Transfer pricing: the main thin capitalisation legislation: UK-UK thin capitalisation
The scope of thin capitalisation legislation
Since April 2004, transfer pricing has applied as much to transactions between two or more connected UK companies as to cross-border transactions involving the UK and other countries, if the basic conditions and relationships explained starting at INTM412020 are present.
Where UK-UK transfer pricing differs from cross border is that if a transfer pricing adjustment arises from a loan or a guarantee between two UK persons, there is a possibility that the other party may be entitled to claim an adjustment which compensates for the disallowance. Compensating adjustments for loans and guarantees between companies are covered in TIOPA10/Part 4 Chapters 4 and 5 and discussed in more detail from INTM413140.
An overseas company can apply to have disallowed interest taken out of the withholding tax regime (see INTM413150), but would need to apply for competent authority involvement where computational adjustments were concerned.
From a UK group perspective, where a transfer pricing adjustment under TIOPA10/S147 is matched by a compensating adjustment, the UK tax position will be the same before and after the adjustments. However, this outcome is not always certain, and claims require critical examination, since potential guarantors may not have the spare borrowing capacity between them to allow them to absorb all of the borrower’s excess debt and interest costs.
An example of where UK-UK loans might present a real tax risk would be where a UK group company which has losses that are no longer available for group relief, provides a loan to a profitable fellow UK group member. A deduction for interest which is in excess of the arm’s length amount can, in effect, transfer the benefit of that loss relief to another company which is able to use it. The borrower’s increased interest deductions are tax effective in reducing its taxable profits while the lender’s higher interest receipts have no tax effect because they are absorbed by its accumulated losses. The UK group thereby gets the benefit of losses which would otherwise have been of restricted use. In these circumstances, the transfer pricing legislation will be applied to deny a deduction on the excessive interest.