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The step here that is illegal is the moment company 1 takes out a high interest loan from company 2.

Company 1's directors have to do what is in the best interests of the company. If they choose to sign up to a high interest loan which will take all their profits, that isn't decision-making in the best interests of company 1. That's the point they can be put in prison.

I just don't quite understand how nobody is prosecuting them...

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When they save of bunch of taxes they have done what’s in the best interest of the company

They need to make decisions in the best interest of Company 1 and Company 2 separately.

An action done on behalf of Company 1 which slightly hurts company 1 but provides large gains to company 2 would be illegal (unless they can argue that it was part of a larger strategy to benefit company 1).

I assume the owners of Company 1 would need to bring the case, and if they're also the owners of Company 2 they would never want to.

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