Business Taxes

Chapter 3Interest

AIM

To teach students about the reliefs available when a company incurs an interest charge.

LEARNING OUTCOMES

Once you have studied this chapter, you should be able to:

3.1 Outline the different types of security a company can give for borrowings 76
3.2 Compare floating and fixed charges from the borrowers and lenders perspectives 81
3.3 Describe why a business might reserve title to goods sold 83
3.4 Outline the three ways in which interest paid by a company can be deductible for corporation tax, including interest as a charge 85
3.5 Describe how recovery of capital, or deemed recovery of capital, can affect relief for interest 90
3.6 Outline when interest is treated as a distribution and the elections available 93

PRE-READING

Personal Taxes Manual

Chapter 4 - Taxation of Business Income – Schedule D Case I and II

Chapter 9 - Taxation of Rental Income: Schedule D Case V

MAIN LEGISLATIVE PROVISIONS

Chapters 2 & 3 of Part 8, sections 10, 97, 130, 452, 626B and 817C of TCA 1997

RELEVANT PAST EXAM QUESTIONS

2015, Autumn, Question 4(c)

2016, Summer, Question 3(c)

2017, Autumn, Question 4(a)

2018, Summer, Question 4(b)(c)

3.1.Outline the different types of security a company can give for borrowings

3.1.1.Legal mortgage and equitable mortgage

In the case of a legal mortgage, the company formally transfers the legal title to the asset in question (usually land, although it could be an insurance policy, shares, etc), to the lender. This transfer is subject to a covenant on the part of the lender to transfer title back to the borrower when the debt is repaid. If the borrower defaults and fails to repay the borrowing, the lender can sell the asset in satisfaction of the debt owing to it.

An equitable mortgage can also be granted as security for borrowing. This usually involves depositing the title deeds to the relevant land with the lender. This can be done without entering into a formal deed of mortgage. The law of equity recognises the lender’s equitable interest on the basis that the deposit of title deeds is evidence of an intention by the borrower to create a mortgage in favour of the lender. Alternatively, an equitable mortgage may also be created by formal conveyance or assignment of the equitable title in the mortgaged property.

3.1.2.Fixed charge

A fixed charge is similar to a legal mortgage in that the lender, in the event of default, can look to (and sell) the specifically identified asset to satisfy his debt. Unlike a legal mortgage, the ­ownership or title to the asset is not transferred to the lender, although he does have rights over it.

A fixed charge attaches to a particular asset, and the company is prevented from dealing with that asset while the debt remains outstanding. Typically, a fixed charge is created over specific items of property which are in the permanent ownership of the company and not bought and sold as stock-in-trade: examples include land and buildings, fixtures and fittings, intellectual property such as patents, the benefit of insurance policies, etc.

3.1.3.Floating charges

A company may also choose to use a form of security known as a floating charge. A floating charge generally attaches to a particular class of assets of the company. However, the company can continue to use those assets in the normal course of business. The floating charge will only “crystallise” (i.e. become fixed on the charged assets) on the occurrence of a particular event, at which stage the company will be prevented from dealing with those assets without the lender’s consent.

Crystallisation of a floating charge

Crystallisation is the process by which the floating charge ceases to float, and “fastens” on the assets covered by the charge. Upon crystallisation, an interest in the charged assets arises in favour of the charge-holder.

The crystallisation of a floating charge will typically occur on the occurrence of:

the appointment of a receiver;

the winding-up of the company; or

any other event(s) agreed by the parties in the charge document itself (it was decided in Halpin v Cremin1 that the parties to a floating charge have full freedom to define crystallising events: “This crystallisation may be brought about in various ways. A receiver may be appointed, or the company may go into liquidation and a liquidator be appointed, or any event may happen which is defined as bringing to an end the licence to the company to carry on business.”)

A floating charge which has crystallised will “de-crystallise” on the appointment of an examiner to the company, so that it ceases to be a fixed charge and reverts to being a floating charge.2 This position has been questioned but remains the law.

Characteristics of a floating charge: difference between floating and fixed charges

In the case of Re Yorkshire Woolcombers Association Limited3    , Romer L.J. set out the three ­characteristics of a floating charge:

1. it must be a charge on a class of assets of a company, present and future; and

2. it must be a class of assets which in the ordinary course of the business of the company will be changing from time to time; and

3. it must be contemplated that until some future step is taken by or on behalf of the lender, the company may carry on its business in the ordinary way so far as concerns the particular class of assets covered by the charge.

As we have seen, a mortgage or a fixed charge attaches to a specific asset of the company, such as land or shares. The lender can look specifically to that asset in the event of a breach of a term of the loan agreement. The right of the lender to look to a specific and identified asset to satisfy his debt is created at the time of signing of the mortgage or charge, and in the event of the borrower’s default the lender can appoint a receiver to deal specifically with that asset. The charge is immediately attached to the particular property that is being offered as security.

In contrast, however, a floating charge does not attach to any specific asset at the time the security is given and the charge created. No estate or interest in any property is vested in the lender upon the grant of the charge: it is only when certain specified events occur that the charge will crystallise and an interest in the charged assets arises in favour of the lender.

