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HMRC internal manual

Double Taxation Relief Manual

HM Revenue & Customs
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Non-residents: UK income: returns and reports: enquiries by FICO - form 4450/I part 3

The questions in Part 3 of the form are designed to prompt consideration of the more common forms of abuse where interest is paid abroad. The guidance at DT1912 to DT1919 may also be of use as many of the considerations for royalty payments apply equally to interest.

ITH109 gives an example of treaty shopping - where interest is routed through an intermediate country so that it can be paid gross. Some treaties (notably with the Netherlands and Ireland) include a paragraph in their interest Articles to deny relief from withholding tax in such cases. If you suspect the \`real' source of the loan is elsewhere and the intermediate country being used has a treaty with an appropriate paragraph, treaty shopping needs to be considered. However arguments in this area may be difficult and you are encouraged to consult International Division when considering a challenge.   
There are various provisions in ICTA88/S209 which provide for reclassification of interest as a distribution.   
For example if the interest rate exceeds a reasonable commercial rate, Section 209(d) may apply (see CT1550 and CT1552). If the security can be converted into shares or their measure is dependant on the results of the company's business, for example, all the interest is a distribution under Section 209(2)(e) (ii) or (iii). For any of these provisions to apply, the borrowing does not have to be from a connected party.   
For guidance on the equity note provisions, which cover very long duration loans or where the duration is indefinite, see ITH1249. \`Repayment on demand' borrowings are not within these.   
If the amount of the interest is excessive for any reason, the provisions of ICTA88/S209 (2)(da) may bite, and interest be wholly or partly reclassified as a distribution.   
The most common consideration here is thin capitalisation. But you should also consider whether the borrowing would have taken place at all if the parties had been unconnected, e.g. because there is no business purpose, or it is part of an avoidance scheme. The legislation is very broad and a good outline of the considerations is given in Tax Bulletin issue17B as well as in ITH1215 and ITH1221 - ITH1223.   
Borrowing capacity is usually decided by looking at the consolidated position of the United Kingdom group of companies to which the borrower belongs.   
Even if ICTA88/S209 (2)(da), does not apply, if the interest is excessive we may be able to deny relief from full withholding tax, so that this is still due under Section 349(2)(c). The interest Article in the double taxation agreement concerned must have a \`special relationship' clause (DT1917) which is not confined to considering only \`the debt-claim' actually made. If this is the case, then the considerations to determine whether interest is excessive mirror those where Section 209(2)(da) applies. A \`special relationship' can extend beyond a common shareholding and if it is suspected some other sort of bond may come within the definition International Division 4/5, Melbourne House should be consulted.