UK: Thin Capitalisation - the Thin End of the Wedge?

Last Updated: 8 January 2003

German thin capitalisation rules have been held to breach EU law because they discriminated against German subsidiaries of overseas parent companies. This was the decision of the European Court of Justice in the Lankhorst-Hohorst case, published in December 2002. This is a significant decision for cross-border tax planning and may affect companies setting up or acquiring subsidiaries in any EU country with thin capitalisation rules, including the UK as well as Germany.

What is "thin capitalisation"?

It is often more tax efficient to finance a cross-border corporate investment with shareholder debt than with equity. This is because interest on debt is generally deductible for tax purposes, whilst dividends and other distributions in respect of equity participations are not deductible. This enables the tax charge to be shifted from the jurisdiction where the investment is made to that of the investor, allowing more flexible tax planning, and, often, a rate arbitrage. This may lead to the shareholder debt representing a higher proportion of the investee company’s total capital than would be normal if the debt finance were provided by an independent bank, with a corresponding reduction in the equity injected by the shareholder, hence the term "thin capitalisation".

Where the shareholder and the investee company are subject to tax in the same jurisdiction, there will usually be little tax advantage stemming from thin capitalisation, as the interest will be tax deductible for the investee company but taxable in the hands of the investor, at the same rate. It is where the shareholder/creditor is located in another jurisdiction (or is otherwise not subject to tax on the interest), that the tax advantage can be gained, at the expense, of course, of the fisc of the investee company’s jurisdiction. It has therefore been common for revenue authorities to adopt anti-thin capitalisation rules in an attempt to eliminate such mismatches and potential loss.

What are the UK’s thin capitalisation rules?

The UK’s thin capitalisation code has, in effect, two "layers". The first consists of rules which attained their current content in 1995 and are contained in section 209(2)(da) Taxes Act 1988 and ancillary provisions ("the Section 209(2)(da) rules"). The other layer is formed by the "transfer pricing" rules in Schedule 28AA Taxes Act 1988, which attained their current content in 1998. The rules in both layers are complex, but in essence:

  • Under the Section 209(2)(da) rules, interest payable by a UK company to a non UK resident member of the same 75% group is treated as a dividend, and therefore not tax deductible, to the extent the interest exceeds what would have been paid had the parties been unconnected, and not otherwise parties to a "special relationship".
  • The transfer pricing rules also apply (at least in the Inland Revenue’s view) where the shareholder debt content of the investee’s total capital is greater than it would have been as between parties at arm’s length, but only where the investor has the majority voting power in the investee (or vice versa) or both companies are under common voting control. (There is an extension of the scope of the provisions to "deadlock", or near deadlock, joint ventures).
  • There are special provisions to extend the Section 209(2)(da) rules to cases where the "shareholder loan" is, in law, provided by a third party but it is the shareholder who bears "the exposure", by means of guarantees and back-to back loans. (There are no corresponding provisions for transfer pricing but the Inland Revenue claim, somewhat unconvincingly, that the transfer pricing rules implicitly cover such arrangements).

Neither "layer" normally applies to a "UK/UK case" – where both the investor and the investee are subject to UK tax – but both layers are capable of applying in a cross-border case, where the investee is taxable in the UK but the investor is not. This is the important point to bear in mind in the European law context and is common to both "layers" of the UK thin capitalisation rules.

What happened in Lankhorst-Hohorst?

In this case, a Netherlands parent company ("LT BV") made a loan to a 100% indirect German subsidiary, Lankhorst-Hohorst GmbH ("Lankhorst-Hohorst"), which was in financial difficulties. The loan, which was for DEM 3,000,000 with variable interest repayable over 10 years, enabled Lankhorst-Hohorst to repay some DEM 2.8m of bank debt and to achieve a substantial reduction of its interest cost. LT BV undertook to waive its right to repayment of the loan if third party creditors made claims against Lankhorst-Hohorst.

The German tax authorities sought to deny a deduction for part of the interest payable by Lankhorst-Hohorst to LT BV on thin capitalisation grounds. German tax law then contained a provision which treated interest on shareholder debt as a "disguised distribution of profits", taxable at the appropriate German rate, rather than a deductible interest payment but only where the recipient of the interest was not itself a German taxpayer. (Like the UK rules summarised above, the German anti-thin capitalisation rules did not apply to the extent that the amount of the shareholder debt did not exceed the amount which would have been lent by an unconnected third party. The German rules also provided a "safe harbour" for companies whose debt-equity ratio was up to 3:1).

The German tax court concluded that a third party would not have lent as much as LT BV did, on the terms on which LT BV lent, and on the facts neither the 3:1 safe harbour nor any other exception in German tax law was available to Lankhorst-Hohorst. The case was, however, referred to the European Court of Justice, which held that, on the facts of the case, EU law invalidated the relevant German law. This was because the German law constituted a discriminatory obstacle to the freedom of establishment, by treating German subsidiaries of non-German EU parent companies less favourably than subsidiaries of a German parent company. Further, the ECJ held, the obstacle could not be justified in terms of EU law.

