Disguised Interest - Deemed loan relationships:

Disguised interest: overview

The ‘shares as debt’ rules at CTA09/PT6/CH7 (CFM45000) were introduced in response to disclosures
made under the disclosure of tax avoidance schemes rules introduced in FA 2004. These disclosures
confirmed the existence of a variety of schemes designed to produce what is economically an interest-
like return but in a form which is for tax purposes either a capital gain or a tax nothing. The rules seek
to identify the features of the avoidance schemes that they were intended to deal with and would bring
the interest-like return into charge as though it were a return from a loan relationship.
While the ‘shares as debt’ rules worked well in stopping the avoidance that they were brought in to deal
with, they were vulnerable to new schemes specifically designed to bypass the legislation and have
needed to be updated, resulting in increasingly complex and unwieldy legislation that still failed to deal
comprehensively with the underlying avoidance.
The disguised interest legislation in CTA09/PT6/CH2A takes a different approach to dealing with such
avoidance. It seeks to ensure that an interest-like return is charged to corporation tax in all
circumstances where it is obtained from a transaction (or transactions) that is not a loan or treated as a
loan, and consequently not taxed as income and is either a tax nothing or a capital return. The legislation
ensures that such arrangements are taxed as though the interest-like return arises from a loan
relationship and consequently will be taxed under the loan relationship rules.
The legislation sets out a comprehensive principle that a company that is party to an arrangement that
produces a return economically equivalent to interest is to be charged to corporation tax on the return as
if it were a profit from a loan relationship. The legislation then deliberately excludes certain types of
arrangement which for good policy reasons should not be treated in this way.
CFM42020 set out the provisions that were repealed as a consequence of the introduction of the
disguised interest rules.
Example
Company A purchases an asset (that is not a security) for £100m from Company B under an
arrangement whereby Company A will sell that asset back to Company B in two years’ time for £112M.
Assuming that the return of 6% per annum (straight line) is reasonably comparable to a commercial rate
of interest, then this transaction provides an interest-like return in a manner that would not, without any
special rules, be taxed as interest.
Further examples can be found at CFM45020.
Disguised interest: repeal of the ‘shares as debt’ and other rules
As a result of the new legislation, the shares as debt rules have been repealed, with the repeals coming
into force on 22 April 2009. See CFM42030 for what happens when shares cease to be ones to which
the shares as debt rules apply.
A range of other provisions dealing with disguised interest have also been repealed. The most
significant of these are:
• Section 736C of ICTA (deemed interest: cash collateral under stock lending arrangement)
• Section 736D of ICTA (quasi-stock lending arrangements)
• Section 547 of CTA 2009 (repo under arrangement designed to produce quasi-interest)
These are referred to below as ‘repealed provisions’.
Disguised interest: commencement
The disguised interest rules brought in by FA2009 will apply as follows:
Arrangements entered into on or after 22 April 2009 (‘new arrangements’)
Any arrangement to which a company became party on or after 22 April 2009 is capable of being within
the disguised interest rules.
Arrangements entered into before 22 April 2009 (and repealed provisions applied)
Any arrangement that was:
• entered into before 22 April 2009, and
• is still in place on 22 April 2009, and
• to which any of the repealed provisions (CFM42020) applied before 22 April 2009 is treated as an
arrangement to which the company became party on 22 April 2009.
This means that the arrangement is treated as a new arrangement, with the result that it can then be
tested against the requirements of Chapter 2A such that returns arising on or after 22 April may then be
brought into account under Chapter 2A.
But this rule does not apply in certain circumstances where the arrangements were previously within
FA96/S91D. CFM45520 has further detail.
Arrangements entered into before 22 April 2009 (and repealed provisions did not
apply)
Any arrangement that was:
