Transfer pricing: the main thin capitalisation legislation: Overview
Definition of thin capitalisation
In the commercial world, a company is said to be thinly capitalised when it has more debt than equity, and many thin cap cases boil down to a company with more debt than it could and would have borrowed on its own resources, because it is borrowing either from or with the support of connected persons.
However, the amount of interest payable may be excessive for one or more reasons - interest rate, excessive duration of lending, restrictions on repayment, etc - so all terms and conditions should be considered in a thin capitalisation review. Other less obvious issues of possible interest are the appropriateness of the currency of the loan (e.g. forex risk) and the presence of guarantees. For HMRC, thin cap means looking at every aspect of lending and borrowing from a transfer pricing angle.
Other legislation on finance
There is other legislation - and this is not an exhaustive list - which may result in a restriction of the interest deduction, including:
- Arbitrage provisions - see INTM590000
- Unallowable purpose legislation - CTA09/S441-442 - see CFM38010
- Remaining provisions of pre-2004 legislation (ICTA88/S209) - now around CTA10/S1000 - such as interest in excess of a commercial rate of return - see below and CTM15502
- World-wide debt cap - Part 7 TIOPA 2010 - seeCFM90100 onwards
The first two represent anti-avoidance legislation, so the choice of applicable legislation depends on the facts and circumstances of the particular case, and transfer pricing concerns may sit alongside avoidance concerns. TIOPA10/S155(6) says that the CTA10/S1000 list and the world-wide debt cap legislation shall be disregarded when calculating the transfer pricing tax advantage. The debt cap applies after any transfer pricing adjustment has been made.
CTA09/S1000 onwards - distributions in the form of interest
While the main provision previously used to deal with thin cap, ICTA88/S209(2)(da), was repealed in 2004, much of the basis of S209 remains, dealing with payments which are interest in form but distributions in substance. These provisions are useful: they require no connection between borrower and lender, and are matters of substance and form rather than pricing. The legislation is now summarised in a list at CTA09/S1000, under the heading of “Meaning of Distribution”, followed by a schedule at S1001 which lists subsequent sections that explain or supplement these summaries. Included are:
- interest in excess of a commercial return - previously at ICTA88/S209(2)(d)
- securities that are convertible into shares - previously at ICTA88/S209(2)(e)(ii)
- interest that is dependent on the results of the borrower’s business - previously at ICTA88/S209(2)(e)(iii)
- securities that are connected with shares - previously at ICTA88/S209(2)(e)(vi)
- interest payable on an equity note issued to an associated company - previously at ICTA88/S209(e)(vii)
These are covered in the Company Tax Manual (CTM). Links within INTM to other manuals may not be “live” links, but will work as search terms on the HMRC website, and possibly on internet search engines.
How thin capitalisation arises
When a company operates at arm’s length from its sources of funding, commercial considerations drive the decision to raise funds either through debt, equity, or a mixture of the two. There is a marked difference in tax treatment between debt finance and equity, in that interest on debt is deductible from profits, whereas dividends on shares are not. This is explored in more detail in the Practical Thin Cap Guidance from INTM510000 onwards.
When a company borrows from or with the support of other group companies, funding decisions may not be driven by commercial considerations alone. The connection between the parties involved might allow them to change the way in which the funding is obtained in ways unavailable or unattractive to the borrower at arm’s length, or to take on funding risks which an independent borrower would avoid. Factors such as group policy, strategy, and tax planning will sit alongside commercial considerations.
As a result of the differences in tax treatment between interest and dividends, a company which increases its indebtedness, and thereby increases its interest payments, reduces the tax it has to pay.
Thin capitalisation is just a form of transfer pricing, and is not limited to companies, except where the legislation says so, but this guidance concentrates largely on corporate relationships.
Thin capitalisation and tax planning
As with transfer pricing more generally, thin capitalisation does not require a tax avoidance motive. The aim of applying transfer pricing legislation is to ensure that arm’s length prices are recognised for goods, services, etc, for tax purposes. However, company finance is an easy and attractive way for groups to change the jurisdiction within which profits arise, and tax planning will be an aspect of the financing plans for any major corporate acquisition.
Corporate thin capitalisation is usually seen in a group context, since it would be counter-productive (though not unheard of) for a company to increase its interest costs payable to a third party, just to reduce its tax liability. Besides, a borrower cannot borrow more (or pay more interest) than an arm’s length lender is willing to lend, unless that money is guaranteed, usually by group members. Where the borrowing is intra-group, the interest remains within the group; the group as a whole is no less profitable, but the borrower has paid less tax, and, where the lender is in a country with a lower corporation tax rate than the borrower or has losses to absorb interest received, the group can end up far better off overall. At the same time, there may be arbitrage (INTM590000) or other opportunities to further reduce tax.
With third party borrowing supported by a group guarantee, interest is paid to a third party and value leaves the group, but in that case the issue may be a matter of where it is most tax efficient for the group’s interest costs to arise. The inference is that the world-wide group has capacity to borrow but not necessarily within the UK entity, which is where it wishes to place the debt. However, guarantees, including less formal support such as a letter of comfort, can enable a company to borrow more cheaply than would be possible on a standalone basis.