Introduction Background Note
13.Under the corporation tax rules on “loan relationships”, interest, discount and other profits, gains, losses and expenses arising on loans and similar financial instruments are normally taxed and relieved in accordance with amounts recognised in accounts drawn up under generally accepted accounting practice (an “accruals basis”). However, this principle is modified in a number of circumstances where there are transactions between connected parties. These circumstances include cases involving late payments of interest and discounts, in order to prevent manipulation which might result in a deduction for such interest or discount by a debtor company, where no corresponding amounts are taxed as a receipt of the creditor company.
14.The current rules operate by allowing a tax deduction for late interest and discounts in certain cases where the parties are connected and the creditor is taxable outside the loan relationships rules, only when the interest is paid or when the deeply discounted security is redeemed (a “paid basis”).
15.Recent decisions of the European Court of Justice have raised the question of whether the legislation as it currently stands is compatible with European law. HMRC issued a consultation document in July 2008 in which options for changes to the rules were presented. The changes set out in the Schedule are based on responses to the consultation. The effect of the changes is that where the connected creditor is a company, the “paid basis” will apply only if that company is resident or effectively managed in a “non-qualifying territory”, which broadly means a tax haven. In all other cases where the connected creditor is a company, the normal loan relationships “accruals basis” will apply.