• entered into before 22 April 2009, and
• is still in place on 22 April 2009,
• to which none of the repealed provisions applied
will not be treated, for the purpose of the disguised interest rules in Chapter 2A, as having been entered
into on 22 April 2009. In other words such arrangements cannot come within the scope of Chapter 2A
(although any later modification to the terms of such arrangements might amount to a new arrangement
to which Chapter 2A may apply).
Overview of CTA09/S486B
CTA09/S486B(1) sets out a simple legislative principle, as follows:
‘Where a company is party to an arrangement which produces for the company a return in relation to
any amount which is economically equivalent to interest, Part 5 (the loan relationships rules) applies as
if the return were a profit arising to the company from a loan relationship’.
The main feature in applying this principle to an arrangement is to be able to identify a return that is
‘economically equivalent to interest’.
CTA09/S486B(2) and (3) therefore set out what is meant by a ‘return that is economically equivalent to
interest’. CFM42050 looks at this in more detail.
CTA09/S486B(4) and (5) ensure that the credits and debits that are brought into account in respect of
the loan relationship rules are taxed on an amortised cost basis, regardless of how the amounts are
accounted for by the company (or, indeed, whether the accounts of the company recognise the amounts
at all). CFM42070 looks at this in more detail.
CTA09/S486B(6) ensures that it is not possible to bypass the disguised interest rules by splitting the
interest-like return between more than one party. Where an interest-like return is split between more
than one party, the overall return is taxed between the two parties on a ‘just and reasonable’ basis.
CFM42080 looks at this in more detail.
CTA09/S486B(7) is an anti-double counting rule to ensure that any amount brought into account in
computing a return to which the Chapter applies cannot be brought into account under any other tax
provision. CFM42090 looks at this in more detail.
CTA09/S486(8) deals with the situation where the return includes exchange gains and losses that arise
as a result of translating the accounts carrying value of the return. Where this is the case, the debits and
credits brought into account by the disguised interest rules will include those exchange gains and losses.
CFM42100 looks at this in more detail.
CTA09/S486B(9) defines ‘arrangement’ for the purposes of the disguised interest rules. CFM42110
looks at this in more detail.
Exemptions: CTA09/S486C-E
CTA09/486C to E provide a number of exclusions from the main rules at CTA09/486B.
CTA09/S486C ensures that any return (or part of a return) that is brought into account for certain other
tax purposes will not be brought into account by the disguised interest rules. CFM42120 looks at this in
more detail.
CTA09/S486D is an important section that means that, in order for the disguised interest rules to apply,
the main purpose, or one of the main purposes, of entering into the arrangement is to obtain a ‘relevant
tax advantage’. CFM42130 looks at this in more detail.
CTA09/486E deals with the notion of ‘excluded shares’. It sets out what is meant by ‘excluded share’
and provides that where the relevant conditions for a share to be an ‘excluded share’ are met, then the
disguised interest rules will not apply to the interest-like return. CFM42140 to CFM42180 looks at this
in more detail.
Returns ‘economically equivalent to interest’
The main feature of the disguised interest rules is to be able to identify interest-like returns or, as the
legislation puts it ‘a return in relation to any amount which is economically equivalent to interest on that
amount.’ CTA09/S486A(2) sets out a definition of ‘economically equivalent to interest’ that runs
through three conditions.
Basic definition of interest (subsection (a))
The return must fit within a basic definition of interest. This basic definition of the meaning of interest
is drawn from a number of the indicia commonly cited in cases on the meaning of interest (e.g. Euro
Hotel (Belgravia) Limited 51TC293 and Bennett v Ogston 15TC374) (CFM33030). This captures the
familiar concepts that the return must be:
• by reference to an amount of money. This means HMRC will be looking for an investment of some sort (or an
entitlement to payment of something akin to a debt) in order for the legislation to apply; and
• calculated by reference to the time value of money.

