Taxation implications of financing U.K. subsidiaries.

• Author: Godbee, Mike

Recent legislation in the United Kingdom denying deductions for interest paid on long-term debt with equity characteristics and clarifying the meaning to be given to interest articles in double tax treaties provides an opportunity to review the problem areas faced by U.S. groups in lending to their U.K. subsidiaries. 1. Can the interest be paid without deduction of tax and, if so, are there any formalities that need to be observed? 2. Is the interest deductible? 3. If so, is it deductible only against restricted categories of income? 4. If the interest exceeds income, can the resulting loss be used and if so how? 5. Is the interest deductible on an accrual basis or only when paid? In relation to group financing from overseas, the first two issues give rise to the major difficulties in practice.

One of the idiosyncrasies of the U.K. system is that it draws a distinction between annual interest and "short" interest. This distinction applies in determining deductibility; only short interest, other than annual interest paid to a U.K. bank, may be deducted, on an accrual basis, as a trading expense. Annual interest generally is allowed only when paid as "a charge on income." Charges on income can offset income and gains within the year, and may be surrenderable within a U.K. group. They may also be carried forward as part of a trading loss, but only if the borrowing is for the purposes of the trade (for example, borrowing to acquire the stock of another corporation will not qualify). An investment company can carry forward charges on income as excess management expenses.

The first task is therefore to determine whether the terms of the financing are such that any interest will be regarded as "short" rather than "annual."

Interest on a loan or advance that is expected to remain outstanding for more than a year is "annual." Interest on advances of a genuinely short-term nature (which would include demand loans and fluctuating advances) is "short." The substance of the borrowing must be considered. Even if an advance from a group member is constructed so that it is legally repayable on demand, the U.K. Revenue may challenge a contention that interest is "short." When the debtor company clearly needs funding and cannot continue to trade without the financial support provided by the group, the reality is that the debt is expected to exceed one year. Repaying debt before the year-end and readvancing the money afterwards may be treated as an admission...