Transfer pricing: the main thin capitalisation legislation: Introduction
Recent legislative changes
This chapter looks at the circumstances in which the thin capitalisation legislation applies, to whom it applies, and how it applies.
Since 2004, thin capitalisation has been within the main transfer pricing legislation now located at Part 4 of the Taxation (International and Other Provisions) Act 2010 (TIOPA10), previously at ICTA88/SCH28AA. TIOPA10 is effective for accounting periods ending on or after 1 April 2010. This guidance uses TIOPA10 throughout, with reminders of the previous legislation.
An explanation of the legislation which applied up to 31 March 2004 starts at INTM413250.
It is worth a quick reminder of the 2004 changes:
- Disallowed interest is no longer recharacterised as a distribution for tax purposes, but remains interest, with consequences for the withholding tax regime (see INTM413150).
- Loans which are wholly within the UK are now subject to the transfer pricing legislation, and this can give rise to double taxation within the UK. To try to eliminate this, a means of claiming compensating adjustments was also introduced (see INTM413130).
- The way that the borrowing capacity of the borrower is measured changed. The old measure of borrowing capacity was defined by ICTA88/S209(8D), which is further explained in INTM413240. The current position is set out in INTM413070.
The general transfer pricing legislation is applicable to thin capitalisation. The main sections of relevance to thin cap are:
- The basic pre-condition set out in TIOPA10/S147 (INTM412020)
- The participation condition set out in TIOPA10/S148 (INTM412020)
- The requirement that the provision under consideration gives rise to a potential UK tax advantage: TIOPA10/S155 (INTM413050)
- That the provision can be made up from a single transaction or a series of transactions TIOPA10/S150 (INTM413060)
- The requirement that the UK’s transfer pricing legislation should be interpreted in accordance with OECD principles, set out in TIOPA10/S164. The UK’s basic transfer pricing rule at Chapter 1, Part 4 of TIOPA10, is based on Article 9 of the OECD Model Tax Convention. There is more detail on this at INTM412020.
Recognising economic substance
Paragraph 1.65 of the OECD Transfer Pricing Guidelines is particularly helpful in finding the appropriate approach towards the arm’s length provision in thin capitalisation cases. This says that the basic transfer pricing approach considers economic substance versus form in thin capitalisation cases:
“[In cases] where the economic substance of a transaction differs from its form… the tax administration may disregard the parties’ characterisation of the transaction and re-characterise it in accordance with its substance. An example of this circumstance would be an investment in an associated enterprise in the form of interest-bearing debt when, at arm’s length, having regard to the economic circumstances of the borrowing company, the investment would not be expected to be structured in this way. In this case it might be appropriate for a tax administration to characterise the investment in accordance with its economic substance with the result that the loan may be treated as a subscription of capital.”
This means that where a borrower obtains an actual loan of £100m from a non-arm’s length source, but would only be able to borrow £60m at arm’s length, the tax deduction for the interest costs should be restricted to those accruing on £60m of the £100m actually borrowed. The balance would have had to be provided in some other form, most likely as equity. This is an explanation, not a literal recharacterisation in the way that excessive interest was once reclassified as a distribution for tax purposes (see INTM413260). Debt which is found to be excessive may be treated as equity for the purposes of a thin cap analysis, but the interest on the £40m excess remains interest for tax purposes; it is simply disallowed in the computation.
There will be variations in the way debt is treated as equity. There may be negotiations which result in an amount of debt being recognised as serving an equity function, as if that debt had actually been permanently converted into equity, but there will be other instances, for example the application of a debt: equity ratio in an advance agreement, where equity will in effect vary from year to year.
This sort of “recharacterisation” should be uncontroversial, assuming the level of disallowance is agreed. It is a case of finding an explanation, should one be needed, for the presence and treatment of funds that have been deemed “excessive” as debt in thin cap terms. However, if the argument goes further, for example towards saying that the loan transaction would not have taken place at all and something different would have happened at arm’s length, it is recommended that the matter be discussed with Business International before the case is developed,
It is important to remember that thin capitalisation considerations are not limited to determining simply the amount which would have been borrowed at arm’s length, but also extend to the other terms attached to the actual provision, such as the interest rate, duration and repayment terms. Any of these is capable of creating or extending a tax advantage for the UK borrower.
Order of precedence
TIOPA10/S155, which defines “potential advantage” in relation to UK taxation, says that for the purposes of working out whether there is a tax advantage, the following shall be disregarded:
- Part 7 - the world-wide debt cap legislation
- Para E of the list in CTA10/S1000(1) (excessive interest etc treated as a distribution). Para E includes Sections 1005 to 1014 (meaning of “non-commercial securities” etc) and Section 1114(1). This includes matters such as securities at more than a commercial rate of return.