Commercial rate of interest (subsection (b))

The return must in all the circumstances be comparable to a commercial rate of interest. There are a
couple of features to this condition that are worth noting.
The return must only be ‘comparable’. Consequently, the return does not have to be exactly the same as
a commercial rate of interest. It therefore provides a range of interest rates within which a return could
be ‘comparable’ to a commercial rate of interest.
In deciding whether an interest rate is comparable to a commercial rate of interest, you should assume
that all factors are taken into account. A commercial rate of interest would therefore take into account
the identity and creditworthiness of the counterparty. It could also include such features as the
relationship between the two parties, the duration of the arrangement and the currency of the
transaction(s).
Practical likelihood of the return (subsection (c))
The interest-like return must be predictable. There must be ‘no practical likelihood’ , when viewed at
the ‘relevant time’ that the return will not be produced in accordance with the arrangement.
It is therefore not enough that an interest-like return results from the arrangements. If the return is the
product of chance or could not have been reasonably anticipated at the outset of the arrangement, then it
cannot be a return ‘economically equivalent to interest’.
In assessing whether there was ‘no practical likelihood’ that the return will not be produced in
accordance with the arrangement you should ignore contingencies such as default outside of the control
of the parties. This would include ignoring the possibility of default.
The ‘relevant time’ (S486B(3))
The ‘relevant time’ is defined for the purposes of S486B(2)(c), as being the later of the time when the
company becomes party to the arrangements or the time when the return begins to be produced. It must
therefore be clear at the outset that the return will be produced. Thus, although there is no express
requirement for the arrangement to be ‘designed’ to produce the return, the return must be initially
predictable.
Credits and debits to be brought into account
The legislative principle at CTA09/S486B(1) sets out that where there is an arrangement that provides a
return economically equivalent to interest, that return is to be brought into account and taxed as though
it is a profit from a loan relationship (under CTA09/PT5).
CTA09/486B(4) ensures that the taxable debits and credits that are brought into account must be
determined on an amortised cost basis.
In a number of cases, the company receiving the return will not be using an amortised cost basis of
accounting. Where that is the case, the amounts that are brought into account will be those that would
have been brought into account if an amortised cost basis of accounting was used.
In some cases, the return from such arrangements will not be reflected in the company’s profit or loss
account in any particular year. Where that is the case, the accounting treatment would be over-ridden
and the return would be recognised as though an amortised cost basis of account had been applied
(CTA09/S486B(5)).
This ensures that the application of different accounting methods cannot be used to manipulate the
timing of a return. Similarly, the fact that a return is not recognised in the accounts of the company will
not allow the return to escape from being brought into account.
Returns split between more than one party
In the absence of any rule to deal with this situation, it would be possible for companies to make
arrangements that bypass the disguised interest legislation by splitting the return between two or more
companies.
If a return is split between two or more companies, the return that is obtained by any individual
company might not be ‘economically equivalent to interest’ in the hands of each company. However,
there would be a return ‘economically equivalent to interest’ when the position of all recipients of the
interest-like return is combined.
Such arrangements would be most likely to be seen in group situations, although it is not exclusive to
groups.
Example
Company A enters into an arrangement that will provide a return of £5m from an investment in shares
in Company Z of £100m over 365 days. The interest rate of 5% is considered to be reasonably
comparable to a commercial rate of interest and the return would fall within the disguised interest rules.
However, Company A arranges for that £5m return to be split between itself and its group member
Company B, with Company A receiving £2m and Company B receiving £3m.
Neither Company A nor Company B has a return that is reasonable comparable to a commercial rate of
interest. For A the return is just 2% and for B there is no interest rate as there is no amount of money on
which B’s return is based.
Consequently, in the absence of special rules, both Company A and Company B would escape from the
disguised interest rules even though, as a group, there is a return that is economically equivalent to
interest from the investment.
Where a return is split between two or more parties, the rule at CTA09/S485B(6) will ensure that the
return does not escape the disguised interest rules for any of the parties.
It achieves this by identifying returns where two or more persons are party to the arrangement and there
is a return that is economically equivalent to interest when those persons are taken together but there is
not a return economically equivalent to interest for any of the parties is viewed individually.
Where that is the case, the overall return should be split between the parties on a just and reasonable
basis.
So, in the above example, the combined return of £5m on an investment of £100m would result in a
return economically equivalent to interest. A just and reasonable basis for apportioning that return may
be for the full £5m to be brought into account in Company A reflecting the fact that Company A has
made 100% of the investment that gave rise to the return (although, of course, the facts in each case
would need to be taken into account).
Anti-double counting rule
CTA09/S486B(7) is an anti-double counting rule to ensure that any amount brought
into account in computing a return to which the Chapter applies cannot be brought
into account under any other tax provision.
The operation of section 486B(7) is easiest to visualise in the context of a simple transaction involving
just one element-for instance, an investment in a share that increases in value in an interest-like way. To
the extent that Chapter 2A applies to the appreciation in value of the share, that element will be
excluded from a subsequent chargeable gains computation.
In some cases, a return brought into account in accordance with Chapter 2A may be composed of a
number of elements some of which would otherwise be tax nothings and some of which would
otherwise be taxed as income or brought into account in computing income. CFM42120 has an
example. In such cases then to the extent that the otherwise taxable (or tax deductible) income has been
taken into account in computing the return, section 486B(7) prevents the amount being taken into
account again.
Exchange gains and losses
Arrangements that produce returns economically equivalent to interest will not always be made in the
functional or accounting currency of the company receiving the return.
Many returns from such arrangements will be in the form of an increase in the carrying value of the
investment providing the return. Where that is the case, it will be necessary for the carrying value of the
investment to be translated into the functional or accounting currency of the company. Consequently,
the return from the investment will be subject to exchange gains and losses.
CTA09/S486B(8) makes it clear that those exchange gains and losses will be included within the debits
and credits brought into account under the disguised interest rules.
Example
Company A has a functional currency of £sterling and has invested in shares in Company B in $US.
The shares in Company B will produce a return to Company A that falls within the disguised interest
rules.
The shares in Company B have the following fair values:

