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HMRC internal manual

International Manual

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Transfer pricing: the main thin capitalisation legislation: Interest which exceeds the arm’s length amount

A transfer pricing adjustment (including a thin capitalisation adjustment) is made when the actual provision between connected persons differs from what would have been agreed between the parties at arm’s length, and creates a potential tax advantage (see INTM412020).

Confusion has in the past sometimes arisen over what aspects of lending HMRC may enquire into. This relates to what may be questioned in the course of looking at the clearance application, and with the separation of the treaty clearance and thin cap processes it should not arise as an issue. It does not affect transfer pricing enquiries linked with a return or Advance Thin Capitalisation Agreement application.

Depending on the wording of the relevant double taxation agreement, it may be possible to question all aspects of the lending for the purposes of the treaty clearance, but a small number of treaties preclude tax authorities from looking at any loan terms except for the rate of interest. These more restrictive treaties follow the wording of Article 11(6) of the OECD Model Tax Convention, which says:

Where, by reason of a special relationship between the payer and the beneficial owner or between both of them and some other person, the amount of interest, having regard to the debt-claim for which it is paid, exceeds the amount which would have been agreed upon by the payer and the beneficial owner in the absence of such relationship, the provisions of this Article shall apply only to the last-mentioned amount.’

“Having regard to the debt claim for which it is paid” is taken to mean that the actual debt claim is a given, not to be questioned, except that the treaty gives authority to question “the amount of interest” i.e. the rate at which it is charged, but not the other terms and conditions.

Most treaties have much wider scope. For example, the USA/UK treaty has this wording at Article 11(5):

Where, owing to a special relationship between the payer and the person deriving the interest or between both of them and some other person, the amount of the interest paid exceeds for whatever reason the amount which would have been paid in the absence of such relationship, the provisions of this Article shall apply only to the last-mentioned amount. In that case, the excess part of the payments shall remain taxable according to the law of each Contracting State, due regard being had to the other provisions of this Convention.

“Exceeds for whatever reason” allows consideration of all terms and conditions of the loan.

Whichever wording is used, these are treaty terms connected with determining the arm’s length interest on which treaty clearance may be given.

When it comes to the application of transfer pricing legislation for income tax or corporation tax purposes, under TIOPA10 or ICTA88/SCH28AA, all terms and conditions may be considered, whatever individual treaties say. At this stage, it is a matter of domestic legislation concerning profits subject in most cases to corporation tax.