INTM541030 - Introduction to thin capitalisation (legislation and principles)

Tax effects of different methods of funding I

A company will typically be funded at arm’s length by a mixture of equity capital and debt capital. The precise balance between equity and debt will depend upon a number of commercial considerations, including the nature of the particular business, and will vary from time to time throughout the life of a company. Tax considerations may have a bearing, however, and this is because the returns on equity and debt are treated differently for tax purposes.

The return on equity investment is normally a dividend, whereas the return on debt is normally in the form of interest. See INTM541040 for an illustration of the tax effects of different methods of funding.

The UK’s tax legislation allows a deduction in arriving at profits assessable to corporation tax for interest paid whereas no deduction is allowable for dividend payments which are distributions of profit and not expenses of earning profits. This difference in tax treatment makes investment using debt capital tax-efficient, provided there are profits out of which interest can be paid, especially for multinational enterprises where funding can be provided intra-group with the interest being received by another group company. Intra-group borrowing is neutral from a consolidated worldwide standpoint. Such groups may therefore seek to maximise the amount of lending by way of debt as opposed to equity finance in tax jurisdictions where it is beneficial to them to do so.

A further advantage of intra-group cross-border lending is that it offers the potential to benefit from asymmetries between different tax regimes. A multinational group may receive a deduction for interest payable in one territory whereas the corresponding receipt may be taxed as something other than interest (typically a dividend) in another regime, or it may even escape tax altogether. This is often known as tax arbitrage. See INTM509130 - INTM509140 for further details. The UK now has specific legislation dealing with tax avoidance through arbitrage at F(No2)A05/S24-31 & SCH3. Draft guidance is available on the HM Revenue & Customs website which will be consolidated into the International Manual early in 2007.

Another way in which multinational groups may seek to maximise relief for interest payments is by arranging for them to be deducted in a high or normal tax rate territory and for the corresponding interest receipts to be taxed in a lower rate territory, such as a tax haven or shelter, although there will normally be withholding tax suffered on such payments (see INTM542010).

In addition to the different treatment for tax purposes of interest and dividends, the UK has generous rules for the application of interest deductions, both before and after the corporate debt legislation. One reason for this is that the UK has no sourcing rules for interest, which means that interest deductions can be given against income generally, not just against income generated by the money borrowed. So, for example, a UK company can borrow to finance a subsidiary company in another territory and the interest may be allowable notwithstanding the fact that no taxable income may arise for a number of years, if at all, from the investment in the subsidiary company. In some countries, such as Australia, deductions for interest payments can only be given when those payments can be matched against the income stream arising from the particular investment.

An exception to the absence of sourcing rules in UK legislation applies in the case of oil companies. See OT21001 and OT22001 for details of the operation of the ring fence oil tax regime and the corresponding restrictions on interest expenditure by oil production companies. The operation of ring-fence legislation is the responsibility of the Large Business Service, Oil & Gas.