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HMRC internal manual

International Manual

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Transfer pricing: the main thin capitalisation legislation: Separate entity basis for determining borrowing capacity

The entity considered for thin capitalisation evaluation

The separate entity principle is part of the basic precondition in TIOPA10/S147(1)(d). This defines the arm’s length provision as that “which would have been made as between independent enterprises”. The arm’s length borrowing capacity of the borrower is therefore the debt which it could and would, as a stand-alone entity, have taken on from an independent lender. To establish this, it is necessary to consider the borrower separately from other members of the same group of companies This is the “separate entity” or stand-alone basis for determining borrowing capacity.

This approach is derived from OECD Transfer Pricing Guidelines, as expressed in paragraph 1.6 of the Guidelines:

By seeking to adjust profits by reference to the conditions which would have obtained between independent enterprises in comparable transactions and comparable circumstances, the arm’s length principle follows the approach of treating the members of an MNE group as operating as separate entities rather than as inseparable parts of a single unified business. Because the separate entity approach treats the members of an MNE group as if they were independent entities, attention is focused on the nature of the dealings between those members.

The “borrowing unit”

The main impact of the “separate entity” basis for determining borrowing capacity is that no account is taken of any guarantees, explicit or implicit, from connected companies (INTM413130). However, it is recognised that, without offending the “separate entity” principle, negotiations with a third party lender would include an assessment of the financial strength of the borrower. This would take into account the income, assets and liabilities of the company, but also of its subsidiaries. In broad terms, this will be based on the strength (or otherwise) of the borrower’s consolidated balance sheet and profit and loss account, subject to some analysis of what underlies the figures on the face of the accounts. This grouping is known as the “borrowing unit”.

HMRC follows a practical approach and, if consolidated accounts are not drawn up as a matter of course, will request a consolidated presentation of the relevant figures. The borrower is not obliged to produce audited consolidated accounts purely for HMRC, so properly drawn up schedules reflecting the consolidated position will be acceptable. This may not be a straightforward task if the exercise embraces companies resident in a number of countries and using a variety of accounting conventions. In such cases it may be helpful to discuss how HMRC may be satisfied without creating major expense and difficulty.

There may be companies that need to be excluded from the consolidation and dealt with according to their own characteristics e.g. finance companies which are likely to have higher proportions of debt to equity than ordinary trading companies. Some subsidiaries may need to be excluded altogether e.g. companies with a dividend block, which a lender might not recognise as assets against which they would be willing to lend. This whole question must be viewed pragmatically.

Further practical guidance on the separate entity measure of borrowing capacity is at INTM542050. The next page gives some background on the pre-2004 treatment; this shows the contrast between the previous statutory approach to the borrowing unit with the practical, analytical approach which has been adopted to deal with the separate entity basis.

UK companies under common ownership with the borrowing unit may be able to make a compensating adjustment claim if they have spare borrowing capacity. See INTM413160 on the conditions for making a TIOPA10/S192 claim.