Viewpoint: a victory for common sense

Today’s AG opinion from the ECJ on the thin cap GLO is a victory for common
sense which should be welcomed by taxpayers and authorities – but particularly
by taxpayers.

The case addresses the question of whether the UK thin capitalisation rules
in existence prior to April 2004 breached EU law by limiting the amount of
interest relief available on debt-financing between members of the same group of
companies in different EU member states.

The same rules did not apply between group companies all based in the UK,
giving rise to the claims.

In his bumper 38-page opinion, advocate general Geelhoed analysed EU and
international law in great detail, but the crux of his view is this:

1. The pre-2004 UK thin cap rules were discriminatory, but
justifiable on anti-abuse grounds.

This will be music to HMRC’s ears as it (rightly) protects against UK members
of groups of companies being stuffed full of debt with hefty interest payments
to the overseas member group. That radically reduces the UK company’s taxable
profits and hence the UK tax take.

2. The taxpayer is free to choose the amount of debt or equity in
financing a subsidiary unless that choice amounts to an ‘abuse of law’.
Therefore transactions should be conducted at an arm’s length basis.

This is good news for the taxpayers. Admittedly, the UK’s rules do already
apply an arm’s length standard and we at KPMG have successfully negotiated with
HMRC on cross-border debt financing using extensive documentation prepared by
our corporate debt advisory colleagues.

What the opinion does is to change the starting point. It suggests that
HMRC’s generally applied rules of thumb – that a 1:1 debt:equity ratio and 3:1
interest cover are acceptable and anything beyond that is highly questionable if
not outright abusive – will no longer stand. Effectively, it bolsters taxpayers’
rights to demonstrate what constitutes arm’s length.

For routinely highly geared companies, such as private equity houses or
service companies with strong cash flow but relatively weak balance sheets, this
is to be welcomed. And we anticipate that we will be calling on our corporate
finance colleagues more and more for independent bench-marking.

3. If not at arm’s length, there should be a genuine commercial
non-tax reason for transactions.

Although he acknowledges these situations may be rare, he gives an example
from the Lankhorst case (which successfully challenged similar thin cap rules in
Germany) of an overseas parent effectively bailing out a struggling subsidiary
and suggested that this was acceptable. For groups of companies in similar
situations or for those engaging in cross-border M&A activity wanting to put
in quick temporary debt financing, this will be very welcomed.

One disappointment

Disappointingly, M Geelhoed felt it was only the Freedom of Establishment and
not the Free Movement of Capital principle which was relevant. Therefore, his
opinion only applies to UK borrowers which share an (indirect) EU parent with
the lender. It does not apply where there is no common EU parent. However, where
there is a common EU parent, intriguingly, the AG suggests EU law may apply even
where the lender is non EU-based.

Chris Morgan is head of the EU law group at KPMG