Transfer pricing: the main thin capitalisation legislation: Removal of disallowed interest from obligation to deduct tax
Claims relating to TIOPA10/S187 (previously ICTA88/Sch 28AA Para 6E)
Compensating adjustments generally apply to UK - UK lending only, since HMRC has no influence over the recognition of profits by foreign parties. However, there may still be a benefit to an overseas company which is lending cross-border to the UK in making a compensating adjustment claim, if non-arm’s length interest costs have been disallowed in the borrower’s tax computation, since a claim under S174 or S182 (INTM413140) acts as a gateway to S187. S187 then explicitly says that the non-arm’s length amount of interest is not subject to the withholding regime at Part 15 of ITA 2007, specifically ITA07/S874.
Where the UK borrower makes payments of yearly interest to an overseas lender, it is obliged (in most circumstances) to deduct income tax at the basic rate, under the provisions of ITA07/S874. This applies even if those interest payments have been disallowed in the UK borrower’s tax computation, because they remain interest.
Unlike ICTA88/S209(2)(da), neither TIOPA10/S152 nor ICTA88/SCH28AA/PARA1A has provision for re-characterising non-arm’s length interest as a distribution, so whatever interest is disallowed remains interest.
A clearance application under a suitably-worded Double Taxation Agreement or the EU Directive on Interest & Royalties can override or modify the terms of ITA07/S874, but only in respect of the arm’s length amount of interest. The obligation to deduct income tax from non-arm’s length interest will not be affected by an application for treaty benefits, though since thin capitalisation is not usually considered at the treaty application stage, interest which is disallowed for CT purposes ceases to be subject to clearance.
This interest is likely to have been previously subject to a successful application to pay at the treaty rate (usually nil withholding tax). Some time later, the disallowance of interest for CT purposes reclassifies the interest as non-arm’s length and removes the clearance, which means that the payer is once again obliged to withhold tax. Unless successful claims are made under either TIOPA10/S187 or S192, it will be necessary to recover income tax on the interest payments made for any period which are now regarded as non-arm’s length.
TIOPA10/S187 removes the obligation to deduct income tax from non-arm’s length payments of yearly interest to overseas lenders by removing such interest from:
- the charge to tax on interest (Chapter 2 of Part 4 of ITTOIA 2005);
- the loan relationship legislation (Part 5 of CTA 2009); and
- the requirement to deduct income tax at source (Part 15 of ITA 2007, specifically ITA07/S874).
The criteria for TIOPA10/S187 to operate
In order for TIOPA10/S187 to take effect, certain conditions must be met:
- interest is paid under the actual provision;
- the actual provision differs from the arm’s length provision;
- the amount of interest allowed as a deduction is reduced by virtue of replacing the actual provision with the arm’s length provision; and
- because of the mismatch between actual interest received by the lender, and the arm’s length interest deducted by the borrower, a Section 174 (Para 6) or Section 182 (Para 6C) claim may be made.
As the final bullet in the above list of conditions shows (taken from TIOPA10/S187(5)), TIOPA10/S187 is an extension of a compensating adjustment claim, and does not require a separate or specific claim. It will take effect when a Section 174 or 182 claim has been made (as long as all the other criteria listed above have been met).