Generally speaking the higher a company’s debt to equity
ratio (or gearing), the lower the corporate tax liability. This is
because returns on debt (interest, most usually) are deductible for
tax purposes whereas returns on equity (typically, dividends) are
not.
The phenomenon of increasing the proportion of debt to
equity in a UK group whilst the commercial activities remain
largely the same is known as 'thinning out'.
For foreign-owned groups, replacing UK equity with UK debt
will reduce the UK tax liability as long as the thin capitalisation
rules are not breached. But it is also possible for UK
multinationals to achieve much the same effect by 'thinning out'
their UK businesses with debt (from foreign subsidiaries, for
example).
As far as foreign-owned groups are concerned, many taxpayers
(and some advisers) believe that the UK’s thin capitalisation
legislation effectively sets a 'ceiling' or maximum amount of debt
on which the corresponding interest charges would be fully
deductible. This is too simplistic a view of the UK’s
legislation. Until it was repealed by FA 2004 ICTA88/S209(2)(da)
re-characterised as a distribution any interest payment that
represented an amount which would not have fallen to be paid to the
other company in the absence of the relevant connection. From 1
April 2004 ICTA88/SCH28AA/Para 1A applies to restrict the interest
payments to what would be paid at arms length. This does not mean
that for every business sector the arm’s length principle
determines a maximum debt to equity ratio and a minimum income
cover ratio. The arm’s length test needs to be applied to the
facts and circumstances of every situation and the behaviour of any
UK grouping needs to be tested against the type of commercially
credible behaviour that would be expected at arm’s length.
For this reason the uncommercial injection of debt into a
group’s UK operations can fall foul of the arm’s length
principle and there are various legislative measures that seek to
implement the arm’s length principle with regard to interest
and debt costs which include
The specific anti-avoidance provisions (see INTM509000 onwards) may be applicable too.