In the case of Illingworth v Houldsworth4, the Court gave a definition of a floating charge and distinguished it from a fixed charge. It was held that a fixed charge is:

“one that more fastens on ascertained and definite property or property capable of being ascertained and defined; a floating charge on the other hand is ambulatory and shifting in its nature, hovering over and so to speak floating with a property which it is intended to affect until some event occurs or some act is done which causes it to settle and fasten on the subject of the charge within its reach and grasp”.

Mr. Justice Costello, in the case of Re Lakeglen Construction Limited v James McMahon Limited5, held that the true test of distinguishing a floating from a fixed charge lay in the ability of the company to deal with the assets in the ordinary course of business, despite the fact that they are covered by a charge. A floating charge permits a company to deal in the ordinary course of its business with the assets for the time being comprised in the charge.

Task 3.1

What is the difference between a fixed and floating charge?

What happens when a floating charge crystallises?

Invalidity of a floating charge (Section 597 CA 2014)

If a company is experiencing trading difficulties or if it seems to a creditor that the company may cease to trade, the creditor may put the company under pressure to secure the debt due to him by creating a floating charge in his favour over some or all of the company’s assets. ­However, Section 597 CA 2014 renders such floating charges, created to secure a past debt, invalid if made within twelve months of the winding-up of the company.

Section 597 CA 2014, states that:

“where a company is being wound up, a floating charge on the undertaking or property of the company created within 12 months before the commencement of the winding up shall, unless it is proved that the company immediately after the creation of the charge was solvent, be invalid.”

Where the conditions of Section 597 CA 2014 are not satisfied, the security provided by the floating charge becomes invalid. Given the presumption of invalidity (12 month time limit), the onus is on the holder of the floating charge to prove that the company was solvent at the time of the creation of the floating charge.

Section 598 CA 2014 also states that if a charge is in favour of a director or certain connected persons or a related company, within 12 months of the winding up of the company, unless the company was solvent immediately after the creation of the floating charge, it will be invalid.

Various transactions by a company, including the creation of a floating charge, made within six months of its winding-up may be invalid as an unfair preference of the company’s creditors (Section 604 CA 2014).

3.1.4.Registration of Charges at the Companies Registration Office

In order to ensure that any mortgage or charge created is valid and has priority over subsequent charges, it is important that it is registered with the CRO within 21 days of its creation pursuant to Section 409 CA 2014. The relevant CRO form is Form C1.

The advantage of the registration system is that third parties who wish to lend money to companies can consult the register to discover charges against the company. If there are no registered charges the lender can use the company’s property as security and be confident that its security will enjoy first priority against the relevant property if the company runs into financial difficulties and is unable to pay its debts.

No extension of time for registration can be given by the CRO. The courts have jurisdiction to extend the time for registration of a charge under Section 417 CA 2014 and also to rectify any omission or misstatement in the particulars delivered, but such a court application is a costly process, and any order made will be usually be without prejudice to the rights of any intervening secured creditors (i.e. if somebody else has registered a competing charge in the meantime, that competing charge will have priority notwithstanding that the court has extended the time limit for registration of the first charge). The court has to be satisfied that the omission to register the charge within the 21-day period was due to inadvertence or was accidental in its nature.

Consequences of non-registration

Failure to register the charge within 21 days of its creation has the effect of making the charge void against a liquidator of the company and any creditor of the company.

If a company fails to register a charge within the 21 days of its creation, the charge will be void as against a liquidator of the company and other creditors. For this reason, although strictly speaking the obligation to register the charge rests on the company, in practice it is the lender who will be especially keen to ensure registration.

It is important to note that the underlying debt remains valid as against the company even if the charge is not properly registered, but the creditor will be ranked as an unsecured creditor rather than a secured one, with consequent loss of priority.

Key Point

A charge will be void against a liquidator and any creditor of the company where there has been a failure to register a charge within 21days

3.1.5.Personal Guarantees

Although they do not strictly speaking constitute security, it is convenient to mention briefly another common means by which bank lending to companies (particularly smaller or riskier companies) is supported – namely, the provision of personal guarantees.

It is common in Ireland for the shareholders/directors of private companies, particularly those with limited assets, to personally guarantee the obligations of the company to its lender. Such guarantees will usually be requested by the bank in addition to (rather than instead of) a full security package from the company itself comprising a legal mortgage of any real property and fixed and floating charges over all other corporate assets, as described above.

The personal guarantee itself is quite a simple document, and is essentially a personal covenant from the guarantor to the bank that, to the extent the company fails to repay its debt to the bank when due, the guarantor will personally pay the sum due. Depending on the means of the guarantor, the guarantee may be an unsecured covenant, or it may itself be supported by security over the guarantor’s personal assets (e.g. a mortgage over any real property owned by the ­guarantor, or possibly a fixed charge over the guarantor’s shares in the borrower or other ­companies).

