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UK thin capitalisation: An overview of the theory and practice

Liz Hughes and Oriana Panidha of Grant Thornton discuss thin capitalisation in the context of HMRC’s increasing scrutiny of the arm's-length nature of interest applied to the lending and borrowing amongst related parties.

Background to this series of articles

Following the Lehman Brothers Bank collapse in September 2008, the flow of credit into the UK economy has at best been volatile and at worst stagnant.

In response, HM Revenue & Customs (HMRC) is looking more closely at the arm’s-length nature of interest applied to lending and borrowing between UK taxpayers to or from group companies.

The rules governing the tax deductibility of interest on related party loans are set out in the UK thin capitalisation legislation. This forms part of the UK's transfer pricing legislation.

This article is one of a series of three papers that will look at the UK thin capitalisation rules. This article considers the theoretical background to the rules; focusing on what thin capitalisation is and identifying what kind of taxpayers are subject to it.

The second article will look at the practical application of the rules. The final article will focus on advance thin capitalisation agreements (ATCAs); what they are and how they are typically applied.

What is thin capitalisation?

HMRC's internal guidance manuals states that "thin capitalisation is the financial branch of transfer pricing which looks to apply the arm’s-length principle to company funding - to treat companies which are in a special relationship, for tax purposes, as if they were independent of each other and acting only in their own separate interests". [INTM571015]

The UK transfer pricing and thin capitalisation rules prescribe an arm's-length test for calculating an acceptable amount of debt. A UK company 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 (the UK thin capitalisation legislation is a form of anti-avoidance legislation).

The expression arm's-length in this context describes an amount of debt-financing in line with what could be achieved in the open market. This statutory test therefore requires taxpayers to consider what would have happened, in the absence of the intra-group relationship, between the unrelated parties in a similar financing transaction (what the borrower and an unrelated lender would have done in comparable circumstances). This is potentially a very broad test because it may apply not only to the borrowing capacity (what a lender would lend) but also to what a borrower, acting prudently, would borrow (the amount he would choose to borrow or appetite for debt).

The concept of excessive debt is not just bearing a greater quantity of interest-bearing debt than the borrower could sustain were it independent, but includes, for example:

· The interest rate charged is in excess of the market rate for the loan;

· The duration of the lending is greater than would be the case in the market;

· The repayment or other terms are more disadvantageous than could be obtained were the loan made available by an independent lender.

What transactions are subject to the UK thin capitalisation rules?

Taxpayers that are considered to be connected under the UK's transfer pricing rules are also considered to be connected for the purposes of the UK thin capitalisation rules. The UK thin capitalisation rules can therefore apply to inter-company lending and borrowing of debt and transactions akin to debt (for example inter-company accounts left outstanding for so long as they take on the characteristics of loans).

The rules apply equally to transactions between UK and foreign jurisdictions as well as loan transactions between UK entities.

Acting together rules

The acting together provisions, as they are commonly known, are a widely drawn set of rules that bring a broad range of lending activity within the remit of UK thin capitalisation, which would not otherwise be subject to these rules under the general transfer pricing regime.

Specifically, where a lender has lent funds to an entity with whom the lender has “acted together” with parties that control the borrower, the funding transaction is subject to transfer pricing scrutiny. Such a broad piece of legislation means that potentially every loan from a bank or independent lender may be subject to these rules. The concept of acting together remains ill-defined and as yet there have been no tax cases where the point has been examined.


There is increasing scrutiny by HMRC of the arm's-length nature of interest applied to the lending and borrowing by UK taxpayers to or from group companies. The scope of the UK thin capitalisation rules (which are part of the UK transfer pricing rules) is broad and can extend to lending and borrowing transactions between unrelated parties.

Liz Hughes, Director, Transfer Pricing Group, Grant Thornton UK LLP

+44 (0)207 728 3214

Oriana Panidha, Assistant Manager, Transfer Pricing Group, Grant Thornton UK LLP

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