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HMRC internal manual

International Manual

Thin capitalisation: practical guidance: introduction: what is thin capitalisation?

The chapter from INTM410000 onwards considers what and who is subject to transfer pricing legislation, the main part of which is at Part 4 of TIOPA 2010.

In simple terms, a UK company is thinly capitalised when it has more debt than it either could or would borrow without group support and acting in its own interests. This leads to the possibility of “excessive” interest deductions i.e. a greater quantum of finance costs than would arise if the parties to the loan were acting on arm’s length terms. This can only happen where a company is either:

  • borrowing from connected companies or
  • borrowing from third parties on the strength of group support, usually in the form of guarantees.

Thin capitalisation work involves applying the arm’s length principle to company borrowing and lending, taking into account all the terms and conditions and other factors affecting the borrowing, including the amount of debt, the interest rate, repayment terms, etc.

As part of self-assessment, companies are (subject to some exceptions - see INTM412000) required to take account of the transfer pricing when making their CTSA returns each year. This means the company is obliged to make its return in accordance with the arm’s length principle, which for finance costs means making the return as if it was borrowing on a stand-alone basis from a third-party lender, disregarding group guarantees.

The “arm’s length” amount which a company is able and willing to borrow at any given time is affected by a number of factors, including what it can offer to a lender as security, the strength of its cash flow, its appetite for risk, the state of the economy, etc.

Although the legislation puts the borrower on a stand-alone basis, separate from group support, for thin cap purposes it may broadly take into account the value of its own subsidiaries, but not that of any other group company, UK resident or otherwise, in assessing its borrowing capacity. This is the “borrowing unit”, which is in practice considered for thin cap purposes. Its exact composition and certain provisos regarding the inclusion of subsidiaries are discussed at INTM517050.

In practice, references to a stand-alone entity or a single entity approach refer to the borrowing unit, which might indeed consist of one free-standing company or it might be a UK holding company with many subsidiaries, so an early look at INTM517050 is advisable.

What makes a company thinly capitalised?

The legislation says consider “all the factors”, including some of the following:

  • The borrower is carrying a greater quantity of interest-bearing debt than it could or would reasonably sustain on its own;
  • The interest charged is in excess of the commercial rate for the loan(s) it is has borrowed;
  • The company has trouble servicing its debt (interest and repayments)
  • The duration of the lending is greater than would be the case at arm’s length;
  • Repayment or other terms are disadvantageous to the borrower, compared with what it could obtain at arm’s length e.g.
  • Debt is retained beyond the time when at arm’s length it would be repaid
  • An adverse lending climate existed at the time the loan was made.

All terms and conditions merit consideration, not just the amount of debt and rate of interest.

The arm’s length approach assumes that borrowing will be on a sustainable basis, so that the business must be able to trade, invest and meet its other obligations as well as servicing the debt. The consideration is not just what it could have borrowed, but what it would have borrowed.

The choice of debt or equity

Thin cap may occur between UK companies, but it is most likely to be a tax risk in the case of cross-border transactions involving multinational groups of companies, which may fund the UK part of the group through or with the support of the wider group. It is a largely a matter of choice how much debt and how much equity is used to fund group companies, since either way the reward remains within the group. Even where the debt is from a third party, the group can choose in which territory the cost should fall. Debt can be a basic tax-planning tool, one which is easy to use. It is relatively simple to purchase assets using debt which creates a tax deduction in the UK, rather than using equity which produces non-deductible dividends. The reward may be similar whether the form of the investment is equity or debt, but the tax consequences are not. For example:

Company funded by SHARE CAPITAL   Company funded by LOAN CAPITAL  
  £ millions   £ millions
Taxable profit 150 Profit 150
    Interest paid 100
    Taxable profit 50
Corp tax (30%) 45 Corp tax (30%) 15
Profit after CT 105 Profit after CT 35
Return to investors      
Dividend 105 Dividend 35
Interest Nil Interest 100



Tax payable is higher where the company is funded with equity rather than debt, since dividends are not deductible in arriving at taxable profits. However, as the interest charge increases, it reduces the profits available to distribute to shareholders. This means that in arm’s length situations the tax advantage of debt is counterbalanced by shareholder expectations; the company has obligations to pay dividends as well as to meet its debt costs. Where shareholder and lender are the same person or under common ownership, the form which the return on investment takes is less important.


Starting at CFM11010, the Corporate Finance Manual includes guidance on the advantages and disadvantages of borrowing vs. issuing shares. It also includes guidance on the application of International Accounting Standard IAS 32 Financial Instruments: Presentation, which deals with the question of whether a financial instrument issued by an entity should be classified as a financial liability such as debt or as equity. The fundamental principle is that on initial recognition the instrument is classified either as a financial liability or as an equity instrument. CFM21220 is a useful starting point, combined with the rules for preference shares at CFM21120, which are perhaps the most relevant in practical terms for thin cap.