1 January 2010 $100m

31 December 2010 $105m

31 December 2011 $110m

The £/$ spot rates of exchange on the appropriate days are:

1 January 2010 1:1.5

31 December 2010 1:1.75

31 December 2011 1:1.6

The fair value of the Company B shares for the purposes of the Company A accounts are, therefore, as
follows:

1 January 2010 £66.67m

31 December 2010 £60m

31 December 2011 £68.75m

Consequently, S486B(8) makes it clear that the amounts to be brought into account under the disguised
interest rules would be as follows:

Year ended 31 December 2010 £6.67m (debit)

£8.75m (credit)
Year ended 31 December 2011

Meaning of arrangement
An arrangement, for the purposes of the disguised interest principle as set out in CTA09/486B(1), is
defined at CTA09/486B(9) as including:
‘…any agreement, understanding, scheme, transaction or series of transactions (whether or not legally
enforceable).’
This is a wide-ranging definition that is intended to capture any type of arrangement under which
disguised interest type returns could be obtained.
There is a specific exclusion for arrangements that constitute a finance lease for the purposes of
CAA01/S219. This ensures that all such arrangements continue to be taxed according to current rules
(and in particular that leases that are not long funding leases within the meaning of CAA01/S70G are
not brought within the scope of the legislation). Operating leases, by contrast, are not within the scope
of the legislation at all.
Returns brought into account for other tax purposes
Without any rule to the contrary, it would be possible for the disguised interest rules to result in double
taxation. This could occur where a return economically equivalent to interest is obtained from an
arrangement and the return is already brought into charge for tax purposes.
In order to remove the possibility for double taxation, CTA09/S486C(1) provides that Chapter 2A does
not apply if and to the extent that the return is taxed as income or brought into account as income for tax
purposes apart from the Chapter.
HMRC’s view is that the exclusion in section 486C(1) applies only where what would be taxed apart
from the Chapter is, or includes, the return with which the Chapter itself is concerned. For instance, the
return on a loan relationship or the return that a financial trader earns from acquiring fixed future cash
flows or the interest-like return that a financial trader obtains from a combination of financial
instruments that together function as a loan. In each of these cases all the return is taxed as income apart
from Chapter 2A so Chapter 2A is disapplied.
By contrast the exclusion does not apply where the return comprises a combination of a loss and a profit
on two separate items where one is taxed/relieved as income and the other is a tax nothing or a capital
matter. In any such case, no part of the return would be brought into account as income apart from
Chapter 2A.
Example
Hedge Ltd acquires shares against a long total return swap. Apart from Chapter 2A Hedge Ltd would be
taxed on an income basis in respect of the total return swap but would not be charged on an income
basis in respect of the shares. However, the combination of the shares and swap will produce disguised
interest.
Section 486C(1)(a) to (c) do not apply because if the value of the shares drops, the profit on the swap
that would be taxed or brought into account as income is not (to any extent) the return. If the value of
the shares increases, the loss on the swap that would be taxed or brought into account as income is
similarly not (to any extent) the return. It follows that Chapter 2A can apply (subject to the unallowable
test).
In these circumstances, if Chapter 2A does apply, then section 486B(7) (see CFM42090) will prevent
any further charge from arising. For instance, in a case where the return includes a loss on a derivative,
then under section 486B(7) that loss will not be eligible to relief under the derivate contract rules since
it is taken into account in calculating the return.
Meaning of tax avoidance purpose
Even though the disguised interest rules set out a number of conditions that must be met in order for the
rules to apply, it is still possible that the rules could catch perfectly acceptable, commercial-driven
transactions that have no tax avoidance motive.
CTA09/S486D contains a very important feature of the disguised interest rules. This provides that the
disguised interest rules do not apply…
‘…unless it is reasonable to assume that the main purpose, or one of the main purposes, of the company
being a party to the arrangement is to obtain a relevant tax advantage.’
This means that unless the purpose (or one of the main purposes) of the arrangements is to obtain a
‘relevant tax advantage’, then the disguised interest rules cannot apply. Consequently, the disguised
interest rules should not inadvertently catch commercially-driven transactions with no purpose of
obtaining a ‘relevant tax advantage’ that just happen to fall within the specific conditions for the
disguised interest rules to apply.
‘To obtain a relevant tax advantage’ is defined in S486D(4) as meaning to secure that the return is
produced in such a way that means it would be taxed more favourably than it would be if it were
charged to tax as income or brought into account as income at the time that the return would be
recognised under the disguised interest rules.
This purpose test requires consideration of two questions:
• Whether, as a matter of fact, the return produced by the arrangements for the company is produced in a form
(e.g. capital gain or dividend) that would be taxed more favourably than it would be if that return were taxed
in the same way as interest.
• Whether it is reasonable to assume that it was a main purpose of the company being party to the arrangements
to secure that the return was produced for it so as to give rise to that advantage.
S486D(5) makes it clear that the tax avoidance exclusion does not apply where the return is produced
