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13.2. Thin-capitalization and other Restrictions to Interest Deduction

Effective from 1 April 2017, the government has introduced new corporate interest restrictions which limit net deductions for interest to 30% of EBITDA, with an optional group ratio rule based on the net interest to EBITDA ratio for the worldwide group. All groups may deduct up to GBP 2 million net tax-interest and other financing costs in a year. Groups deducting more than GBP 2 million in a year may appoint a reporting company to file the corporate interest restriction return. Where a group is subject to corporate interest disallowance and has not appointed a reporting company, the UK companies are required to disallow their share of the group interest disallowance in their returns.

The government has also enacted two sets of regulations in respect of the new corporate interest restriction rules. The first set addresses certain potential transitional mismatches arising on commencement of the new rules, while the second set provides for certain consequential amendments. The regulations are effective from 1 April 2017.

The prior thin-capitalisation rules were covered by the financing aspects of transfer pricing which applies the arm’s length principle to company funding where for tax purposes, companies which are in a special relationship were treated as if they were independent of each other and acting only in their own separate interests.

A UK company is said to be thinly capitalised when it has more debt than it either could or would borrow if it were acting purely in its own interest, which may lead to the possibility of excessive interest deductions (i.e. greater amount than would arise if the borrower were acting at arm’s length from the lender or guarantor). Where a company is able to borrow excessively because it is borrowing from third parties on the strength of group support in the form of guarantees, these loans are considered to fall under S147 T(IOP)A 2010.

Many other countries operate safe harbour rules in terms of interest deductions, in contrast the UK position is to focus on determining whether loan was issued on an arm’s length basis. HMRC regards the practice as “a simplistic method of determining tax consequences by reference to publicly-stated formulae” (INTM 577120). HMRC released updated guidance with respect to thin capitalisation in March 2010 and March 2011.

HMRC takes a broader view than just the amount of debt and the interest rate when looking at thin capitalisation. One of the key considerations is whether indeed the borrower would have chosen to take on a loan, even if the lending were available. In summary it is necessary to look at the transaction from both sides; on what terms is a third party willing to lend, and on what terms would a third party be willing to borrow.

HMRC describe this approach as looking at the ‘could’ and ‘would’ arguments :

  • the “could” argument - what a lender would have lent and therefore what a borrower could have borrowed; and
  • the “would” argument - what a borrower acting in the best interests of their own business would have borrowed.

With respect to the “would” argument, the borrower would have to assess if it is acting in the best interests of its own business through entering into this arrangement with the lender. To assess the “could” argument, the associated terms which the debt had been obtained based on the financial capacity of the borrower would have to be assessed.  

For the submission of its tax return, the company will have to self assess its arm’s length borrowing capability and ignoring any support it gets from connected parties.

HMRC offers an Advanced Thin Capitalisation Agreement (“ATCA”), which covers the thin capitalisation treatment of one or more borrowers, which may also extend to interest imputation and the taxation of finance and treasury companies, for a period of up to 5 years.  The benefits for businesses are clear in that it can plan its operations and investment over the ATCA period in the knowledge that within the limits set by the ATCA, the interest payable on the debt will be deductible.  It is also advantageous to HMRC as it saves time and resources into the entity’s debt structure and whether this complies with the UK thin capitalisation and transfer pricing provisions.