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Revisions to compensating adjustment rule change "more logical", says expert


Revisions to the way in which the Government intends to prevent taxpayers from using 'compensating adjustments' to reduce their tax bills are more logical and less likely to lead to those who lend to their companies being double taxed, an expert has said.

Tom Cartwright of Pinsent Masons, the law firm behind Out-Law.com, was commenting as HM Revenue and Customs (HMRC) published more details of the proposed changes to the rules, including draft legislation. The new rules apply from 25 October and will be enacted as part of the 2014 Finance Bill.

"The revised rules ameliorate some of the risks of double taxation from the first proposal, since the treatment of excessive debt loaned by an individual, or a partnership with some individual members, is now to be taxed as a dividend," Cartwright, a tax expert, said.

"However, companies in this position will still need either to pre-agree the levels of interest deductibility with HMRC or, at the very least, to have undertaken a proper analysis of the appropriate arm's length position in respect of their debt," he said.

Compensating adjustments fall within the transfer pricing regime, which exists to ensure that transactions made between connected parties are taxed in the same way that they would have been had the connection not existed. The transfer pricing rules operate by replacing the actual price paid with what the 'arm's length price' would have been for tax purposes. When this happens, the other party can apply a compensating adjustment to reflect the changes imposed on the other side.

In a technical note published for informal consultation in September, HMRC said that some partnerships that employ staff through a separate service company, owned by the partnership, had been able to use the rules to their advantage. As the partners do not pay the 'arm's length' fee to the company for providing this service, the transfer pricing compensating adjustment rules are triggered. In similar cases, individuals that lend money to companies in which they are shareholders can trigger the transfer pricing rules.

The main change to be introduced by the draft legislation is the removal of the compensating adjustment mechanism for transactions between companies and individuals who would otherwise be liable to income tax. This change will prevent compensating adjustments being claimed in respect of amounts of service fee income or interest arising to individuals on or after the effective date.

"To fall outside the scope of the measure, the service company scheme will need to re-price at the correct economic prices," HMRC said in a technical note. "The legislation will apply only prospectively, to amounts of fee income referable to times after the legislation comes into effect [on 25 October]."

In response to its informal consultation, HMRC has made two changes to its original proposals affecting excessive leveraging arrangements, where individuals make loans to a company not at arm's length which typically result in the company being excessively leveraged with debt. In these cases, the excess interest over an arm's length amount will be treated for income tax purposes as a dividend rather than interest. In addition, interest which has accrued but not yet been paid out will not be affected.

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