SolvedTTM07500 | The ring fence: Interaction of finance costs and transfer pricing
From HM Revenue & Customs · Tonnage Tax Manual
State aid/subsidy control considerations
Tonnage tax was when introduced recognised as a 'state aid' as defined in EU law, broadly a benefit out of public resource to a particular sector of economic activity which could potentially distort competition. It is now subject to subsidy control in UK law, administered by the Competition and Markets Authority.
Among the conditions to be observed are
that open market values are used for tax purposes where transactions within a group take place across the ring fence, and
that no tax relief for the costs of debt finance relating to qualifying activities within the ring fence are available outside.
These conditions underpin the existence of transfer pricing arm’s length principles, see TTM07300, and the finance cost adjustment, see TTM07400.
Interest-free loans
Where there are any intra-group interest-free loans across the tonnage tax ring fence, the transfer pricing rules should be applied before the finance cost adjustment rules are applied to the group. Where the borrowing company is inside the ring fence, no deduction for the imputed interest payable (notional finance cost) will be available. The finance cost adjustment rules will then apply to restrict to activities taking place outside ring fence the group’s allowable finance costs by reference to a just and reasonable proportion.
Interest-free loans used as an alternative to equity investment
Many shipping groups use intra-group interest-free loans from one UK company to another as a more flexible alternative to an equity investment. Under the transfer pricing rules, interest is not imputed on loans which cross the ring fence if they are properly regarded as performing an equity function – that is, where and to the extent that the loan renders the debtor company thinly capitalised.
The fact that an interest-free loan is made as an alternative to an equity investment does not in itself mean that the loan is performing an equity function. The transfer pricing rules will operate to impute interest on loans where they cross the ring fence unless they do perform an 'equity function'. There is guidance on this at INTM502010 onwards. If the loan or any part of the loan is actually performing an equity function, so the debtor is thinly capitalised, interest will not be imputed, or it will be imputed only on the balance of the loan which does not serve an equity function.