In the UK, interest on debt is generally deductible for tax purposes, unless the deduction is denied or restricted due to:
- the thin capitalisation rules;
- The interest being re-characterised as a dividend; or
- The world-wide debt cap.
The UK’s world-wide debt cap limits tax deductions for interest, not by reference to a global cap or percentage of taxable profit, but by reference to a company’s debt which is excessive when compared with the debt of the group as a whole. It is therefore less draconian than some of the rules implemented in jurisdictions such as Spain and Italy.
The UK's thin capitalisation rules were incorporated into its transfer pricing rules in 2004. The regime applies to most transactions between associated persons (including companies, trusts and individuals) and applies even where both parties are UK resident. Where the rules apply, the interest on excessive debt (i.e. debt which would not normally be available from a third party lending on an arms length basis) will be disallowed. There is no fixed debt to equity ratio which is laid down as being an acceptable limit.
The worldwide debt cap
In 2009 the UK government introduced a "worldwide debt cap", which applies to all accounting periods beginning on or after 1 January 2010. The purpose of the rules is to limit the tax deduction which may be claimed by UK members of a group for finance expenses to the external interest and other finance expenses of the world-wide group. The rules apply only to "large" groups - i.e. those where at least one member has 250 or more employees, annual turnover of £50 million or an annual balance sheet of £43 million or more. Qualifying financial services businesses and certain other bodies are excluded from the rules. This rule was introduced in addition to the existing thin capitalisation rules described above.
Interest treated as distribution
Finally, in certain circumstances, the UK tax authorities have the power to re-characterize payments of interest as a distribution. Where a company borrows money from a shareholder, the interest rate on which is more than a reasonable rate of return, the amount paid in excess of a reasonable rate of return is treated as a distribution. Similarly, where a company borrows money, the interest payments on which are dependant on the business results of the company or the value of its assets, all of the interest payable will be treated as a distribution. (This rule does not apply where the recipient of the interest is within the charge to UK corporation tax, so its application is limited in scope.) Where either rule applies, the borrowing company will not be entitled to a tax deduction for any amount re-characterised as a distribution. Changing the nature of the payment may also give rise to other tax issues which are outside the scope of this article.