for a company that is a controlled foreign company (CFC).
Where a question of purpose arises the matter should be referred to Anti-Avoidance Group.
Election
It is possible that some companies may enter into arrangements that were specifically structured so that
they fall within the disguised interest rules. This would allow the tax treatment of the value of the shares
to be brought into line with their amortised cost-based accounting treatment or, possibly, to achieve a
post tax hedge.
These arrangements would not fall within the disguised interest rules because they will not have a tax
avoidance motive. Consequently, companies have the option of electing out of the tax avoidance
purpose test so that they are within the disguised interest rules regardless of their motive of entering into
the arrangements.
The election cannot be made by a company where the disguised interest rules apply due to S486B(6)
(CFM42080).
The election must be made no later than the time when the arrangement begins to produce a return for
the company and any election, once made, is irrevocable.
Excluded shares
The disguised interest rules will not apply where the arrangement involves an investment in shares and
the share is ‘excluded’ by CTA09/S486E.
The intention behind the excluded share rules is that it will prevent arrangements being caught by the
disguised interest rules where the interest-like return arises to a company purely as a result of an
increase in the value of any share that it holds in a group company.
Without this rule, it would be possible for a single interest-like return to be taxed repeatedly within a
chain of companies in the same group.
Example
Company A holds 100% of the share capital in Company B. Company B holds 100% of the share
capital in Company C and has no other assets. All companies are UK resident.
In the year ended 31 December 2009 Company C has no assets other than a £100m deposit with a bank
at an interest rate of 5% p.a.
Company C receives £5m interest in the year ended 31 December 2009 and that income is relieved by
non-trading debits on loan relationships brought forward. The fair value of the shares held by Company
B in Company C will also increase by £5m as compared to a previous fair value of £5m. This would be
a ‘return economically equivalent to interest’ and potentially could fall within the disguised interest
rules. Similarly, the increase in the fair value of Company B’s shareholding in Company C will cause a
similar increase in the fair value of Company A’s shareholding in Company B. Consequently, Company
A will have a return on its shares in Company B that would potentially be within the disguised interest
rules.
The impact of this chain is that both Company A and Company B could potentially be taxed on a return
that has already been brought into account by Company C.
The ‘excluded share’ rules will prevent the same economic gain from being taxed repeatedly within
group situations. In the above example it would mean that Company B’s holding would be excluded if
the return Company B obtains is an increase in value of the Company C shares. Company A’s holding is
excluded if its return is an increase in the value of the Company B shares.
It achieves this by ensuring that:
• investments in shares in connected companies are automatically ‘excluded shares’;
• investments in shares in joint venture companies are automatically ‘excluded shares’;
• investments in shares in a ‘relevant CFC’ are automatically ‘excluded shares’
CFM42130 to CFM42160 looks at the rules in greater depth.
Excluded shares: the basic rules
CTA09/486E(1) sets out the basic rule that the disguised interest rules will not apply in any ‘relevant
accounting period’ where the return ‘involves only’ ‘relevant shares’.
Relevant accounting period
CTA09/486E(2) defines ‘relevant accounting period’ as:
• beginning when the holding company becomes party to the arrangement or, if later, when the arrangement
begins to produce a return to the company;
• ending when the holding company ceases to be party to the arrangement or, if earlier, the end of the relevant
accounting period.
See CFM42160 for more in the meaning of ‘involves only’, and CFM42170 for more on ‘relevant
shares’.
Meaning of ‘involves only’
CTA09/486E(3) sets out that, for the purposes of S486E an arrangement ‘involves only’ relevant shares
if (and only if) the return produced reflects only an increase in the fair value of the shares.
This definition of ‘involves only’ is important as it prevents any returns from arrangements, other than
those arrangements that the excluded shares exemption is intended to prevent from being within the
disguised interest rules, from being taxed within the disguised interest rules.
In this context, ‘only’ should be interpreted strictly although legislation makes clear that the payment of
a dividend will not affect the question of whether the requirement is met. Similarly, if the shares are
sold for their fair value, the return has already been produced so the disposal itself does not prevent the
return reflecting only the increase in the fair value of the share.
The fair value of shares is the amount that a company would obtain from a knowledgeable and willing
purchaser of the shares dealing at arms length (CTA09/486E(4)).
Relevant shares
CTA09/S486E(5) defines ‘relevant shares’ as:
1. Fully paid-up shares of a ‘relevant company’ (see CFM42180)
2. Shares, other than shares in a ‘relevant company’ that fall within the rules for ‘shares accounted for as
liabilities’ at CTA09/PT6/CH6A (CFM45500). Briefly, such shares are those:
○ that would be accounted for in accordance with GAAP as a liability by the company in which they are
shares, and
○ which produce for the company holding the shares a return in relation to any amount which is
economically equivalent to interest.
CTA09/S486E(7) provides that a company is a relevant company if:
• it and the holding company are connected companies
• it is a relevant joint venture company or
• it a relevant controlled foreign company