If the guarantee is in fact called upon and the guarantor discharges the sum due to the bank on behalf of the company, he will enjoy a “right of contribution” against the company and can sue the company for recovery of the relevant amount. However, he is unlikely to recover the full amount, because if the company had the resources to meet such a claim it is unlikely that the personal guarantee would have had to be enforced by the lender in the first place.

It is important to note from the perspective of a shareholder giving a personal guarantee that this effectively amounts to the removal of the limited liability, in respect of this loan, which he would otherwise enjoy as a shareholder of the company, because – by guaranteeing repayment of the company’s bank debt – he and is personal assets will be directly exposed to a creditor of the company (i.e. the bank) should the company not have the necessary resources to pay its debt.

3.1.6.Group Guarantees

Similar to a personal guarantee, where banks are lending to a group of companies they may seek guarantees over the shares or assets of other companies within the group in addition to any security they have over the assets of the company who is borrowing.

Example 3.1

Moon Ltd is an established distributor of precious gems. It is planning on expanding into the sale of crystal jewellery through a newly formed subsidiary Crystal Ltd and seeks bank financing. The bank agrees to lend to Crystal Ltd on condition that in addition to having security over the assets of Crystal Ltd and over the shares of Crystal Ltd, it obtains a charge over the assets of Moon Ltd.

In this way the bank can provide funding to a new venture but without taking excess risks.

3.2.Compare floating and fixed charges from the borrowers and lenders perspectives

3.2.1.The borrower’s perspective

From the borrower’s (company’s) point of view, one of the significant advantages in granting a floating charge over some or all of its assets, as opposed to a fixed charge, is that a company retains the power to deal with the assets covered by the charge in the normal course of business without any restrictions, and the lender does not have any interest in those assets unless and until one of more specific events occur which lead to the crystallisation of the charge.

The concept of a floating charge, and its common use over the last century and more, has increased the ability of companies to borrow money, by permitting companies to use working capital as an effective security for their borrowings without hampering their ability to deal in their working capital on a day-to-day basis.

3.2.2.The lender’s perspective

From a lender’s point of view, there are a number of disadvantages to a floating charge when compared to a fixed charge:

1. The principal disadvantage to the lender is that on the winding up of the company the floating charge does not enjoy the same priority as a fixed charge. When the assets of the company are distributed by the liquidator, a lender holding only a floating charge will rank for payment behind lenders holding fixed charges, and behind preferential creditors ­prescribed by the Companies Acts (principally the Revenue Commissioners, and employees in respect of certain payment entitlements). Obviously this means that the holder of a floating charge is more likely not to recover its debt than the holder of a fixed charge when the company is wound up insolvent. The floating charge-holder will however rank in priority to the company’s unsecured creditors in the winding up.

2. There is also a danger that a fixed charge will be created by the company after the grant of the floating charge. If this occurs, the later fixed charge, being a fixed charge, will rank ahead of the earlier floating one. Lenders try to guard against this by inserting into the floating charge a “negative pledge” clause, which is a contractual commitment by the borrower ­company that it will not create any security ranking ahead of or equal in priority to the floating charge in question without the prior written consent of the holder of the floating charge. In the case of Welch v Bowmaker (Ireland) Ltd6 , it was held that unless the holder of the subsequent fixed charge had actual knowledge of the fact that there was a negative pledge clause contained in the earlier floating charge, the subsequent fixed charge will have priority over the earlier floating charge (i.e. actual, rather than constructive, notice of a negative pledge clause is required in order for the subsequent fixed charge not to have priority). In order to combat this ruling, a practice had developed of including details of a negative pledge on the Form C1 filed at the CRO in respect of the grant of the floating charge (see above re requirement to file details of charges at the CRO), in an attempt to put the world at large on notice of the negative pledge and the company’s contractual commitment not to create further security. However CA 2014 now stipulates that the CRO are not permitted to record details of a negative pledge when recording particulars of a charge created by a company.

3. As the class of assets normally subject to a floating charge are ever-changing and not fixed at the time the security if first granted (unlike the assets the subject of a fixed charge), the lender has no certainty up until crystallisation of the floating charge as to the precise assets over which it enjoys security. If a company gets into financial difficulties, it may find it difficult to resist the temptation to dispose of more realisable assets. It may be that when the lender comes to enforce its security, many of the assets formerly covered by the floating charge may have been disposed of.

4. As we have seen above, a floating charge that is created within 12 months (2 years in the case of a connected company) before the winding-up of the company shall, unless it is proved that the company was solvent immediately after the creation of the charge, be invalid, except as to money paid or advanced to the company at the time of or subsequent to the charge, and in consideration for the charge.

Example 3.2

TimberCo is involved in processing timber from trees. The recent slump in the construction industry has adversely affected its business and it is struggling to survive. It has approached the Big Bank for a loan. It already has a number of other loans which are secured on its factory premises, and so it is offering up its stock of felled trees as security to Big Bank for the purposes of a floating charge. This would allow TimberCo to continue processing the trees into timber and sell on the finished product. However, Big Bank is not happy with this. It wants a fixed charge over the trees. It is concerned about the financial viability of TimberCo and believes a fixed charge over the trees offers it a better security than a floating charge. This may be impracticable for TimberCo, because if it grants a fixed charge over the felled trees (which are of course its stock-in-trade), it will not be able to make day-to-day sales (i.e. routine disposals of stock for payment) without the prior ­consent of Big Bank.

