Thin capitalisation and intra group debt

Q: What does an adjustment look like?

Illustration only. A UK subsidiary with EBITDA of £2 million borrows £20 million from its overseas parent at 6%, paying £1.2 million of interest. Evidence from lenders to similar stand alone businesses suggests it could have borrowed about £10 million at that rate. Interest on the extra £10 million, £600,000, would be disallowed, and the subsidiary would need to consider withholding tax on that amount. Its interest cover on the arm's length debt would also need to look reasonable for its sector.

The UK has no fixed debt to equity safe harbour. Instead, interest on borrowing from or guaranteed by connected parties is tested under the transfer pricing rules in Part 4 of the Taxation (International and Other Provisions) Act 2010, and a deduction is allowed only for the amount and terms a company could and would have borrowed as a stand alone business from an independent lender. HMRC looks mainly at interest cover, debt to earnings ratios and the other terms of the loan, and since 1 January 2026 the rules on guarantees and implicit group support have been rewritten.

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What does thin capitalisation mean for UK tax?

HMRC’s International Manual at INTM413010 describes a company as thinly capitalised when it has more debt than it could and would have borrowed on its own resources, usually because it borrows from, or with the support of, connected persons. Because interest is deductible and dividends are not, extra intra group debt moves profit out of the borrower. The manual stresses that excessive interest can come from the rate, the duration, repayment restrictions, currency or guarantees, not just the amount, and that no tax avoidance motive is needed.

Since 2004 thin capitalisation has been part of the main transfer pricing legislation, now Part 4 of the Taxation (International and Other Provisions) Act 2010 (TIOPA 2010). The basic rule in section 147 applies where the participation condition in section 148 is met, the terms differ from arm’s length terms and there is a potential UK tax advantage. Most small and medium sized enterprises are exempt, as explained in transfer pricing for smaller companies. INTM516050 confirms that the UK does not use safe harbours such as a 3:1 debt to equity ratio applied to all companies; ratios are agreed case by case.

How does HMRC work out what a company could and would have borrowed?

INTM413030 frames the test as two questions, both asked of the borrower as a separate entity dealing with an unconnected lender, without guarantees or comfort from connected parties:

The could argument: how much, and on what terms, a lender would lend, judged on the borrower’s capacity, default risk, security, other liabilities and ability to service the debt.
The would argument: how much a borrower acting in its own interests would take on, leaving headroom for downturns and unexpected events and the ability to repay, and whether it would have borrowed at all.

INTM413070 explains the separate entity basis. A lender would still look at the borrower’s own subsidiaries, so HMRC measures capacity across a borrowing unit, broadly the borrower’s consolidated position, and will accept properly prepared schedules where consolidated accounts do not exist.

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What factors does HMRC examine?

The practical guidance from INTM510000 draws on how banks lend. The main measures are:

Interest cover. INTM516010 defines it as earnings before interest and tax divided by interest payable, so £12 million of EBIT against £3 million of interest gives cover of 4:1.
Debt to earnings. INTM515010 notes that agreements often cap arm’s length debt at a multiple of profit, commonly measured by EBITDA, the measure used in third party covenants.
Gearing. Debt to equity ratios are covered from INTM517000, including how to treat cash, netting and companies in acquisition or expansion mode.
Cash flow. INTM516080 suggests testing whether cash flow covers interest and scheduled repayments.
Loan terms and context. INTM511035 lists the economic climate, credit risk, currency, and the size and maturity of the debt, larger amounts usually being available only for shorter terms.

INTM516050 adds that acceptable cover varies by business type, that lenders accept lower cover for a few years after an acquisition, and that commercial databases can show debt levels for comparable companies.

How are guarantees and group support treated from 2026?

Finance Act 2026 changed the financial transactions rules. INTM414410 explains that sections 152 and 153, which required guarantees to be ignored when testing borrowing, were repealed for chargeable periods beginning on or after 1 January 2026, to align with Chapter X of the 2022 OECD Transfer Pricing Guidelines. In their place:

Section 153A provides that a guarantee which increases the amount of debt available to a borrower is never arm’s length. A guarantee can still reduce the interest rate, for which a fee may be due.
Section 154 now excludes implicit support, the incidental benefit of belonging to a group, from the meaning of guarantee. INTM414430 says it is taken into account in pricing and may improve the borrower’s credit rating, but it should not increase the amount it can borrow.
Section 153B lets a UK resident company with a direct participatory relationship elect to be treated as guarantor of the excess part of another UK company’s borrowing. INTM414420 says the election is irrevocable and must be made within four years after the end of the borrower’s first chargeable period it covers.

For borrowing made before 1 January 2026 the new guarantee rules apply from chargeable periods beginning on or after 1 January 2028, unless the company elects to apply them earlier.

What happens to interest that is disallowed?

INTM413020 gives the logic: if a company borrowed £100 million but could only have borrowed £60 million at arm’s length, the deduction is limited to interest on £60 million. The excess debt is treated as if it were equity for the analysis, but the disallowed interest remains interest. That has a withholding tax cost. INTM413150 explains that treaty clearance to pay interest gross covers only the arm’s length amount, so tax may need to be deducted from the excess paid to an overseas lender unless a compensating adjustment claim brings section 187 into play. See withholding tax on interest and royalties.

Where the lender or guarantor is UK resident, compensating adjustments under sections 174 and 192 can relieve the other side, as covered in does transfer pricing apply between UK companies.

How does this fit with the corporate interest restriction?

Transfer pricing is one of several rules. INTM413010 lists others: the arbitrage provisions, the unallowable purpose rule in sections 441 and 442 of the Corporation Tax Act 2009, the distribution rules for interest above a commercial return, and the corporate interest restriction in Part 10 TIOPA 2010. Section 155(6) says the corporate interest restriction and paragraph E of section 1000(1) of the Corporation Tax Act 2010 are disregarded in deciding whether there is a transfer pricing advantage, so the arm’s length test is applied first on its own terms.

Can a company get certainty in advance?

Yes. Statement of Practice 1 (2012) sets out how HMRC provides an Advance Thin Capitalisation Agreement under the advance pricing agreement legislation. INTM512020 explains that an application should precede the return it relates to, that HMRC will not help fine tune proposals, and that an agreement can also cover earlier periods under section 224, so one can run alongside an enquiry. INTM516010 shows how breaches work: if a 4:1 interest cover covenant is breached, enough interest is disallowed to restore the ratio.

What does an adjustment look like?

Illustration only. A UK subsidiary with EBITDA of £2 million borrows £20 million from its overseas parent at 6%, paying £1.2 million of interest. Evidence from lenders to similar stand alone businesses suggests it could have borrowed about £10 million at that rate. Interest on the extra £10 million, £600,000, would be disallowed, and the subsidiary would need to consider withholding tax on that amount. Its interest cover on the arm’s length debt would also need to look reasonable for its sector.

What mistakes come up most often?

Testing only the interest rate and not the amount, duration and other terms.
Assuming a parent guarantee justifies more debt; section 153A now says it cannot.
Forgetting withholding tax on disallowed interest paid overseas.
Applying the corporate interest restriction first and assuming transfer pricing is covered.
Missing the four year window for a section 153B deemed guarantor election.
Keeping no evidence of borrowing capacity; see transfer pricing documentation.

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Reviewed by Christine Anderson, Broker, Solar Protect. Last reviewed 19 October 2026. Part of Accountapedia, the Solar Protect guide to UK tax and accounting. This page is general information, not personalised advice.