INTM541020 - Introduction to thin capitalisation (legislation and principles)

Importance of arm's length principle

In order to determine whether a UK company (or a group of companies) is thinly capitalised, it is necessary to:

• ascertain how much the company or companies would have been able to borrow from an independent lender (the arm’s length amount), and
• to compare this with the amounts actually borrowed from group companies or with the backing of group companies.

A comparison can then be made between the interest payable on the actual debt and that which would be payable on the amount which could and would have been borrowed at arm’s length. Deductions for corporation tax purposes can be limited to those on the latter amount.

The UK tax authorities rely on the arm’s length principle to enable them to define excessive debt. The arm’s length principle is an important concept in UK transfer pricing legislation (see INTM431030). In the context of thin capitalisation the application of the arm’s length principle requires an Inspector to form a judgement as to what amount of interest-bearing debt the company or companies could - and would - have borrowed on a standalone basis from a third party lender who was entirely unconnected with that company or group of companies. Having formed this judgement, the Inspector must then compare that level of debt with the level of debt which the same borrower has obtained from a related party, typically another group company, or from a third party but with the backing of other group members by way of a guarantee or other form of comfort. The interest payments which can be deducted in arriving at profits assessable to corporation tax will then be limited to those on the non-excessive or arm’s length debt.

By contrast with the UK’s approach to defining excessive debt, some other countries have what is described as safe harbour legislation, whereby excessive debt is defined as borrowing which exceeds a statutorily prescribed limit (see INTM581010). This approach has certain administrative advantages for taxpayers and for tax administrations. However, there is an element of arbitrariness in defining for tax purposes acceptable and non-acceptable levels of debt by way of a statutory maximum level applicable to all taxpayers, and such an approach does not replicate the processes which an independent lender would follow when deciding how much he would be prepared to lend to a particular borrower. This is the main reason why the UK does not endorse the concept of statutory safe harbours and Inspectors should not accept that any safe harbours are applied in practice.

For the purposes of the UK rules on thin capitalisation it follows that a separate evaluation has to be made of the borrowing capacity of each borrower on the occasion of each separate loan. See INTM544060 for details as to what constitutes a ‘UK borrowing unit’.

In respect of interest payments made on or after 1 April 2004 the UK grouping rules are not retained but in practice much the same effect is preserved for inward loans through the operation of the guarantee rules (see INTM563050).