Thin capitalisation - considerations of a refinancing

Transfer pricing rules for borrowing encompass both the assessment of how much debt would have been agreed at arm’s length (often referred to as ‘thin capitalisation’), and the assessment of the interest rate and other terms that would have been agreed. All these requirements apply to the refinancing of debt in a similar way as they do to new loans.

When financing arrangements are created intra-group, groups must assess the terms that would have been available to the borrower on the market, and consider how the borrower would have acted if dealing with an independent lender. This is particularly pertinent with changes in the financial markets over recent years, and there are high-profile HMRC challenges to consider when refinancing intra-group.

Do we need to look at both the unallowable purpose and transfer pricing rules?

UK tax deductions for interest paid by a company must be disallowed if the purpose of paying it falls within the ‘unallowable purpose test’ set out in S442(5) of CTA 2009. In simple terms, if the main or one of the main purposes of being party to a debt and paying interest is tax avoidance, then this is an unallowable purpose.

The transfer pricing rules are separate, considering the economic realities that would exist in an open market (arm’s length) transaction.

Failing to reflect arm’s length pricing does not necessarily mean the arrangements have an unallowable purpose, neither does following commercial terms absolve an underlying unallowable purpose. Both rules can be triggered in similar situations if it is not clear why the loan arrangement is in place. Both rules are also highly topical, with HMRC actively challenging financing arrangements under both headings.

HMRC has had recent success with a trio of cases covering unallowable purpose. BlackRock, Kwik-Fit and JTI all had interest deductions disallowed in 2023. This has continued with Court of Appeal rulings for BlackRock, Kwik-Fit and JTI in the Court of Appeal in 2024 and all have been denied leave to appeal further by the Supreme Court.

The BlackRock case explicitly featured transfer pricing as a separate topic in the judgement. The Court of Appeal found that the interest deduction would have qualified on transfer pricing grounds, but that it was trumped by failing the unallowable purpose test for the overall structure of the financing arrangement.

However, where considering refinancing, it is the Kwik-Fit case that is most pertinent. Although HMRC did not challenge the transfer pricing arrangements in Kwik-Fit, the taxpayer used transfer pricing principles as a key part of its rationale for its refinancing, arguing this gave a commercial purpose. This claim was roundly dismissed, not least because some relevant transfer pricing positions within the group were entirely ignored at the time of the refinancing, seemingly because this would have limited the tax benefit of the refinancing. Had Kwik Fit applied thorough transfer pricing approaches to all its internal financing (including transfer pricing adjustments for low interest loans) the Court’s view may have been different.

This ruling should not cause concern for transfer pricing or groups needing to refinance - in particular, the Kwik Fit judgement confirms that, as a starting point, a funding arrangement made for trading or acquisition purposes will not have an unallowable purpose solely because there is an associated tax deduction - just that the transfer pricing rules must be taken into account.

How does this apply the current market?

Increases in interest base rates in the market mean that if a fixed-rate shareholder loan matures or needs to be amended, the appropriate interest rate is likely to be higher than it was. This can bring about thin capitalisation risks that need to be understood and mitigated.

For refinancing arrangements to not appear artificial, there are a number of criteria you should consider (these apply both for the unallowable purpose rules and for determining how the transfer pricing rules apply):

1. Has the actual financing arrangement changed / required terms to be reconsidered or reset?
2. At arm’s length, with a typical market loan tenor and appropriate financial covenants, would the agreement have been renegotiated?
3. Does the borrower have a non-tax reason to (re)draw the loan, and importantly in the context of higher interest rates, does the debt make good commercial sense?
4. Has transfer pricing been considered fairly and not as part of an artificial set of arrangements?

As found in the BlackRock case, a tax avoidance motive does not itself flavour the transfer pricing assessment of transactions, but as seen in Kwik-Fit, having (partial) adherence with the transfer pricing rules will not prevent a tax driven arrangement failing the unallowable purpose tests.

Distressed debt

There will be situations where the tests above need to be considered alongside wider factors. For instance, a common thin capitalisation issue is if a company had significant cash reserves available, would it have refinanced a loan in full or reduced the balance?

Other unique considerations could arise if there has been a change in market circumstance, such as a reduction in value of an investment property or fall in business performance that has led to a (likely or actual) default on loan terms and a fall in the amount of debt that lenders would like to advance. In such cases, the existing lenders may or may not choose to permit debt to extend to increase their likelihood of a full, or at least greater, recovery of funding compared with seeking immediate repayment.

Well known examples of this arose following the Covid pandemic where many loan terms were relaxed and where loans may have been extended or refinanced on more generous terms at maturity. Assessing and pricing such cases can be a highly subjective exercise and must be treated with great care to arrive at a robust transfer pricing position.