for the borrower. If such charges appear from group company lenders, they should be added to the interest charge and other similar costs in order to assess whether the total finance cost amounts to an arm’s length price. There will also be the issue of whether an upfront fee is disproportionate, effectively frontloading the cost of the finance. It may be susceptible to challenge under ICTA88/S74 as being not wholly and exclusively for the purposes of the trade.

Facility Fee

Another charge levied by third-party lenders, over and above the interest charge, may be a facility fee. For example, if a lender has granted a total loan facility of £100m and the borrower has drawn only £60m, a small fee may be payable for continuing to hold the remaining £40m available within the notice period specified by the agreement, even though it is not currently required. Such fees are smaller than the interest rate, and are allowable tax deductions where lender and borrower are not connected, although they are not interest. If such a charge is made between connected persons, it is necessary establish whether the charge is justifiable. The same considerations apply as for arrangement fees above, as they do to any other one-off or annual fees of a similar nature (see INTM582020 on connected party facility fees). If borrowing has been agreed for thin cap purposes as less than the total facility, then the cost of making available any more than has been agreed will be disallowable as relating to non-arm’s length debt. If it is agreed that the arm’s length amount of the facility should be a maximum of £80m in the example above, then a reasonable facility fee might be acceptable on £20m, the difference between the drawn amount and the agreed maximum. There would still be the consideration as to what the fee was actually in return for.