Non-arm’s length loan through creditor’s fault

A loan between associated parties cannot qualify as arm’s length where the lender has accepted a bad debt risk that no independent third party would have consented to. It is assumed in such a scenario – unless there was a question of special circumstances – that the bad deb risk was accepted with the intention of furthering the recipient associated party’s interests. Where a loss is suffered in connection with the non-arm’s length loan, this cannot be charged to the lender’s earnings or income. A loan may start out as an arm’s length arrangement and change to non-arm’s length over time. Here too a potential loss is not (or no longer) chargeable to the lender’s earnings or income.

A director cum controlling shareholder who had furnished his private limited-liability company with a loan was found by the District Court during the term of the loan to have allowed his own position as creditor to downgraded. The director had consented to the company changing its credit facility with the bank, with the bank increasing the company’s line of credit on condition that it should be presented with additional security by insisting that the director should stand surety for the company and agree to his own loan to the company being rendered subordinate to the loans from the bank. The director in consenting to all of this allowed his own position as creditor to be affected and in doing so rendered his loan to the company non-arm’s length by accepting the kind of bad debt risk, according to the District Court, that no independent third party would have settled for. The ultimate consequence of the non-arm’s length nature of the loan was that the subsequent downward revaluation failed to be chargeable to the director’s income.