INTM508060 – Intra-group Funding: 'thinning out'

How to tackle 'thinning out'

There are a number of different ways of tackling 'thinning out' depending on the facts and circumstances. All thinning out cases should be referred to the Thin Cap/Arbitrage Group at CT & VAT, International CT before a serious challenge is made.

For accounting periods commencing on or after 1 April 2004

ICTA88/SCH28AA Para 1A

FA 2004 brought the thin capitalisation legislation within SCH28AA and imposed transfer pricing considerations to intra-group transactions wholly within the UK . For full details see INTM560000 onwards.

Charging income tax on the recipient

Payments of yearly interest out of the UK are subject to UK income tax of 20% unless the non-resident recipient is entitled to a reduction in the UK’s tax charge by virtue of the interest article provision of a relevant double taxation agreement. Many treaties have an interest article which ordinarily reduces to nil our right to tax non-residents’ interest receipts from the UK. However, most interest articles will also contain a special relationship clause (article 11.6 of the OECD Model Tax Convention), which can have the effect of denying the treaty benefit (and therefore reinstating the UK’s right to withhold and retain tax) where the interest exceeds what would have been paid in the absence of the special relationship. The way in which this special relationship provision operates is further clarified by ICTA88/S808A. Please consider the guidance above in the context of ICTA88/209 and the OECD commentary on Article 11.6 of the OECD Model Tax Convention.

Upstream loans

Where UK multinationals use upstream debt (loans from subsidiary companies) to thin out their UK tax base, you need to bear in mind the following considerations

• For accounting periods ending before 1 April 2004 ICTA88/S209(2)(da) can apply to cross-border payments by fellow subsidiary companies in a UK-owned multinational group
• in these circumstances ICTA88/S209(2)(da) will generally apply only where the debt 'would not' (as opposed to 'could not') have been taken at arm’s length
• ICTA88/S209(2)(da) cannot apply if the company paying the interest is not a 75% subsidiary of another company (either in the UK or elsewhere). The use of this aspect of the distributions legislation is therefore unavailable where interest is paid by the top company of a UK-owned group or multinational
• it is also important to consider whether the profits of the recipient of the upstream loan interest are caught by the Controlled Foreign Companies legislation ( see guidance at INTM201000 onwards).

For advances made or interest paid in accounting periods commencing on or after 1 April 2004 ICTA88/SCH28AA/Para 1A applies. For details see INTM560000 et seq.

Avoidance schemes

For avoidance schemes involving thinning out, specific anti-avoidance legislation may be applicable (for further guidance see INTM509000 onwards).

For accounting periods commencing on or after 1 July 1999

ICTA88/SCH28AA

ICTA88/SCH28AA operates in a very similar way. Furthermore, it is clear that transactions that would not have happened at all at arm’s length are to be ignored (see ICTA88/SCH28AA/PARA1(3)) with the result that the associated interest costs are not relievable. On this point you need to be aware of a potential restriction on the application of ICTA88/SCH28AA by virtue of the OECD Transfer Pricing Guidelines. For further information see the discussion of the issues surrounding 'recognition of the actual transactions undertaken' at paras 1.36-1.41 of the OECD Guidelines.

For accounting periods commencing before 1 April 2004

ICTA88/S209(2)(da)

ICTA88/S209(2)(da) applies to recharacterise as a distribution finance costs which represent an amount which would not have fallen to be paid to the other company in the absence of the requisite connection between borrower and lender. The test is much more than looking at the borrowing company’s circumstances and determining its debt capacity (that is, the maximum amount that it could borrow). And it is certainly not enough for a company to prove that an independent lender would be prepared to advance the sums on the agreed terms. The legislation requires you to consider whether or not the company’s actions are commercially credible by reference to what you would expect at arm’s length. If at arm’s length the company would not have borrowed the funds, the interest falls to be recharacterised as a distribution.

ICTA88/S209(8B) permits you to take into account

• the appropriate level or extent of the issuing company’s overall indebtedness
• whether it might be expected that the issuing company and a particular person would have become parties to a transaction involving the issue of a security by the issuing company or the making of a loan, or a loan of a particular amount, to that company
• the rate of interest or other terms that might be expected to be applicable in any particular case to such a transaction

ICTA88/209(8A) provides for the factors at ICTA88/S808A - which deals with the application of the 'special relationship' provision in the Interest Article of Double Tax Agreements ('DTAs') - also to be taken into consideration when applying ICTA88/209(2)(da). ICTA88/S808A(2) states that the special relationship provision shall be construed as requiring account to be taken of all factors, including

• whether the loan would have been made at all in the absence of the relationship
• the amount which the loan would have been in the absence of the relationship
• the rate of interest and other terms which would have been agreed in the absence of the relationship.