Thin capitalisation Definition

GLOSSARY

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What does Thin capitalisation mean?

A company is said to be 'thinly capitalised' when its capital is made up of a much greater proportion of debt than of equity, ie, its gearing or leaverage is too high.

From 1 April 2004, thin capitalisation has been included within the UK transfer pricing rules. Where a loan between connected parties is of a greater amount than that which would have been lent had the parties acted on an arm's length basis, interest payments on the excess is disallowed as a deduction for the borrower, and a compensating adjustment is made such that the lender is only taxed on the amount of interest that it would have received on an arm's length loan.

View the related practice notes about Thin capitalisation

A history of EU law and thin capitalisation and transfer pricing regimes [Archived]

ARCHIVED: This Practice Note has been archived and is not maintained.Thin capitalisation and transfer pricing are related but slightly different concepts. Some consider that thin capitalisation rules are a specific expression of transfer pricing rules.EU law applies in the context of thin capitalisation and transfer pricing in that, although direct tax is not within the competency of the EU, domestic rules must still comply with general principles of EU law and with the treaty in force at the time (currently the Treaty of the Functioning of the European Union) (the Treaty).The key Treaty provisions relevant to thin capitalisation and transfer pricing are those on non-discrimination in respect of the fundamental freedoms. Potentially applicable freedoms are: •freedom of establishment•free movement of capital, and•free movements of goods and servicesWhat are transfer pricing and thin capitalisation?Transfer pricing rules are generally rules that:•consider transfers of value between related entities, and•entitle the taxing authority to substitute a market value for the value of the item transferred, as if the transaction had been effected on...

Transfer pricing—loans and finance

FORTHCOMING CHANGE relating to UK transfer pricing legislation: As pre-announced at Tax Administration and Maintenance Day 2023, in June 2023 the government published a consultation on updating UK transfer pricing legislation (as well as legislation relating to the diverted profits tax and to permanent establishments). The stated aims of the reforms are to modernise and simplify these rules in order to improve tax certainty and alignment with treaties. The consultation ran until August 2023. A summary of responses to the consultation was published in January 2024, noting that the proposals were broadly welcomed by respondents, although some areas of concern were noted. The government intends to hold a technical consultation on draft legislation in 2024. For some more information, see: Analysis—Reform of the UK’s international tax laws: a step closer (2024): Tax Journal, Issue 1652, 18 and Analysis—Reviewing HMRC's consultation on transfer pricing reform (2023): Tax Journal, Issue 1629, 12.As more fully discussed in Practice Note: Transfer pricing—key concepts and principles, ‘transfer pricing’ refers to the pricing of goods, services,...

Discover our 42 Practice Notes on Thin capitalisation

What method will HMRC use when determining an arm's length interest rate on a related party loan?

What method will HMRC use when determining an arm's length interest rate on a related party loan? In this Q&A we have assumed that the lending in question is between two companies (or is within the same company) rather than between individuals, partnerships or other sorts of unincorporated organisations. A UK company that lends money to or borrows money from another company to which it is related (or to be precise, where the participation condition in section 148 of the Taxation (International and Other Provisions) Act 2010 is met) may be subject to transfer pricing adjustments if the loan is not on arm’s length terms. This applies both to the amount of the loan and the interest rate. Equivalent provisions apply to lending between branches, or between a branch and the head office, of the same company. For this purpose the lending and borrowing entities are treated as though they were separate enterprises, as explained in Practice Note: How is a UK permanent establishment taxed? For...

Does the UK (or HMRC in practice) express a preference for a particular transfer pricing method for establishing an arm’s length price of interest, which is based on the location of the lender and the borrower?

Does the UK (or HMRC in practice) express a preference for a particular transfer pricing method for establishing an arm’s length price of interest, which is based on the location of the lender and the borrower? Transfer pricing rules in the UK and elsewhere require that transactions between connected parties are recognised for tax purposes by applying the amount of profit that would have arisen if the same transaction had been carried out by unconnected parties. This is referred to as the 'arm's length principle'. The arm's length principle is endorsed by the Organisation for Economic Co-operation and Development (OECD) and enshrined in the Associated Enterprises Article (Article 9) of the OECD Model Tax Convention. See also HMRC Guidance: INTM421010. Most countries (other than the US and some developing countries who take a different approach) enforce transfer pricing laws and guidelines based on the arm's length principle as defined in the OECD's Transfer Pricing Guidelines (the TP Guidelines). The UK transfer pricing legislation is set out in...

See the 3 Q&As about Thin capitalisation

Private Client weekly highlights—9 March 2023

This week’s edition of Private Client highlights includes: (1) The Spring Budget 2023 and possible key tax announcements of interest to private client practitioners; (2) The government announces publication of the Spring Finance Bill 2023 on 23 March 2023; (3) The Court of Protection clears up ‘common confusion’ around circumstances in which court approval is required to sales of property where a property and financial affairs deputy for a co-owner is also acting as a trustee; (4) Clipperton v HMRC, in which the Upper Tribunal ruled out dividend tax planning involving a trust; (5) Re Scherzade Khilji (In Bankrutpcy), in which the court considered when does a trustee in bankruptcy become aware of the bankrupt’s interest in a given property to start the three year ‘use it or lose it’ period in s 283A of the Insolvency Act 1986; (6) Kenig v Thomson Snell & Passmore LLP, which concerned beneficiaries’ applications for assessment under section 71(3) of the Solicitors Act 1974; (7) The Financial Action Task Force’s Report ‘Money Laundering...

Private Client weekly highlights—19 January 2023

This week’s edition of Private Client highlights includes: (1) Croydon LBC v Oasis Community Learning, which considered how the status as a quasi-trustee of adminstering authorities affected the nature of claims by the defendant to resist debt proceedings brought against it by the claimant authority; (2) The Office of the Public Guardian updates notification of death processes; (3) Hudson v Hathway, which held that detrimental reliance is still an essential ingredient of a common intention constructive trust; (4) The Mandatory Disclosure Rules to be in force and DAC6 to be repealed in the UK with effect from 28 March 2023; (5) Wilson and another v McNamara and others, where a high-profile bankrupt property developer succeeded before the Court of Appeal in protecting his retirement savings plan from creditors; (6) The Charity Commission launches a consultation on draft guidance for charities on the use of social media; (7) SwissIndependent Trustees SA v Sofer and others, where the High Court preferred the trustee’s construction of trust instruments despite the potential negative effect...

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