Intercompany Debt: Thin Capitalisation

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In response to the sluggish flow of credit into the UK since the banking crisis of 2008, HM Revenue & Customs (HMRC) are scrutinising the ‘arm’s length’ principle of interest applied to lending in relation to companies that form part of groups.

What is the ‘Arm’s Length’ Principle?

For these purposes, the arm’s length principle requires those engaging in an intercompany transaction to consider what would have happened if they were unrelated parties going through a similar transaction.

What is Thin Capitalisation?

The rules governing the tax treatment of interest on intercompany loans are set out within the UK’s transfer pricing legislation. Thin capitalisation falls within this legislation and specifically looks to apply the ‘arm’s length principle’ to lending between connected parties.
The Thin Capitalisation rules are a form of anti-avoidance and prescribe a test for calculating an acceptable amount of debt. Where a UK company is considered to have excessive debt, the Thin Capitalisation principles may deem it to be benefiting from disproportionate interest deductions.

What would be classed as ‘excessive debt’?

Although the basic determination of excessive debt is built on a UK company incurring interest on debts which are higher than it could sustain if it were independent, Thin Capitalisation also examines whether the:

• duration of the loan is longer than it would be in market conditions;
• terms are more disadvantageous than if the loan was received from an independent lender; and
• interest rate being charged exceeds the market rate for the loan.