In tax terms a UK company (which may be part of a group) may be
said to be thinly capitalised when it has excessive debt in
relation to its arm’s length borrowing capacity, leading to
the possibility of excessive interest deductions.
An important parallel consideration is whether the rate of interest is one which would have been obtained at arm’s length.
The arm’s length borrowing capacity of a UK company is the amount of debt which it could and would have taken on from an independent lender as a stand alone entity rather than as part of a multinational group. It follows that in establishing the arm’s length borrowing capacity of a particular borrower, it is necessary to hypothesise that the borrower is a separate entity from the larger group of which it is part.
Before 1 April 2004 the legislation at ICTA88/S209(2)(da) applied, so that in some circumstances the financial strength of a so-called UK grouping (which includes, but is not limited to, the borrowing company) needs to be considered when evaluating borrowing capacity (see INTM544060). This reflects the fact that independent lenders will tend to consider a consolidated position when evaluating borrowing capacity. In respect of interest payments made on or after 1 April 2004 the UK grouping rules are not retained but under ICTA88/SCH28AA the stand-alone borrowing capacity of the borrower needs to be considered. In practice, the existence of guarantees between group members may mean that much the same effect is preserved for inward loans. (see INTM563050).
Thin capitalisation is a problem from a tax perspective because the returns on equity capital and debt capital are treated differently for tax purposes. The returns to shareholders on equity investment are not deductible for the paying company, being distributions of profit rather than expenses of earning profits. On the other hand, the returns to lenders on debt, most commonly in the form of interest, are normally deductible for the payer in arriving at profits assessable to corporation tax (see INTM541030 for further details). This can result in attempts by multinational enterprises to present what is in substance equity investment in a UK company in the form of debt and thereby to obtain a more favourable tax treatment. Thus, the UK thin capitalisation legislation is a form of anti-avoidance legislation.
Thin capitalisation commonly arises where a company is funded by another company in the same group. It can also arise where funding is provided to a UK company by a third party, typically a bank, but with guarantees or other forms of comfort provided to the lender by another group company or companies (typically the overseas parent).
The effect of funding a UK company or companies with excessive intra-group or parentally- guaranteed debt is, potentially, excessive interest deductions. It is the possibility of excessive deductions for interest which the UK legislation on thin capitalisation seeks to counteract. It seeks to do so by limiting interest deductions to those which a UK borrower could and would have incurred at arm’s length (see INTM541020).
For practical guidance on how to determine whether a UK company (or in some circumstances a UK grouping) is thinly capitalised, see in particular the chapters at INTM578000 and INTM579000.