BVCA Taxation Committee alert on the UK tax treatment of shareholder debt

With effect from 4 March 2005, HM Revenue and Customs (HMRC) proposed significant changes to the UK tax treatment of shareholder debt. Despite strong resistance from the BVCA, these proposals, as set out in the Finance (No.2) Act 2005, received royal assent on 20 July 2005.

The likely effect of these changes on many UK transactions is a reduction in the quantum of interest deductibility and a restriction on the timing of any remaining deductions. In summary:

    * Loan interest on shareholder debt will only be deductible to the extent that it can be demonstrated that the loan could have been arranged on an arm’s length basis.

    * In the case of portfolio companies that are “close”, interest that is deductible can only be deducted when the interest is paid. As before, payments of interest may be subject to a 20% withholding tax that may prove difficult to recover.

    * Some exemptions exist but these are likely to be of limited use for the majority of BVCA members.

    * There are transitional provisions to allow existing arrangements to remain unaffected until 1 April 2007. However, these cease to apply if there are certain changes to the structure or terms of the shareholder debt.

Following consultation, including with the BVCA, HMRC will shortly issue additional guidance on transfer pricing and the treatment of shareholder debt. This will be found on www.hmrc.gov.uk/international/transfer-pricing.htm. In addition, HMRC has set up a ''helpline'' to address issues/questions raised by the new rules and has indicated that it is prepared to provide on a case-by-case basis an early indication of which debt falls within the new rules.

Separately, a Judicial Review hearing will shortly consider interpretation of pre-4 March 2005 transfer pricing rules. It is possible that open tax returns for many transactions completed before this date will be impacted by the outcome of this case. We understand that the Judicial Review hearing, originally set for the autumn, may not now happen until early 2006.

Members are advised to seek professional tax advice in connection with these matters.