To understand the basis for this remarkable decision, and to appreciate its full implications, it is necessary to explain briefly the principles of EU law involved.

The "freedoms"

The EU Treaty guarantees four fundamental freedoms, and these include:

  • Freedom of "establishment" (Article 43) – the right for an individual or body corporate which is a national of a Member State to establish itself, either in the form of a branch or a subsidiary – in another Member State of its choosing; and
  • Free movement of capital (Article 56) – the right for nationals of Member States to move capital freely to and from other Member States, and, since 1 January 1994, to and from non-Member States.

These freedoms are not unqualified and some of the qualifications relevant to tax disputes will be discussed below. The important point, though, is that it is now established that direct taxation provisions, which are still mainly within the legislative domain of Member States, will be set aside by the ECJ if they restrict these freedoms in a discriminatory manner and there is no adequate "justification".

In Lankhorst-Hohorst, freedom of establishment meant that the (Netherlands) parent company had the right to form and operate subsidiaries in Germany, as it had done, and that freedom would be denied if discriminatory and unjustified restrictions were placed in its way. The restriction imposed by the German anti-thin capitalisation rule clearly discriminated between those German companies which had German parent companies and those which did not. (German companies owned by restricted categories of German parent companies, were also subject to the thin capitalisation restrictions but the ECJ concluded that German companies in those categories were not in a comparable situation to Lankhorst-Hohorst’s parent).

Can the restriction be "justified"?

A number of arguments were put to the ECJ to the effect that, even if the rule did constitute a discriminatory restriction on the freedom of establishment, it was nonetheless justified by the "public interest", which is specified in the Treaty to be a qualification to freedom of establishment and free movement of capital (see Articles 43 and 58). At the outset though it should be noted that the ECJ does not take at face value claims by Member States that provisions restrictive of one of the freedoms are justified. No restriction can be justified unless its aim is clearly identified, it is apt to secure that aim and it does not go further than is necessary for that purpose. Further, as the ECJ reiterated, the prevention of a reduction in German tax revenue is not a sufficient justification.

A number of suggested justifications were put to the ECJ both by the German Government, and the UK Government (which offered observations).

Coherence of the tax system

The German (and UK) Governments argued unsuccessfully that the thin capitalisation rule was necessary to protect the "coherence of the tax system". Some ECJ case law supports the need to ensure the coherence of Member State’s tax system as a justification. The Court’s approach is currently that coherence can only be a justification where there is a "direct link" between the tax restriction at issue and an associated tax benefit for the taxpayer affected by the restriction. The best-known example is Bachmann, where a German national individual lived and worked in Belgium but proposed to retire to Germany. He took out a pension contract with a German insurer, it being assumed that the pension (following the taxpayer’s retirement) would not to be taxable in Belgium. Belgium allowed a tax deduction for pension payments to Belgian insurers but not to German ones. The ECJ held that the resulting discriminatory restriction of freedom of establishment was justified, because in the case of a Belgian taxpayer there would be a link between tax deductibility of pension contributions and taxation of the pension.

In Lankhorst-Hohorst the German and UK Governments could demonstrate no such benefit linked to the discriminatory restriction. The German and UK Governments had prayed in aid the "arm’s length principle" enshrined in Article 9 of the OECD Model Convention, but to no avail.

Effectiveness of fiscal supervision

The UK Government also argued that a rule of the type at issue in Lankhorst-Hohorst could be justified by the need to ensure the "effectiveness of fiscal supervision". This argument was based on the ECJ’s decision in the Futura Participations case in 1997. It was held by the ECJ in that case that a Member State (Luxembourg) was entitled to require that an overseas company seeking to carry forward tax losses in its Luxembourg branch justify the calculation and allocation of those losses under Luxembourg law. It is not clear how (if at all) anti-thin capitalisation provisions enhance "fiscal supervision" in this sense and the ECJ in Lankhorst-Hohorst did not accept this proffered justification.

Tax evasion/avoidance (Article 58 of the Treaty)

The ECJ was prepared to accept in principle that, had abuse been proved on the facts, "tax evasion" ("tax avoidance" in UK terminology) might have been a justification. The ECJ noted, however, that the German anti-thin capitalisation rules applied even in the absence of "wholly artificial arrangements, designed to circumvent German tax legislation" (implying that the aim of the provisions was not clearly identified) and that LT BV would be subject to corporate tax on its profits in the Netherlands.