Key Point

A fixed charge takes priority over a floating charge. a lender holding only a floating charge will rank for payment behind lenders holding fixed charges, and behind preferential ­creditors prescribed by the Companies Acts (principally the Revenue Commissioners, and employees in respect of certain pament entitlements).

3.3.Describe why a business might reserve title to goods sold

It is common for the suppliers of goods to attempt to retain either the legal or the equitable title in the goods they supply to a company until the company has paid them for those goods. This concept is known as retention of title. The supplier retains the contractual right to take back the goods s/he supplies. This is usually done by inserting a retention of title clause into the ­commercial contract between the parties.

If the clause is correctly drafted and the seller succeeds in retaining the title in the goods pending payment, then he does not need to rely on a charge or other security over the goods, since the law recognises that he (and not the purchaser company) is still the owner of the goods in ­question. It is only if the courts regard the beneficial interest in the goods as having been ­transferred to the purchaser that the seller will be relying on a charge over the goods.

The principal advantage of an effective retention of title clause is that it protects the supplier against the insolvency of a purchaser (and the consequential loss to the supplier where goods are not paid for).

Does a retention of title clause have to be registered as a charge?

The courts has held that in certain circumstances, a retention of title clause is akin to a charge on goods (as it gives the supplier a beneficial interest in goods which are in the possession of the company) of a type which requires to be registered under Section 409 CA 2014 in order to be valid as against a liquidator or another creditor. In other cases, however, the courts have found that these clauses do not create a charge (as it is merely a reservation of legal title) and there is no need for registration under Section 409 CA 2014

The case law on the area is complex but, in summary, where the court finds that:

under the terms of the contract between supplier and the company the ownership in the goods did not pass until payment was made in full; and

the goods sold remained in an identifiable state and have not been used by the purchaser in any manufacturing or other process;

then there is a valid retention of the legal and equitable title by the seller and there is no need for a charge which requires registration under Section 99.

The validity of these retention of title clauses and whether a registrable charge was created was discussed in the case of Somers v James Allen (Ireland) Limited.7 In this case, a firm supplied ingredients to a manufacturing company that was involved in the selling of animal feed ­compounds. In the contract for sale of the goods there was an retention of title clause which stated that the transfer of title of the goods would not occur until the goods had been paid for in full. The company ran into financial difficulties and a receiver was appointed over its assets. The supplier was not paid for the goods that he supplied to the company, and brought an action against the receiver claiming ownership of the goods. The ingredients supplied had not been used in any manufacturing process and in fact were still in an identifiable state similar to the state they were in when supplied.

The High Court held that it was within the providence of the parties to provide that both the legal and equitable ownership remained with the supplier until payment for the goods has been made in full and as a matter of law this is what had occurred. Accordingly, the seller retained ownership of the goods and there was no need to register a charge under Section 409 CA 2014.

In the Somers decision the goods that were supplied to the buyer were the raw materials or some part used to bring about the finished product. This is not an uncommon situation. Unlike the situation in the Somers decision, however, the goods supplied will often have been used in some manufacturing process by the time the seller is looking to rely on the retention of title clause. Some retention of title clauses will therefore try to retain ownership in the finished goods with respect to the proportion of the goods supplied, and in some cases endeavour to retain some right to any proceeds received by the buyer for sale of those finished goods. The courts have held that these types of clauses are valid but they are more of the nature of a charge over goods and must be registered in order to be valid as against the liquidator and other creditors.8

3.4.Outline the three ways in which interest paid by a company can be deductible for corporation tax, including interest as a charge

3.4.1.Interest allowed in full as a trading expense

Where interest is incurred wholly and exclusively for the purpose of a trade it is allowable as a trading expense i.e. bank overdraft interest on funds used to purchase trading stock is allowed in full.

In ascertaining whether interest is allowable as a trading expense you should refer to the discussion of the Sean MacAonghusa (Inspector of Taxes) v Ringmahon Co [2001] ITR 117 case.

Where banks provide financing to companies they will usually seek security, as you saw in sections 3.1 to 3.3. If a bank provides overdraft facilities to a company they may seek a floating charge over the assets of the company to the value of the overdraft facility provided. If a bank provides loan facilities to a company to finance the purchase of a property they may seek a fixed charge over the new property to the value of the loan provided. They may also require personal bank guarantees from the company directors.

3.4.2.Interest allowed as a rental expense (s. 97 TCA 1997)

The same rules which apply to the deductibility of interest as a rental expense for income tax purposes apply to corporation tax. In determining whether interest is allowed as a rental expense you should refer to Chapter 9 of the Personal Taxes Manual.

