INTM581010 - Thin capitalisation: practical guidance -comparison of lending in the UK with other countries: Thin capitalisation rules in different jurisdictions

Examining the approaches of tax administrations to their own thin capitalisation rules may provide some clue as to the attitudes of that country’s lenders. The line which the fiscal authority takes may be presumed to be broadly aligned with the acceptable financial ratios of the particular country. In the UK for example, with a few notable exceptions, the debt:equity ratios of the companies in the Financial Times Stock Exchange (FTSE) 200 top companies are significantly less than 1:1, and whenever a major company exceeds what may be regarded as the norm it may come under shareholder pressure to reduce its debt. Commentators will quickly point out any weakening in the financial structure.

On the other hand, there is an international market for the lending of money, and the types of companies which are reviewed by HM Revenue & Customs (through advance agreement application or through HMRC enquiry) are likely to have a wider market available to them than the UK. The UK bond market, for example is relatively small. It may be better to consider what options might be available to the company under review, according to its funding requirements, preferred interest and repayment options, and means of access to funds, rather than to take a narrow territorial approach.

This does mean that third-party loans raised outside the UK by other group members and passed on to the UK subsidiary or affiliate will not necessarily represent arm’s length terms for the UK borrower; quite apart from having to consider (and adjust for) the probable greater borrowing power of these group companies, there is the question of whether it would be appropriate for the UK borrower to seek finance in the market in which the loan was raised.

The UK does not have ‘safe harbours’ with regard to financial ratios that measure companies’ capitalisation, but some other countries do. Other countries rely on transfer pricing legislation, with no statute specifically to deal with thin capitalisation. The table below gives some examples.

Financial rules adopted by various countries as thin capitalisation rules


Country

Limitation

Comments

Australia

Debt:equity 3:1

In 2002, Australia’s thin capitalisation regime changed substantially, bringing in lengthy and complex legislation.

  • A ‘safe harbour’ debt amount has been introduced, with an alternative “arm’s length” test which can potentially increase the permissible interest
  • Exceptions made for certain financial businesses - authorised deposit takers
  • Interest in excess of the prescribed level is denied as a deduction. However, it is fully deductible if the company satisfies the arm’s length test.

The Australian Tax Office has a well-organised and accessible website, with good search facilities.

Germany

Limit to deductibility of interest (30% of income)

The legislation was substantially revised in 2008

  • Interest deductibility is limited to 30% of taxable income before interest, taxes on income, depreciation and amortisation.
  • There are exceptions for low interest expense, and where interest paid to any one shareholder falls within limits.
  • Previously Germany had a widely available safe harbour: a debt:equity ratio of 1.5:1

France

Interest limitation by ref to third party rates

Arm’s length measure for interest rate

Debt:equity 1.5:1

25% interest: operating income ratio

A new system was applied from January 2007, applying limitations between related parties, and bringing in the arm’s length measure.

Interest rate limitations:

  • deduction limited to an average of rates charged by lending institutions, or
  • the interest rate that the debtor company could have obtained from a third-party lender

and

Debt-based limitations:
  • overall indebtedness (debt:equity ratio), and

Disallowed interest can be carried forward indefinitely at group level, but will be reduced annually by 5% from the second year after the expense was incurred. There is no differentiation between types of companies.

Companies are considered on a stand alone basis.

Certain financial businesses and transactions are excluded.

Japan

3:1
  • Japanese thin capitalisation rules were revised in 2006.
  • A debt:equity safe harbour rule applies to foreign-owned corporations
  • The 2006 rules extend this to third parties where foreign corporations guarantee the borrowing

    • China

    Financial 5:1

    Non-Financial 2:1

    China introduced thin capitalisation legislation for the first time late in 2008.

    • Two safe harbour ratios have been set, one for financial industry enterprises, one for non-financial.
    • If these ratios are breached, it appears that the taxpayer will still have the opportunity to try to demonstrate that the transaction is still consistent with the arm’s length principle.

     

    USA

    1.5:1

    The US “earnings stripping rules” currently include a restriction on interest paid by a corporation to related persons, if the corporation has:

    • A debt-to-equity ratio exceeding 1.5:1, and
    • A net interest expense exceeding 50% of the company’s adjusted taxable income. This is likely to be tightened, probably to 25%

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