Funding costs, predominantly fees and interest, are generally deductible on an account basis, even if capital in nature, subject to the following provisions:
- thin capitalization and transfer pricing - transactions between related parties should be on arm's length terms;
- debt cap - restricts the UK tax deductions for finance costs to a group's consolidated external finance expense;
- Anti-arbitrage rules – interest deductions may be disallowed if there is a "hybrid entity" or "hybrid instrument" included in the financing arrangements and tax avoidance is the main or one of the main purposes of the scheme;
- Purpose test - where a loan is considered to be a loan for an "unallowable purpose", which includes tax avoidance, interest arising on such a loan will be disallowed;
- Reclassification as a dividend - interest can be reclassified as a dividend (and hence nondeductible) if (e.g.) the loan is convertible into equity, or the interest rate is dependent on profits. To the extent interest payments to related parties exceed the amount which can be paid based on the allowable debt, it is added back to the taxable income. Further, such interest is considered to be a hidden dividend distribution (subject to withholding tax); and
- Late paid interest rules – interest accrued on loans from connected companies resident in certain "tax haven" territories will only be deductible on an accruals basis if paid within 12 months of the end of the accounting period in which it is accrued, otherwise tax relief will be available on a paid basis.
See Section 13.2 for detailed thin capitalisation rules.
Additionally, in the debt cap rules, interest is also capped based on the group’s external debt levels, The rules apply to UK group companies which are members of a UK or non-UK headed group, for accounting periods begining or after 1 January 2010. These measures are designed to curb the push down of excessive debt into the UK.
The UK measure of borrowing costs (referred to as the tested expense amount) is the sum of the net finance deductions of the UK members of a group that are 75% subsidiaries of the ultimate parent of the group. Only UK companies, or UK permanent establishments, with net finance deductions are taken into account. The net finance deduction of any company is the aggregate of the financing expense amounts and financing income amounts that would otherwise be taken into account for the purposes of calculating corporation tax profits.
The worldwide measure of borrowing costs (referred to as the available amount) is the gross consolidated borrowing costs of the group as a whole. They are the finance expenses that are included in the group’s consolidated financial statements.
The tested expense amount is compared with the available amount and any excess is disallowed.
Where the group has UK members (that are members of the group for accounting purposes) that have net financing income, financing income can be exempted up to the amount of the total disallowance.
The costs of borrowing for both the UK and worldwide measures consist of interest, interest- like payments, ancillary costs of borrowing, finance charge element of finance leases and debt factoring costs.
The debt cap rules do not apply if the group does not satisfy certain gateway conditions; debt cap only applies when the aggregate net debt of each relevant group company, calculated on an entity by entity basis and excluding debt of less than £3 million in any company exceeds 75% of the worldwide gross debt of the group.