OT22050 - Interest and Financing

Gearing. Introduction

It is often the amount of debt rather than the interest rate that causes the main problems with interest deductions. In an international context a multi-national enterprise may manipulate its level of debt in a particular company in order that interest charges are used to transfer profit from one territory to another. This is one way of extending group relief across State boundaries. OTO has the same concerns on that particular issue as does any other Inspector but is also interested in the manipulation of debt levels within a company to transfer income across the ring fence, either wholly within a UK resident group, or across international boundaries. Having recognised that a company may manipulate its debt level to obtain a tax advantage it is necessary to form a view on the appropriate level of acceptable debt.

In international tax matters the usual yardstick acceptable to OECD countries, including the UK, is the arm’s length arrangement. That is, in looking at UK group subsidiaries with a common overseas parent it may be necessary to limit the interest deduction to the arm’s length level of interest charged on a total debt level no bigger than that which the relevant consolidated UK grouping would or could borrow from a third party without outside support. Outside support includes guarantees, back to back loans, external collateral, letter of comfort etc., provided by other UK groupings or overseas parts of the world-wide multi-national group.

In reviewing the financing of downstream activities OTO would consider the level of debt that would or could be obtained on such a stand alone basis by the relevant UK grouping as a whole including the North Sea interests. (In the past OTO was prepared to consider representations that each company should be considered on its own, rather than looking at the UK group as a whole. Such treatment is not normally appropriate following FA95/s87 as the need is to look at the consolidated UK grouping).

By extension of this policy OTO seeks to apply the same standard to the ring fence activities in the North Sea and onshore, taken as a consolidated unit. That is, looking at the consolidated assets and liabilities of the UK ring fence activities, does the level of debt exceed that which financiers acting at arm’s length would provide to that group without any further security?

Until the introduction of the transfer pricing rules in ICTA Schedule 28AA the only statutory defence against thin capitalisation was to be found in s209(2)(e)(iv) and subsequently s209(2)(da) ICTA 1988. But these do not apply where the borrowing is from a UK resident, and where the borrowing is from an overseas lender they contain no provision allowing the upstream activities to be considered as a separate unit.