In general, interest on money borrowed to purchase, improve or repair a rented premises is allowed as a deduction against the related rental income in arriving at the taxable Case V income. Section 97(2J) restricts the deduction to 75% of the interest accruing on or after 7 April 2009 to 31 December 2016 on loans for the purchase, improvement or repair of residential rental property, including foreign property loans (on the basis that Case III rental profits are computed in the same way as Case V rental profits, s. 71(4) TCA 1997). The restriction is being reduced by 5% every year from 2017 until it reaches 100% relief in 2021. Therefore the qualifying interest charge for 2018 is 85%. The deduction of interest on loans used to purchase, repair or improve rented commercial premises is unrestricted.

Interest on money borrowed to purchase, repair or improve a rented premises is not allowed as a Case I trading deduction and is added back in calculating taxable Case I income.

Example 3.3

Buildings Ltd rents the following premises to third parties in the year ended 31 December 2018:

(i) an office building in Cork city. The annual rental income is €50,000 and accrued interest on a loan used to refurbish the property was €30,000.

(ii) a retail unit in Galway. The annual rental income is €40,000. During the year, the company borrowed money to defend a lawsuit taken by a member of the public injured on the premises. Interest of €3,000 accrued on this loan during the period. The company also accrued interest of €10,000 on a loan used to acquire the property.

(iii) 5 identical apartments in Dublin. The annual rental income per apartment is €15,000 and the total interest accrued on money drawn down to purchase the apartments was €25,000. Buildings Ltd has not registered the tenancy of one of the apartments with the RTB.

Buildings Ltd’s Case V taxable income for the year ended 31 December 2018 is as follows:

Cork Property Gross Rent €50,000
Cork Property allowable interest (€30,000)
Cork Property taxable income €20,000
Galway Property Gross Rent €40,000
Galway Property allowable interest (€10,000)
Galway Property taxable income €30,000
Dublin Apartments Gross Rent €75,000
Dublin Apartments allowable interest (€17,000)
Dublin Apartments taxable income €58,000
Total taxable Case V €108,000

The interest on the loan drawn down to defend the lawsuit is disallowed as the loan was not used for the purchase, repair or improvement of the premises. The interest on part of the loan drawn down to fund the purchase of the apartments in Dublin is disallowed as the tenancy for one of the apartments is not registered with the RTB. The remaining allowable interest is restricted to 85% of the amount accrued in the period.

3.4.3.Interest allowed as a charge (s. 247 TCA 1997)

Where interest is incurred by a company on funds borrowed to acquire shares in or loan money to certain other companies it is added back in the computation but may be allowed as a charge, see chapter 4. There are a number of requirements which must be met before the interest paid can be deducted as a charge:

1. The investing company must hold more than 5% of the ordinary share capital in the other company at the time the interest is paid

2. The two companies must have at least one common director from the date of purchase of the shares to the date of the payment of the interest

3. The company whose shares are being acquired must exist wholly and mainly for the purpose of carrying on a trade (s.247(2)(a)(i) TCA 1997) or whose income consists wholly or mainly of rental income (s. 247(2)(a)(ii) TCA 1997) or whose business consists wholly or mainly of the holding of stocks, shares or securities of such a trading (s. 247(2)(a)(iii) TCA 1997) or rental (s.247(2(a)(v) TCA 1997) company and the funds from the share subscription must be used in full by the company issuing the shares for business purposes.

4. Relief is also available when borrowings are used to acquire shares in an intermediate holding company (s.247(2)(a)(iv) TCA 1997. This would be the case where a holding company owns shares in another holding company which in turn owns shares in a trading company. It should be noted that this relief does not extend to intermediate holding companies of rental companies. The relief for intermediate holding companies of trading companies applies to loans drawn down on or after 19 October 2017.

5. During the period of the loan there must be no recovery of capital by the investing company from the other company i.e. the loan must not be repaid in any form, except payment directly against the loan itself.

6. If the investing company simply lends money to the other company it must be used by that other company for the purpose of its trade (s.247(2)(b)(i) TCA 1997) or for carrying on its business of rental income (s. 247(2)(b)(ii) TCA 1997) or lending to a company whose business consists wholly or mainly of the holding of stocks, shares or securities of such a trading (s. 247(2)(b)(iii) TCA 1997) or rental (s.247(2(b)(v) TCA 1997). Similar to 4 above, relief is also available for lending to intermediate holding companies of trading companies, (s. 247(2)(b)(iv) TCA 1997),and does not extend to intermediate holding companies of rental companies.

Similar relief also applies to lending to connected companies.

No interest payment will be treated as a charge on income if:

1. It is charged to capital e.g. interest on funds borrowed by property developers to finance a development may be charged to a capital account, thus increasing profits available for distribution (s. 243(6)(a) TCA 1997).

2. It is not ultimately borne by the paying company e.g. exercising a right of reimbursement against a third party for interest paid (s. 243(6)(a) TCA 1997).

3. It is treated as a distribution of the company e.g. certain types of interest (s. 243(1) TCA 1997). See chapter 8.

4. It is non-yearly interest paid to a third party institution not based in the State (or in another EU member state) (s. 243(4) TCA 1997).

