INTM541040 - Introduction to thin capitalisation (legislation and principles)

Tax effects of different methods of funding II

A company will normally be funded by a mixture of equity capital ad debt capital for sound commercial reasons. However, tax considerations will normally play a part in determining the balance of debt and equity and the following example illustrates the tax effects of different methods of funding a UK company:

Equity:

• UK to be entirely funded by equity of £10 million
• Year 1: pre-tax profits £3 million

CT @ 30% = £900,000

Dividend £900,000

Debt:

• UK funded entirely by debt: £10 million @ 9% pa
• Year 1: pre-interest and pre-tax profits £3 million

Interest due £900,000

CT £2.1 million @ 30% = £630,000

This shows that funding by way of debt reduces the UK tax payable because the UK company will receive a deduction for the interest payable. Where the relevant loan is provided by a fellow group company, the interest payable will be received by that company, and from a consolidated worldwide standpoint such borrowing may be neutral, even where the interest received is taxable on the recipient. In many cases, multinational enterprises will arrange for interest receipts by fellow group companies to be taxed at a lower rate or not at all – known as tax arbitrage. See INTM509130 for details. However, the UK now has specific anti- arbitrage legislation at F(No2)A05/S24-31 & SCH3, for which the Thin Cap/Arbitrage Group at CT & VAT, International CT is responsible.