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HMRC internal manual

International Manual

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Transfer pricing: the main thin capitalisation legislation: Treatment of interest when it is paid

Disallowance of interest

Where HMRC has identified interest as non-arm’s length because the borrower is thinly capitalised, Part 4 of TIOPA10 simply disallows the non-arm’s length element in the borrower’s tax computation.

The disallowed interest remains interest for tax purposes, which means that unless the interest paid falls into an exempt category, for example it is payable on a qualifying Eurobond - (see CTM35218), the provisions of ITA07/S874 apply:

(1) This section applies if a payment of yearly interest arising in the United Kingdom is made—

(a) by a company, 

(b) by a local authority, 

(c) by or on behalf of a partnership of which a company is a member, or 

(d) by any person to another person whose usual place of abode is outside the United Kingdom. 

(2) The person by or through whom the payment is made must, on making the payment, deduct from it a sum representing income tax on it at the savings rate in force for the tax year in which it is made.

The disallowed amount will have lost any treaty clearance it may have had, and the withholding obligation is reasserted.

This contrasts with pre-2004 treatment, where “excessive” interest which was disallowed under the thin cap legislation at ICTA88/S209 was reclassified for tax purposes as a distribution and tax treatment would be consistent with that recharacterisation.

However, as an extension of the compensating adjustment legislation, TIOPA10/S187 may apply to remove the non-arm’s length interest from the charge to income tax. See INTM413150.