5. It is made by a non resident company unless it is paid through a branch or agency in Ireland and it is in respect of a liability incurred wholly and exclusively for the purpose of a trade carried on in the State through that branch or agency (s. 243(6)(b) TCA 1997).

S.247(4A) TCA 1997 – Circular flows of funds in a group

Interest will not qualify as a charge under s. 247 TCA 1997 where the borrower:

is connected with the lender, and

uses the funds to purchase the ordinary share capital or any other type of capital of a company from a company (including the company whose shares are being purchased) which, on or after the time of purchase of the capital, is connected with the borrower.

This legislation was introduced to prevent borrowed monies being transferred around a group with resultant interest charge claims, when the real intention of the borrowing was to allow one group company acquire another group company. This transaction came within the original guidelines set above in that once the company being purchased was trading, the interest charge was allowable. Borrowing to acquire subsidiary companies is most commonly used in order to avail of s. 626B TCA 1997 participation exemption relief. This element will be discussed in greater detail at Part 3.

A company is connected with another company if one has control of the other or both are under the control of another company, or individual, s. 10 TCA 1997.

Example 3.4

A Ltd owns B Ltd and C Ltd. For taxation and operational reasons A Ltd wants B Ltd to own C Ltd.

A Ltd borrows funds from its own bankers and provides a loan to B Ltd to allow it purchase the share capital of C Ltd. B Ltd uses those funds to purchase C Ltd.

Under s. 247(4A) TCA 1997, A Ltd cannot claim as a charge the interest charged by its bankers on the loan given to B Ltd.

The restrictions will not apply in the following two instances:

1. The funds are ultimately used for trading purposes provided that there are no arrangements in place to achieve repayment of the original loan either directly or indirectly.

2. If the borrowings create taxable income (such as interest income, but not dividend income).

S.247(4E) TCA 1997 – Restriction of interest on certain asset acquisitions

Section 247(4E) TCA 1997 imposes restrictions on interest deductions on loans made on or after 21 January 2011 (unless there was a binding agreement in connection with the loan prior to that date).

The section applies to interest on a loan from a connected company which is lent to the investing company which then in turns lends the funds to another company. If the other company uses those funds to acquire assets from a separate company which at the time the assets were first acquired was connected with the investing company then the interest will be restricted.

Example 3.5

Loan Ltd lends funds to a connected company A Ltd. A Ltd lends those funds to B Ltd who acquires an asset from C Ltd. If A Ltd was connected to C Ltd when C Ltd first acquired that asset there would be no interest relief for A Ltd on the loan from Loan Ltd, subject to the exclusions noted below.

The definition of asset within the section, (S. 247(4E)(a) TCA 1997), excludes the following and therefore the interest charge would be allowable:

1. Share capital in a company

2. Intangible assets within the meaning of S.291A TCA 1997

3. Assets acquired as trading stock.

Also excluded from the restrictions are the following:

1. Interest on loans given to a connected company to acquire a trade carried on by a company not within the charge to corporation tax, S. 247(4E)(c) TCA 1997.

2. Interest on loans given to a connected company which acquires a leased asset which was not previously in use by a company within the charge to corporation tax, S. 247(4E)(d) TCA 1997.

Key Point

The reason for the interest payments governs how/if it is tax allowable.

Figure 3.1. Summary of interest deductibility

3.5.Describe how recovery of capital, or deemed recovery of capital, can affect relief for interest

This section discusses the anti-avoidance legislation in relation to s. 247 TCA 1997 interest charges, relief for which is discussed in section 3.4.3.

There are three main anti-avoidance sections of legislation:

1. S. 249 TCA 1997 – Recovery of capital

2. S. 817C TCA 1997 – Unpaid interest

3. s. 840A TCA 1997 – Restrictions on interest deductions

3.5.1.S. 249 TCA 1997 – Recovery of capital

The anti-avoidance provisions of s. 249 TCA 1997 cover s. 247 TCA 1997 relief. If any capital is recovered by the investor in the following circumstances then interest relief is disallowed/restricted:

1. If any capital has been recovered within a two year period before the loan was granted. This is anti-avoidance to prevent the loan being repaid before it is actually granted.

2. If an investor company sells part of its interest in the company it has invested in or in any other connected company.

3. There is a repayment of all or part of any loan made by the investor company to the investee company or any connected company.

4. The investor transfers the right to receive a debt due from the company or a connected company and receives consideration for the assignment.

Relief is not restricted on any of the above events if the capital recovered is used to repay the original loan, as the interest charge will decrease accordingly.

Example 3.6

A Ltd owns 60% of B Ltd and loans it €1,000,000 on 1 January 2018 which it obtains from its own bankers to use in B Ltd’s business. A Ltd’s bankers charge 10% interest on the loan.

B Ltd uses the loan to purchase new plant and machinery. On 1 July 2018 it repays 50% of the loan to A Ltd who uses the repayment to invest in the stock market.

