INTM561000 - Thin capitalisation: FA2004 legislation - main changes to the thin capitalisation legislation

The UK legislation to be applied in cases of thin capitalisation of a UK borrower has been amended with effect from 1 April 2004.

For a definition of thin capitalisation and an explanation of the legislation applying up to 31 March 2004, please see INTM541000 et seq.

With effect from 1 April 2004 the legislation at ICTA88\S209(2)(da) and ICTA88/S209(8A) – (8F) has been repealed, although some of the provisions of ICTA88/S209(2)(da) have been preserved in the extended ICTA88/SCH28AA, as an aspect of the UK’s transfer pricing legislation.

The main effect of these changes is that loans which are wholly within the UK are now subject to the transfer pricing legislation. This follows the repeal of sub-paragraphs 2-5 of ICTA88/SCH28AA/PARA5, which had previously excluded from the application of the UK’s transfer pricing legislation loans where the recipient was within the charge to UK corporation tax in respect of those payments.

Thus, with effect from 1 April 2004, excessive interest on a loan between two UK companies is to be disallowed in arriving at the assessable profits or allowable losses of the borrower under the provisions of ICTA88/SCH28AA/PARA1A. There is provision for a compensating adjustment to be claimed under paragraph 6C so that the lender is not taxed on the excessive interest on the loan. These changes are explained at INTM562040.

There is no equivalent in the new legislation to the concept of a UK borrowing unit which extends beyond the borrower, as was the case under ICTA88/S209(2)(da) by virtue of ICTA88/S209(8). This means that the borrowing capacity of a UK company must be assessed on a stand alone basis, disregarding any relationship with other group companies, as explained at INTM563010. This is the case even where there are guarantees provided by those companies. Thus a UK company may suffer a restriction in interest deductions where a fellow UK company guarantees a loan either from a third party or an overseas group company. On the face of it this represents a substantial change in the thin capitalisation legislation. However, in cases where a loan to a UK company has been provided on the strength of a guarantee from another UK company or companies, a compensating adjustment may be claimed by or on behalf of the guarantor company or companies under paragraph 6D. This means that the guarantor company or companies can be treated as if it/they rather than the actual borrower had taken out the loan and paid the interest on it and may deduct the respective interest payments. See INTM563020 for further details.

Finally, the new legislation provides for a claim to be made under ICTA88/SCH28AA/PARA6C for exemption from the deductions at source obligation in ICTA88/S349 in respect of excessive interest (see INTM565000).