INTM413030 - Transfer pricing: thin capitalisation legislation and principles: the “would” and “could” arguments

Putting the parties at arm’s length

The test of thin capitalisation is to test the actual borrowing position against the arm’s length borrowing position.

The arm’s length principle recognises that connected parties may enter into transactions with each other on terms which differ from those which would be found in the open market between entirely unconnected persons. Where profits arise and the extent to which those profits are taxed may also differ from the arm’s length position.

The application of the arm’s length principle requires a judgement on the merit of each individual case to establish what would have happened at arm’s length; the terms on which the company in question could have borrowed and would have borrowed (if anything),

  • as a separate entity
  • from a third party lender unconnected with the borrower, and
  • without guarantees or other forms of comfort from any party connected with the borrower.

There are two main ways of looking at the borrowing: what the lender would do and what the borrower would do if the circumstances were as outlined above, and these are expressed as:

  • the “could” argument - what a lender would have lent and therefore what a borrower could have borrowed - and
  • the “would” argument - what a borrower acting in the best interests of their own business would have borrowed.

The “could” argument

This is generally the less subjective issue. The could argument focuses on what a lender would be prepared to lend to the company and on what terms, taking into account the borrower’s capacity to borrow, the risk of default, assets (as security) and liabilities (additional drains on the borrower’s resources), and its ability to service the debt: in short, how much and on what terms a lender would lend.

Risk elements will include amount, duration of lending, purpose, security, currency and the economic climate at a sector, national and international level.

The “would” argument

This issue is more subjective, since it can involve the whole basis on which the business is run. The “would” argument considers the borrower’s perspective: whether the borrower would have entered into the actual transaction in the absence of a special relationship (INTM412020) with the lender. Therefore, when trying to establish the amount and terms of arm’s length debt, the “would” argument relates to how much, and on what terms, the borrower would have borrowed at arm’s length bearing in mind the sort of issues mentioned below.

So, the “would” argument requires consideration as to what terms a borrower would have agreed at arm’s length, such as

  • the amount of debt, and whether that leaves headroom to allow the borrower to absorb cyclical or seasonal variations, an unforeseen event or a fluctuation in interest rates or profits, and ultimately repay the principal;
  • the costs of borrowing, and whether forecasts indicate that the borrower is likely to be able to service the debt fully and still have sufficient cash to operate as a profitable going concern;
  • whether the other terms, such as the interest rate or provision for early repayment are ones to which the borrower would have agreed in the absence of a special relationship;
  • whether the borrower would have taken out the loan at all.

Consideration of all aspects of the “could” and “would” arguments should highlight situations such as where

  • an arm’s length interest rate is being applied, but the amount of debt is more than the borrower could have borrowed from an independent lender, or
  • an arm’s length interest rate is applied to an arm’s length amount of debt, but the borrower appears to have no purpose of its own for borrowing the money (and therefore no reason to borrow other than the group relationship).

Debt reduction

Debt is not necessarily paid down to nil. A certain level of debt is acceptable, even desirable in most companies, and while higher levels of acquisition debt tend to be reduced in the years following the transaction, there is likely to be a level of debt appropriate to the needs of the business, year on year, appropriate to achieving the right balance between debt, equity and profitability. However, any debt which is treated as to any extent renewed rather than paid off should be considered in the light of circumstances at the time of the renegotiation as original terms may well not be applicable. If debt taken on to finance a large acquisition is renewed as finance for general purposes, different considerations will apply. