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HMRC internal manual

International Manual

Transfer pricing: the main thin capitalisation legislation: Evolution of the thin capitalisation legislation: pre 29 November 1994

Thin cap legislation before 29 November 1994

The key thin capitalisation provision within ICTA 1988 was at S209. S209(2)(e)(iv) related to company distributions, defining a distribution as:

(e) any interest or other distribution out of assets of the company in respect of securities of the company… where the securities are-

(iv) securities issued by the company (“the issuing company”) and held by a company not resident in the United Kingdom where the issuing company is a 75 per cent subsidiary of the other company or both are 75 per cent subsidiaries of a third company which is not resident in the United Kingdom;

This meant that

  • where the borrower was a 75% subsidiary of the lender, the borrower was resident in the UK and the lender was resident elsewhere, or
  • where both the UK borrower and non-UK lender were 75% subsidiaries of another company, which was resident other than in the UK,

all of the interest payable by the borrower to the lender was treated as a distribution (INTM413050).

SICTA88/S788(3) mitigated this by giving effect to the terms of the double taxation agreement (DTA), if there was one, between the UK and the lender’s home territory. DTAs provided for the arm’s length part of the interest payment to be taxed in the recipient’s country. So, to avoid the double taxation which would occur when the UK disallowed all of the interest payable to a connected company (as defined above), that part of the interest which would have been payable at arm’s length (and taxed elsewhere) was taken outside the scope of ICTA88/S209(2)(e)(iv) and allowed as a deduction.

In this way, where there was an appropriate DTA in force, only the non-arm’s length interest would be re-characterised as a distribution, disallowed for CT purposes and charged to Advance Corporation Tax. Thus a deduction for arm’s length interest would not be denied by the domestic legislation.

DTAs followed one of two ways to interpret what could be taken into account in the arm’s length test, as explained at INTM413200.

To the discrepancy between the narrower and wider interpretations, ICTA88/S808A was enacted with effect from 14 May 1992. This broadly said that where there was a provision in the DTA relating to the existence of a special relationship between the borrower and lender, the wider interpretation would apply.

S209(2)(e)(iv) was repealed in Finance Act 1995 with effect generally in relation to any interest or other distribution paid after 28th November 1994. It was replaced by ICTA88/S209(2)(da) which became effective from the same day.