The implication seems to be that liability to tax, at whatever rate and calculated on whatever basis, in a Member State negates tax evasion/avoidance and rules out any justification on that ground. The possible corollary of this conclusion is that the freedom of establishment includes the right to select a structure and place its various elements in Member States with beneficial tax regimes. The Court further noted that a conclusion that the German anti-thin capitalisation provisions were justified opened up the risk of double taxation, if under Netherlands law the interest would have been taxable there (despite being recategorised as a distribution of profit in Germany). Such double taxation would have meant that the German anti-thin capitalisation rules were disproportionate to the aim sought to be achieved and therefore unjustifiable.

How do the UK’s thin capitalisation rules compare with the German?

The structure of the UK’s thin capitalisation rules so far as relevant is very similar to the that of the German rules considered in the Lankhorst-Hohorst case, apart from the absence of the 3:1 safe harbour.

The configuration of the UK rules is very slightly different, in that in UK law the discriminatory feature is included through what purports to be a relieving provision, ICTA 1988 Section 212 in the case of the "first layer", Section 209(2)(da), and Schedule 28AA paragraph 5, in the case of the "second layer", transfer pricing. By contrast, the discriminatory feature in the German rules was to be found in the body of the provision itself. This minor difference would not, it is thought, carry the day with the ECJ, which has shown a determination in direct tax cases to look through convenient labels attached by Member States to direct tax provisions, to their substantive effect (as in the case of Epson where an impost on a dividend was held to be a withholding tax even though it was described as a gift tax by the source Member State).

The conclusion which appears to follow is that the UK’s anti-thin capitalisation rules are likely to constitute an unjustified restriction on freedom of establishment, where the investee company is UK resident and the shareholder or lender is resident in another EU State. It would only be in a case where the Inland Revenue could show that the financing structure employed was a wholly artificial arrangement designed to circumvent UK tax legislation that the ECJ might be prepared to take a view more favourable to the UK Government.

How might the UK (and other Member States) react?

It is worth noting at the outset that decisions of the ECJ are binding throughout the EU and are not appealable.

There appear to be two ways forward for the UK and other Member States wishing to keep anti-thin capitalisation restrictions in place. First, the scope of the restrictions could be restricted to "wholly artificial arrangements designed to circumvent" the tax laws of the relevant Member State, with appropriate agreements with other Member States to safeguard against potential double taxation (and consequent disproportionality). Secondly, the scope of the restrictions could be widened to embrace inter-company financing wholly internal to the Member State concerned (i.e where the subsidiary, the corporate shareholder and the affiliated lender are all resident in that Member State). It is understood that the Netherlands is considering such a step as a result of an EU law challenge on a separate issue regarding group financing.

What about interest paid to non-EU companies?

As was pointed out above (see "The freedoms"), free movement of capital is a separate and distinct freedom from freedom of establishment. Free movement of capital applies not only to movements of capital between two or more Member States, but, with effect from 1 January 1994 (and with a saving for restrictions already in place on that date), to movements of capital between one or more Member States and a non member state.

When a company ("X") resident in a particular territory ("A") forms and capitalises a subsidiary ("Y") in another territory ("B"), X is not only (in terms of EU law) establishing itself in B, it is also moving capital from A to B. Where both A and B are EU States, it is more natural to analyse the issues in terms of freedom of establishment (as was the case in Lankhorst-Hohorst) and there is no need to consider free movement of capital. However, where A is a non-EU State and B is an EU State, anti-thin capitalisation rules under the law of B may be capable of constituting an unjustifiable obstacle to Y’s right to obtain its capital from the territory of its choosing. It should not, therefore, automatically be assumed that anti-thin capitalisation rules which apply only to companies whose parent is not in a Member State will be upheld.

What should UK companies do now?

In cases where thin capitalisation restrictions are relevant to an open enquiry, consideration of arguments based on the Lankhorst-Hohorst decision, will clearly be appropriate. (Indeed in view of the Court’s general approach to Member States’ direct international tax rules, some of the wider points of principle may be relevant to disputes in other areas, such as the controlled foreign companies rules). Consideration might also be given to review, to the extent permitted by applicable time limits, of CTSA returns which are not the subject of an enquiry.

© Herbert Smith 2003

The content of this article does not constitute legal advice and should not be relied on as such. Specific advice should be sought about your specific circumstances.

For more information on this or other Herbert Smith publications, please email us.

To print this article, all you need is to be registered on

Click to Login as an existing user or Register so you can print this article.

In association with
Related Video
Up-coming Events Search
Font Size:
Mondaq on Twitter
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
Email Address
Company Name
Confirm Password
Mondaq Topics -- Select your Interests
 Law Performance
 Law Practice
 Media & IT
 Real Estate
 Wealth Mgt
Asia Pacific
European Union
Latin America
Middle East
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.


Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.


Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.


A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.


This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.


If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.


This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at and we will use commercially reasonable efforts to determine and correct the problem promptly.