INTM565000 - Thin Capitalisation: FA2004 legislation - obligation to deduct tax

A payer of interest may be obliged to deduct tax at source under the provisions of ICTA88/S349, although an application under a double taxation agreement may reduce or eliminate the tax deductible. However, where interest is denied as a deduction in arriving at the assessable profits or allowable losses of the borrower under ICTA88/SCH28AA, the legislation at ICTA88/SCH28AA/PARA6C provides for a compensating adjustment to be made on behalf of the lender to enable payment to be made without deduction of tax.

The combination of the ICTA88/SCH28AA/PARA1 disallowance and the compensating adjustment claim under paragraph 6C causes the borrower and lender to be taxed as if the excessive interest had not been paid or received. Paragraph 6E provides that excessive interest is not chargeable to tax under Case III Schedule D so that the condition in S349 is not met, thus enabling the excessive interest to be disallowed as a CT deduction and paid without deduction of withholding tax.

ICTA88/SCH28AA/PARA6 allows a compensating adjustment claim to be made before the borrower has made its tax return. This means that a compensating adjustment claim for the part of the interest payment that exceeds the arm’s length amount can be made alongside a treaty claim for exemption from deduction at source. In such cases, and where the relevant treaty provides for a nil rate of withholding tax, the two claims together, if approved, will enable the full payment to be made gross.

There is no special form for the paragraph 6C claim but it should be made on the basis that the interest that is the subject of the claim will not be claimed as a deduction by the borrower. If the interest is deducted from taxable profits in a way that is inconsistent with the compensating adjustment claim, the claim is treated as having been amended, thereby reinstating the obligation to deduct tax at source (paragraph 6C(7) to (9)).

If a loan guarantor is treated as the borrower in accordance with paragraph 6D, the obligation to make the payment will pass to that company. Where this is the case, the actual borrower will not also have any obligation to make the payment.

If treaty exemption from the obligation to deduct tax at source is given to the lender in respect of a loan, this will release the guarantor from the obligation to deduct tax at source, in the same way as it releases the actual borrower.