Adviser Q&A: New rules tackling ‘compensating adjustments’

A new measure will shortly take effect to counter ‘compensating adjustments’ claimed by individuals on transactions with companies. Individuals have benefited by receiving income either effectively taxed at corporate rates or completely untaxed. The gap in the law was created by the way in which UK–UK transfer pricing was introduced in 2004. Affected individuals will need to take action quickly or potentially face double taxation.

What’s happening?

One of the (regrettable) modern trends is for ministers to make tax announcements at party conferences. Apparently, ministers saunter into the Treasury and ask if there’s anything good to announce on tax avoidance. And so it came to pass that at the Lib Dem conference, chief secretary to the Treasury Danny Alexander announced a ‘crackdown’ to stop people avoiding tax by using compensating adjustments. The government considered that the rules, which are designed to avoid double taxation between individuals and connected companies, are increasingly being used by individuals to reduce their income tax bill. The change is envisaged to raise £100m.

What transactions will be caught?

HMRC issued a brief Technical Note on 18 September. It is proposed that individuals will no longer be able to claim ‘compensating adjustments’ in relation to transactions with related companies. This affects two areas:

• Service companies owned by partnerships: HMRC’s Technical Note acknowledges that many professional partnerships use service companies for commercial reasons, but that they can also claim tax advantages. The advantage arises where the partnership pays for services at cost. A transfer pricing adjustment is made to record a profit and an opposite adjustment claimed by the partners. Since cash is not paid to the service company but retained by the partnership and distributed to the partners, the result is that part of the partners’ income is effectively taxed at the corporate rate, instead of the higher income tax rates.
• Loans from individuals to companies: The typical scenario here is a highly indebted company, where the individuals are both share and loan holders. Either the loan amounts or the interest rates (or both) are excessive. The intended consequence is that when interest is paid to the individuals, often using a payment in kind (PIK) note, it will be disallowed in the company and tax-free to the individuals. Usually this arrangement arises in private equity controlled companies, but it is not confined to them.

HMRC proposes that the measures take effect after consultation and apply to profits accruing in service companies and interest arising, i.e. paid from the effective date.

What’s next?

HMRC is holding an informal consultation to ascertain whether these proposed changes could adversely impact commercial structures. It is expected to be concluded by the end of September, when ministers will decide on the way forward. It is expected that draft legislation will then be issued, with an effective date of around the middle of October.

Is this a problem?

The BVCA – private equity’s trade union – immediately rushed out a statement, warning of economic damage. It’s not immediately clear where such damage could arise, other than of course to the loan note holders and partners who will be asked in future to pay a little more tax.
HMRC’s proposal does bring with it quite a few issues, though. People affected will almost certainly need to take positive action if they are not to face double taxation in future.

What should those affected do next?

Companies and loan note holders will need to consider whether to pay accrued interest before the effective date. They will also need to consider whether to capitalise the notes, or take other steps to prevent the accrual of interest in the future. If they do not, then not only will they not get the hoped-for tax benefit for the past but they could also face a higher tax liability than if the notes had never been created.

HMRC has indicated that it will look closely at arrangements to pay the interest. Circular flows of money may well not be acceptable, although many of these loan notes are funding bonds, where payment is effected through issuing additional notes. There is also an arcane issue over whether or not the individuals are to be treated as an ‘enterprise’ which is needed to bring the transfer pricing rules into effect in the first place. This issue isn’t helped by a recent strange note issued by HMRC about the meaning of ‘enterprise’.

For service companies, the issue may be slightly easier. Probably the best approach will be to pay the transfer pricing adjustment in cash, followed by a distribution to the partners. It seems to me that the right way for HMRC to make the change it wants is to legislate that compensating adjustments should only be allowed to the extent of ‘balancing payments’, made in accordance with the transfer pricing legislation. The effect of this would be to require that partners pay cash to service companies and note holders refund excessive interest. This would have the effect of leaving the cash and the profits in the right place, whilst allowing for the amount of the pricing adjustment to be agreed with HMRC.