Q&A: What does "arms-length interest rate" mean in the context of thin capitalisation?

Please could you explain the meaning of a "reasonable arms-length interest rate" test and how this differs to other possible tests? I can't see this detail covered anywhere. Many thanks in advance.


Hi David.

Thanks for the question.

Let me start by saying I'm not a tax expert or tax advisor. So what I'm going to share here is my understanding; as I mentioned in the book, always take professional tax advice.

In the UK, the guidance says that a company is thinly capitalised to the extent that it has excessive debt in relation to its "arms-length" borrowing capacity, leading to the possibility of "excess interest deductions" and therefore avoiding tax. In this context, arms-length means the amount of debt funding that they could achieve were they to borrow on the open market. Since shareholder loans are loans between related parties, they do not take place on the open market. And so the tax authorities will look at what could reasonably be expected to have happened were the parties not related.  

The concept of "excessive debt" does not just include the amount of debt raised, it also includes the interest rate, the duration of the lending, the repayment terms etc.

Interest paid above what would be paid had the loan been obtained on open market terms, may be deemed disallowable for tax purposes.

Does this help, David?

Thanks again for the question.



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