Meaning of connected companies

Connected companies are those that are connected within the meaning of connected used for loan
relationship purposes at CTA09/S466 (CTA09/S486E(8).
Joint venture company
To be a joint venture company for these purposes, a company must be one of two persons who, taken
together, control it.
Additionally, two ‘40% tests’ taken from the legislation for Controlled Foreign Companies must be
passed. Although these tests have been taken from the CFC legislation, the tests do not apply only to
situations where there is a CFC (although, of course, do apply to such situations).
The two 40% tests are at ICTA88/755D(3) and (4) and apply to this definition of ‘joint venture
company’ in the same manner that it does for the CFC rules with the exception that no rights and
powers are attributed to a person by ICTA88/S755D(6)(c) or (d). More detail on the CFC tests can be
found at INTM202020.
Relevant CFC
Subsection (11) defines relevant controlled foreign company as one whose profits are apportioned to the
holding company in accordance with ICTA88/S752 or are not so apportioned because of an exemption.
Fully paid-up shares
For the purposes of identifying relevant shares in CTA09/486E(5), one of the categories of shares are
those that are ‘fully paid-up’.
This means that there are no actual or contingent obligations:
• to meet unpaid calls on the shares, or
• to make a contribution to the capital of the company in which they are shares that could affect
the value of the shares.
This rule ensures that arrangements that, typically, use deferred subscription shares or capital
contributions to provide a return economically equivalent to interest in a non-taxable or capital form
will not be exempted from the disguised interest rules.
This definition of ‘fully paid-up’ share is similar to that used to identify ‘outstanding third party
obligations’ in relation to shares at FA96/S91A(6) and it is FA96/S91A that previously dealt with
arrangements involving deferred subscription shares.
CTA09/S486E(5) therefore seeks to ensure that arrangements that were previously caught by
FA96/S91A will not be exempted from the disguised interest rules.