The transfer pricing rules (see box "Key terms") operate to disallow tax deductions to a person paying interest to a connected party if the loan is not on an arm's length basis (because a third party would not have made that loan).

These rules have now been extended so as to disallow deductions for up to all of the interest paid by a UK borrower (for example, a Newco set up to acquire a business or to undertake a project) if the loan is not on an arm's length basis and if:

It is likely that in many private equity and PFI deals (and other deals involving joint ventures) the condition that the persons be "acting together" and "collectively" capable of controlling the borrower will be fulfilled, although this would need to be reviewed in each case. For example, relations may often be governed by a shareholders' agreement or interests held through a partnership. In these circumstances, the shareholders or partners are likely to be treated as acting together for transfer pricing purposes.

It is also often the case that those providing shareholder loans will together control the company and, therefore, for existing investments, it is likely that a significant number of shareholder loans will now be caught by the transfer pricing rules. For those loans that were not entered into on arm's length terms, deductions will not be affected until 1 April 2007 (or until an earlier change to the terms of the loan).

The rules are also extended to include the situation where there is no control relationship (broadly, where the lender controls the borrower, or where both the lender and the borrower are controlled by the same person) when the loan is made, but such a relationship comes into existence within six months thereafter. In this case, deductions will be affected from the later of the date of the loan or 4 March 2005.

Existing shareholder loans should therefore be reviewed to assess the potential impact of the rule changes on each deal and to establish whether steps can be taken to mitigate any material adverse effect. It is probable that a comprehensive assessment will not be possible until the Bill has been published.

On new deals signed on or after 4 March 2005, the challenge will be to establish whether there is a way of ensuring tax deductions for shareholder loans without prejudicially affecting the equity structure.

It should be noted that Inland Revenue guidance on the application of the transfer pricing rules (as they were at that stage) to PFI deals gives some comfort in determining whether shareholder loans are made on arm's length terms ("Risk Assessment - Thin Capitalisation - PFIs", www.inlandrevenue.gov.uk/international/pfi.pdf). The Inland Revenue has not yet confirmed that that guidance is unaffected by these changes.

While the new rules are clearly aimed at shareholder loans, the Inland Revenue announcement is widely worded and it remains to be seen, on publication of the Bill, to what extent the new rules will affect mezzanine and other loans by third parties which are accompanied by warrants or other equity participation rights.

Under current loan relationship rules discount or rolled-up interest, including zero coupon bonds and deep discount bonds, is not deductible until paid (as compared to the normal position where interest is deductible as it accrues) where the borrower is a close company (see box "Key terms") and the lender is both a participator in the borrower (whether as a holder of shares or of a contingent equity participation such as warrants) and not within the charge to UK corporation tax.

An exception which has often been relied on to obtain a deduction for interest on an accruals, rather than a paid basis, is where:

Under the changes, this exception will only be available where the borrower is a small or medium-sized enterprise and where the lender is not resident in a tax haven jurisdiction.

This change may therefore result in a deferral of tax deductions for interest on certain loans where there is a discount or a roll-up of some or all of the interest. Loans most likely to be affected are shareholder loans on arm's length terms (that is, where the transfer pricing rules allow a deduction) and certain mezzanine and junior debt provided by non-UK lenders involving an equity participation (including contingent equity participations such as warrants). For existing loans, the changes will only affect the timing of tax deductions from 1 April 2007 (or earlier where the terms of the loan are changed).

For the purposes of the loan relationship rules, a creditor may be connected with a debtor (generally imposing an accruals basis of taxation and affecting the availability of bad debt relief). The anti-avoidance rules are now to be extended to include within this category creditors who control a participator in a company, or a creditor who is controlled by a company that controls a participator in the debtor.

The Inland Revenue's announcement of 4 March 2005 is not to be confused with the ongoing disagreement between the Inland Revenue and the British Venture Capital Association (BVCA) over whether a partnership is a "person" for the purposes of the transfer pricing legislation.

If a partnership is a person then interest paid by UK borrowers on loans from partnerships which hold 50% or more of the equity of the company will not be deductible where the loan was not made on arm's length terms. The converse view, held by the BVCA, is that a partnership is transparent for these purposes and that it is necessary to look behind the partnership to see whether any partner individually holds a 50% indirect interest in the borrower (or any two parties hold more than 40% each).

On the basis that the partners' indirect interests in the borrower would be aggregated under the new rules in any case, the transfer pricing rules could apply to deny tax deductions going forward to such borrower regardless of the outcome of this dispute. However, the outcome could affect periods before 4 March 2005, which would involve companies recalculating their tax computation back as far as, perhaps, 1998. The impact of this recalculation could be significant.

The announcement came without warning and therefore it may be expected that representations will be made by those affected. The press release was worded largely in terms of anti-avoidance although the majority of the types of arrangements that will be affected by the changes have been market practice for many years. It is to be expected that industry will react strongly against this.

On the basis, however, that these rules will be implemented, deals which have not yet signed should take into account the possible effect of the new rules. Companies should also, in conjunction with their advisers, begin to review existing deals with a view to identifying where tax deductions may be denied or deferred.