A Ltd’s qualifying interest charge is calculated as follows:

Interest 1 January – 30 June 2018 – €1,000,000 × 10% × 6/12 = €50,000
Interest 1 July – 31 December 2018 – €500,000 × 10% × 6/12 = €25,000
Total interest charge €75,000

The interest charge for the second half of the year is only 50% as A Ltd is deemed under s. 249 TCA 1997 to have recovered 50% of the loan, even though it did not apply the repayment by B Ltd to its loan account with the bank.

3.5.2.S. 817C TCA 1997 – Unpaid interest

S. 817C TCA 1997 concerns claims for interest as a trade deduction which was due on loans between connected companies.

In this situation a parent company would lend to a subsidiary company who would accrue the interest in its books, but not actually pay it over.

Under tax legislation, trade interest is always tax deductable even if it is not paid, whereas interest as a charge must be paid.

As the parent company was not receiving the interest no charge to tax arose, as under tax legislation interest is only taxed when it is received.

Under s. 817C(3) TCA 1997 the borrowing company can only claim interest as a deduction equal to the interest being charged to tax on the lender.

Any excess interest charged in the borrowers accounts over the interest being taxed in the lenders tax return can be carried forward until eventually the lender is taxed on all the interest.

The section does not apply if the lender is non-resident and is not controlled by Irish residents, s. 817C(2A) TCA 1997.

Example 3.7

Valentia Ltd owns 80% of Inis Ltd and loans it €250,000 on 1 January 2018 from its own cash reserves. It charges Inis Ltd €25,000 interest on the loan for the year ended 31 December 2018.

Inis Ltd uses the loan to fund the purchase of new stock for its retail trade. On 1 July 2018 it makes an interest payment to Valentia Ltd of €15,000. It pays the balance of interest due, €10,000 in February 2019 and therefore accrues this amount in its Statement of Comprehensive Income for the year ended 31 December 2018.

Inis Ltd’s qualifying interest charge for the year ended 31 December 2018 is limited to the amount it paid to Valentia Ltd, €15,000. The balance of €10,000 is allowable in 2019 when Valentia is also charged to tax on this amount.

If Inis Ltd had borrowed the funds from its own bank, the interest of €25,000 would have been allowed in the year ended 31 December 2018.

3.5.3.Section 840A – restrictions on interest deductions

Section 840A TCA 1997 imposes restrictions on interest deductions on loans made on or after 21 January 2011 (unless there was a binding agreement in connection with the loan prior to that date).

The section applies to interest on a loan from a connected company to acquire assets from the same or a different connected company. Any interest which would otherwise be deductible under any case under Schedule D is within the scope of the section. This means that an interest deduction under Case I/II, Case III (foreign trade, property, etc.), Case IV (e.g. leasing trades), or Case V may be denied. Note that Section 840A does not apply to interest treated as a charge on income as it is allowed as a deduction against profits of more than one description (e.g. profits under other schedules, chargeable gains, etc.).

The definition of asset within the section excludes an intangible asset where the acquiring company would be entitled to tax depreciation in accordance with S.291A TCA 1997 (i.e. specified intangibles) and if the asset is acquired as trading stock. The Revenue issued an e-brief (11/2011) which provides guidance on assets that will be treated as trading stock with particular reference to the financial services industry.

Subsections 3, 6, 7 and 8 of Section 840A TCA 1997 reduce the impact of the restrictions where:

The investing company acquires a trade

The acquired asset is a leased asset

Certain loans are financed by a third party (note anti-avoidance provisions in Section 840A(9))

Interest is paid to a securitisation vehicle (Section 110 Company)

3.6.Outline when interest is treated as a distribution and the elections available

3.6.1.Interest treated as a distribution (s. 130 TCA 1997)

In certain circumstances interest paid is treated as a distribution and is therefore not allowed as either an expense in computing profits or as a charge on income.

Dividend Withholding Tax at the standard rate of income tax (currently 20%) must be applied to all interest payments that are regarded as distributions (subject to any exceptions outlined in chapter 9).

The main provisions which treat interest as a distribution are set out in Section 130(2)(d) TCA 1997. The following interest payments are deemed to be distributions under this provision:

Interest on any loan which is convertible directly or indirectly into shares in the company where the shares are not quoted on a recognised stock exchange (Section 130(2)(d)(ii) TCA 1997).

Interest for the use of money which is to any extent dependent on the results of the company (Section 130(2)(d)(iii)(I) TCA 1997).

Interest which represents more than a commercial rate of return for the use of money (Section 130(2)(d)(iii)(II) TCA1997).

Example 3.8

Hat Ltd borrows €1,500,000 from a third party. Interest is set at the higher of €10,000 per annum or 5% if the profits of Hat Ltd for any 12 month accounting period are greater than €2,000,000.

As the interest payment is dependent on the results of Hat Ltd, it is treated as a distribution under Section 130(2)(d)(iii)(I) TCA 1997.

Example 3.9

Socks Ltd borrows €500,000 from a third party. Interest is charged at 12% per annum. Interest rates on loans of this size to companies in circumstances similar to Socks Ltd are normally in the region of 8% per annum.

