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Recovering capital Back  
Two recent developments have focused attention on tax relief for interest ‘as a charge’ and on the circumstances in which that relief can be lost. This tax relief is critical to the financing structure of many groups. Tax directors need to pay close attention to the rules relating to loss of relief.
For historical reasons going back to 1803 some income tax reliefs are called ‘charges’. These represented portions of a persons income earmarked in advance to meet certain outlays, and therefore for tax purposes not regarded as being that person’s income at all. In 1803, a common example was annuities payable by landed gentry to dowagers and younger sons as a condition of their inheritance of the family estate. Today all that remains of this class of tax relief is relief for patent royalties and interest on borrowings used to fund certain investments.

Relief for interest
Both an individual and a company can obtain tax relief for interest on borrowings used to invest by way of shares or loans in certain companies. The investee companies are broadly trading companies, Irish rental income companies, or a holding company of either.

The focus in this article is primarily on the tax relief for a company in respect of interest on its borrowings to invest in other companies. That tax relief is dependent inter alia on the two companies having a common director, and on the investing company holding at least 5p.c. of the shares in the investee company or in a connected company.

The tax relief is lost where the company paying the interest has ‘recovered capital’. In a very broad way, what the concept of ‘recovery of capital’ is attempting to deal with is a situation in which the moneys, which were borrowed and invested, have once again been realised by the investing company and are back in its hands. However the legislation gives a much wider scope to what constitutes a recovery of capital. Indeed it can treat a company as recovering capital up to two years before it even borrowed the money it is alleged to have recovered! Because of the extended scope given to the concept of ‘recovery of capital’, a company which is paying interest can be surprised to discover that the tax relief it was depending on has been cancelled as a result of events to which it might have attached little significance at the time.

What is recovery of capital?
In considering what is a recovery of capital it is important to bear in mind that interest relief may be available to a company both where it has acquired shares in an investee company and where it has loaned money to that company which is used by it for the purpose of its business.
• A recovery of capital can occur if the investor company sells any part of the ordinary share capital of the investee company, or of a connected company of the investee company or was repaid any part of the share capital by either company.

That might seem clear enough if the borrowings on which interest relief is claimed was used to purchase shares. If the shares are sold, why shouldn’t the interest relief cease to that extent? However the sale of some shares can cause a loss of interest relief even if the moneys borrowed were used not to acquire shares in the investee company, but to lend money to it. That loan might be still in place, and the investor company might still hold the required 5p.c. interest in the investee company but nonetheless a sale of other shares in the company by the investor company can lead to a loss of interest relief.

If the investor company owns shares in subsidiary A, and also owns shares in subsidiary B, and has borrowed money to lend money to subsidiary B, it can find that its interest relief on those borrowings cease to the extent that it disposes of shares in subsidiary A. This is notwithstanding the fact that the borrowings were not related to shares in subsidiary A, and it had not even loaned the money to subsidiary A. In the situation outlined subsidiary A and subsidiary B are treated as connected companies and therefore the interest relief on a loan to subsidiary B is affected by the sale of shares in subsidiary A by the investor company.
• Interest relief will also be lost where the investee company, or a company connected with it, repays a loan to the investor company.

The loss of relief can happen even if the interest relief is on borrowings used to acquire shares rather than to make the loan in question. Also, the repayment of a loan by one company to the investor company can result in loss of interest relief in the financing of its investment in a different company. This is not a consequence that might logically be expected, nor would it occur to a finance director in every instance.

The investor company might well be providing seasonal finance to one subsidiary, and so continually making loans, and receiving repayments of those loans from that subsidiary, and quite separately have borrowed for the purpose of investing in the share capital of a second subsidiary. Each of the seasonal repayments of loans from the first subsidiary would lead to a cancellation of interest relief in relation to the investment in the second subsidiary.

Where the interest relief enjoyed by the investor company is in respect of an investment made into a holding company of a trading company, or into a holding company of an Irish rental income company, it can be deemed to have recovered capital, and consequently lose its interest relief, by reason of transactions entered into by the investee holding company, rather than by itself. Where the investee holding company would be regarded as recovering capital from its subsidiaries (where it holds more than 50p.c. of their ordinary share capital), that recovery of capital can be imputed to the investor company, leading to a loss of interest relief. The same circumstances as outlined above can give rise to a deemed recovery of capital by the investee holding company. As outlined above, some of these circumstances can be quite remote from anything most people would regard as a recovery of capital.
• The legislation makes provision for the possibility that a company can be treated as recovering capital before it has even laid out that capital!

Where any of the events that are treated as giving rise to a recovery of capital occurs in the two-year period prior to the borrowing being taken out and applied to make an investment, the investor company may find that from day one it is already regarded as having recovered its capital and accordingly from day one is not entitled to interest relief to that extent. There is one exception to this bizarre and broad rule. That is that where the recovery of capital is a repayment of a loan, and the loan is one used by the borrower for trade purposes, or for the acquisition or improvement of a rental income property in Ireland, or (quite importantly) is a loan made prior to 6 February 2003, the repayment of that loan is not regarded as a recovery of capital, solely for the purpose of the deemed recovery of capital in the two year period preceding the making of an investment by the investor company.

Tax relief is usually critical to a company when it makes a decision to borrow money for investment purposes in its group. The new rules are undoubtedly complex. They consist of a series of traps which the average businessman would not suspect exists, and which are capable of denying a company tax relief for its interest payments. Where a company is making a borrowing, it is critical that it takes expert advice as to how to structure that borrowing so as to ensure that it is, from day one, entitled to tax relief on the interest, and that it does not ‘accidentally’ loose that interest relief before it has realised the investment which it is to finance with the borrowings.

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