In the UK, companies can generally claim interest expenses on debts as deductibles; but there are some restrictions when the interest cannot be claimed. Interest expense deductions may be denied due to:
- Thin Capitalisation
- The worldwide debt cap
- Re-characterisation of interest expenses as distributions
In this chapter, we will examine each of these restrictions.
In 2004, the UK’s transfer pricing rules expanded to incorporate thin capitalisation. These restrictions mostly apply to transactions that occur between associated individuals, and, when applicable, they dictate that the interest on excessive debts (meaning debts that exceed the foreseeable amount that would typically be granted by unrelated, third-party lenders) do not qualify for tax relief.
While there is no specified debt to equity ratio, the UK government reserves the right to perform an enquiry in any instance where the incurred debt appears proportionately high compared to the equity of the borrowers to realistically reflect an unbiased investor relationship without financial guarantee. Companies that are found to fall under this restriction, can only deduct a portion of their incurred interest expenses.
Because there is no fixed equity to debt ratio, it can be difficult to guarantee that your company will not fall under this restriction if it has incurred large amounts of debt. Real estate companies, for example, tend to be more highly geared than other types of companies, and therefore often risk falling under this rule. In practice, however, most real estate investment companies have been able to skew this restriction with debt-to-equity ratios of over 200%, without financial guarantees. When financial guarantees are provided by related parties, it is typically acceptable to gear up to this level and still qualify for tax deductions on the accumulation of interests based on debts.
While there is no fixed equity-to-debt ratio, the UK legal system utilised the “arms-length test”—which asks whether the borrower would have qualified for a loan of the amount in question, with a realistic expectation of repayment (including interest), from a third party lender without providing them with a financial guarantee.
Withholding tax on interest payable
Company owners may withhold tax (at a 20% rate) to be deducted as annual interest payments (for example interest related to outstanding loans) to no-UK resident lenders. The same method can be applied to interest payments due to non-UK companies that fall under the same intra-group funding arrangement, or non-UK banks (as long as the loan was not provided by a UK branch).
Non-UK resident lenders are liable to UK income tax for interests received by UK sources. In this case, the UK borrower is obligated to withhold tax on the interest payments made and report it to the HMRC for the deductible amount. The HMRC will determine that the interest payment is UK sourced based primarily, but not entirely, on the residence address of the borrower, as well as the location of their assets. In cases when a non-UK lender grants a loan to a non-UK borrower, the HMRC has not regarded this transaction as UK-sourced—even in cases when UK real-estate is transferred as security collateral.
Non-UK-resident lenders may be able to qualify for tax relief under double tax provision treaties if there is withholding tax payable due to UK-sourced interest. Because of double tax treaty provisions, non-UK residents may not be obligated to pay withholding tax, or the rate may be reduced. Non-UK-lenders seeking this tax exemption will need to receive authorisation from the HMRC. In order to avoid this complication entirely, investors can opt instead to borrow from a UK bank (or a UK branch) in order to circumvent the withholding obligation.
The worldwide debt cap
Introduced by the UK government in 2009, the worldwide debt cap went into effect for any accounting period on or after 1 January 2010. These rules are in addition to the thin capitalisation rule discussed previously. The worldwide debt cap was established to prevent large UK groups from claiming excessive interest expense deductions related to the external affairs of the larger worldwide group. The worldwide debt cap is designed to apply only to “large” groups that fall under at least one of the following categories:
- 250 or more employees per group
- The group has an annual turnover rate of £50 million
- An annual balance sheet totalling £43 million or more.
There are some exclusions to the worldwide debt cap, such as some financial services companies among some other businesses.
Interest characterised as distribution
Lastly, in certain cases, UK tax officials may treat interest payments as a distribution.
This is most commonly the case when a company borrows from a shareholder and repays the debt at an interest rate that is higher than the reasonable return rate. If this is the case, then the company will not receive tax relief for the amount excess interest payments and they will be treated instead as distributions.
This rule also applies in instances where a company makes a loan where the interest payments are dependent on the business or the value of its assets; however, this rule does not apply when the recipient of the interest falls under UK corporation tax, so the efficacy of this rule is limited.
If either of these circumstances applies, then the borrower will not be entitled to tax relief for interest payments that are re-characterised as distributions by UK tax officials.