OT22051 - Interest and Financing

Schedule 28AA ICTA transfer pricing rules

For accounting periods ending on or after 1st July 1999, FA 1998 introduced new transfer pricing rules, which are to be found in ICTA 88/Sch 28AA. These rules are much more widely drawn than s770 ICTA, so that if any aspect of the loan (including the amount) differs from arm’s length terms, the allowable interest may be restricted. The rules also catch indirect borrowing arrangements i.e. borrowing from an unconnected third party on the strength of a guarantee given by an associate.

The new rules also make it clear that the arm's length standard must apply to all cross-ring fence transactions even when both the parties are UK resident. Furthermore the arm's length standard will apply where the cross-ring fence transaction occurs within a single company as well as where it occurs between separate companies.

This means that where a company’s borrowings finance a mixture of ring fence and non-ring fence assets, the latter should be regarded as if they belonged to a separate business when it comes to considering any restriction to arm’s length terms of the interest deductible against ring fence profits.

Example

Considered as a whole the above company is not thinly capitalised. But if the ring fence assets are treated as belonging to a separate business, then that business is entirely financed by debt, and the equity is actually negative. The application of an arm’s length standard to the separate ring fence business would require the ring fence assets to be funded partly by equity. Accordingly, so far as the claimed ring fence debt exceeds what the company could or would have borrowed on arm’s length terms if it had held only its ring fence assets, the interest should be disallowed against ring fence profits.

Schedule 28AA therefore provides a clear remedy against the problems of excessive and unnecessary borrowing. It therefore must be considered where the gearing is inappropriate and we have concerns about thin capitalisation. It may also have to be considered where there are other reasons for regarding the borrowing as excessive and/or unnecessary.