Interest in excess of a normal commercial return (i.e. 4% in this case) is deemed to be a distribution under Section 130(2)(d)(iii)(II) TCA 1997. Socks Ltd will be entitled to a corporation tax deduction for interest of 8% per annum (assuming other tests for interest deductibility such as wholly and exclusively, etc. are satisfied) and the balance of interest payable on the loan facility will be disallowed in computing Socks Ltd’s taxable income.

Example 3.10

Ties Ltd borrows €750,000 from a third party. The loan must be repaid within 36 months. If the full amount is not repaid within the specified period, Ties Ltd will issue 1 ordinary share per €100 to the lender.

As the loan is convertible into shares, any interest payable on the loan is treated as a distribution under Section 130(2)(d)(ii) TCA 1997.

S. 130(2)(d)(iv) TCA 1997 deems certain interest payments to be distributions. This treatment applies to interest in respect of securities which are issued by an Irish company and are held by a company not resident in the State where:

(i) the company which issued the securities is a 75% subsidiary of the other company,

(ii) both companies are 75% subsidiaries of a third company which is not resident in the State, or

(iii) except where at least 90% of the ordinary share capital of the company which issued the securities is directly owned by an Irish resident company, both the company which issued the securities and the company not resident in the State are 75% subsidiaries of a third company which is resident in the State.

Interest paid by Irish resident companies in the ordinary course of their trade to non-resident companies noted above will be treated as a tax deductible trading expense provided the following conditions are met:

interest would otherwise be deemed to be a distribution by virtue only of s. 130(2)(d)(iv) TCA 1997, and

the interest is paid by a company in the ordinary course of a trade carried on by it, and

would but for the deeming distribution provisions be deductible as a trading expense in computing the amount of the company’s income from the trade.

The company may make an election under s. 452 TCA 1997 to have the interest treated as not being a distribution and therefore tax deductible in the normal way as a trading expense. This election would also remove the interest payments from the scope of dividend withholding tax. This includes non-EU and non-DTA resident companies who receive annual interest payments from an Irish resident company. While it will nearly always be more advantageous from an Irish perspective to make this election, when looking at group structures (as you will in your Part 3 studies) you will see that it is the global tax bill rather than any individual domestic tax bill that is important. Certain group structures better suit payments being treated as distributions than as interest in which case no election will be made here.

It should be noted that the above elections for interest deductibility (to avoid them being classified as distributions) do not extend to non-trade interest, i.e. if interest is a charge on income, rental interest etc.

S. 130(2B) TCA 1997 exempts all non-trade interest payments to EU resident companies (except Ireland) from s. 130(2)(d)(iv) TCA 1997, therefore there is no requirement to treat the interest paid as a distribution. In practice therefore s. 130(2)(d)(iv) TCA 1997 only affects companies who choose not to make the election for trade interest under s. 452 TCA 1997 or who make non-trade interest payments to non-EU companies.

Withholding tax on interest payments to non-residents

Income tax at the standard rate (currently 20%) must be withheld from certain interest payments, including interest payments to non-residents. Section 246(3) TCA 1997 includes a number of exemptions from this withholding obligation. In particular, as regards interest paid to non-residents, under Section 246(3)(h)(I) income tax does not have to be withheld from interest payments where the following conditions are met:

1. The interest is paid by a relevant person (meaning a company or investment undertaking) in the ordinary course of a trade or business carried on by that person.

2. The interest is paid to a non-resident company which is resident in a relevant territory for tax purposes by virtue of the law of that territory (note definition of relevant territory includes territories where a DTA has been negotiated but does not yet have the force of law). It is critical that the recipient is a resident of a relevant territory under the laws of that other territory and therefore confirmation of the residence rules of the foreign territory are required. For example, this is relevant in the context of the Ireland/Bahrain DTA as Bahrain does not have a concept of tax residence and therefore this provision would not apply to interest payments to a company managed and controlled in Bahrain.

3. The relevant territory imposes a tax that generally applies to interest received from outside that territory. This does not mean that the recipient company must be subject to tax on the interest paid by the Irish person – only that companies in that territory would generally be liable to tax on the interest. This allows for situations where the relevant territory might provide an exemption from the liability to tax for certain companies.

Task Answer

Task 3.1

A fixed charge is a charge over specific identified assets of the company, whereas a floating charge does not attach to any specific asset but floats over a class of assets or a number of classes of assets or the entire undertaking of the company until an event specified in the debenture deed occurs where-upon it crystallises.

Upon crystallisation, the floating charge ceases to float over the assets of the company and fastens on to the specific assets in that class of assets which are covered by the charge. Upon crystallisation the legal and equitable interest automatically switches from the company to the charge holder.

1 [1954] IR 19
2 Re Holidair Limited [1994] 1 ILRM 481
3 [1903] Ch 284
4 (1904) AC 355
5 3 [1980] IR 347
6 [1980] IR 251
7 [1984] ILRM 347
8 Kruppstahl AG v Quitmann Products Limited [1982] ILRM 551