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HMRC internal manual

International Manual

Transfer pricing: the main thin capitalisation legislation: Potential UK tax advantage

Smaller profits or bigger losses

In addition to establishing that the basic precondition (TIOPA10/S147) and the participation condition (TIOPA10/S148) are met (INTM412020), the transfer pricing legislation requires consideration as to whether the actual provision confers a potential advantage in relation to United Kingdom taxation on one or both of the affected persons.

TIOPA10/S155 (previously SCH28AA/PARA5(1)) defines “potential advantage” in relation to UK taxation by considering whether the actual provision produces a tax advantage when compared to the provision which would have been agreed at arm’s length. The legislation applies where the tax advantage has one or both of the following effects on a person in relation to UK taxation for any chargeable period:

  • that a smaller amount (which may be nil) would be taken for tax purposes to be the amount of the person’s profits for any chargeable period.
  • that a larger amount (or, if there would not otherwise have been losses, any amount greater than nil) would be taken for tax purposes to be the amount for any chargeable period of any losses of the person.

Transfer pricing, and therefore thin capitalisation, looks to charge the right amount of tax on the right person in the right country. It seeks to ensure that, for tax purposes, the profits from a transaction or series of transactions are calculated on an arm’s length basis and are taxed on the appropriate persons in the appropriate jurisdictions. Accordingly, if the UK Exchequer stands to receive less tax from a provision than it should, because

  • the transaction took place between connected persons, and
  • the actual provision conferred a potential advantage

then S147(5) (previously SCH28AA/PARA1(2)) applies to adjust the tax computation of the advantaged company or companies to deny the tax advantage.

The arm’s length provision is only substituted for tax purposes when there is a potential advantage in relation to UK taxation, as defined in the first set of bullet points above, so the thin capitalisation legislation - as with transfer pricing more generally - operates as a ‘one way street’: the legislation can only apply to increase the taxable profits or decrease the allowable losses in the UK. The test, however, is to establish whether the actual provision is the same as the arm’s length provision, not to assume that it is not.

Further guidance on the meaning of tax advantage for transfer pricing is at INTM412020.

When to enquire into a potential tax advantage

There may be a time difference between interest being debited to the accounts and actual payment being made, which can create a dilemma about when is the appropriate time to raise thin cap enquiries. There is sometimes a gap of several years between the first debit to the P&L account and the first interest payment on a loan. The word “potential” and the terms of HMRC’s enquiry powers means that there is a choice as to whether to wait until a provision has a tax effect, or to enquire more closely to the “real time” of when provisions are first put in place, while memories are fresher. If enquiries are needed, preferably their timing can be agreed between the parties who will be involved.