Loan Interest Deductibility in a Group or Holding Company Structure

Holding company borrowing: the basic position

A holding company that borrows from a third-party lender and on-lends to subsidiaries creates a loan relationship at each level. The holding company's interest payable on the external debt is potentially deductible, as is the interest payable by subsidiaries on the intra-group loan. However, the interest receivable by the holding company from the subsidiaries is taxable income, creating a roughly matching charge and credit within the group.

Where a UK group files a group tax return (a group payment arrangement or consortium arrangement), the netting can simplify the picture, but the individual company computations still need to be correct. Your group's tax adviser should model the flows carefully.

Transfer pricing on intra-group loans

When one group company lends to another, HMRC requires that the interest rate and terms reflect what would have been agreed between unconnected parties dealing at arm's length. If the rate is too high (benefiting the lending entity) or too low (benefiting the borrowing entity), HMRC can adjust the computation to reflect the arm's length rate.

The UK transfer pricing rules apply to medium and large companies and to small companies in certain circumstances. Maintaining contemporaneous documentation of how the intra-group rate was set is important for defending the position in an HMRC review. Your tax adviser can recommend appropriate benchmarking approaches.

The Corporate Interest Restriction

The Corporate Interest Restriction (CIR) caps the amount of net interest expense that a UK group can deduct at 30% of the group's UK EBITDA (the fixed ratio rule), or at a higher amount if the group ratio rule produces a better outcome. The CIR applies only where the group's net UK interest expense exceeds £2 million per year.

For most SME groups this threshold is not breached, and the CIR does not apply. However, rapidly growing companies, or those undertaking significant acquisition finance, can approach this limit faster than expected. Where the CIR applies, disallowed interest can be carried forward for potential future relief. The rules are complex; take specialist advice if your group's interest costs are material.

Thin capitalisation

Thin capitalisation is the specific transfer pricing concern where a company has more debt than an independent lender would have advanced. HMRC can restrict interest deductions where the level of debt within the group is excessive relative to what the borrowing entity could support on a standalone basis.

Thin capitalisation is most commonly an issue for holding companies that have borrowed heavily to fund acquisitions, or for subsidiaries that have received large intra-group loans. A formal thin capitalisation analysis, ideally agreed in advance with HMRC through an Advance Pricing Agreement, provides certainty. Confirm whether your structure warrants this analysis with your tax adviser.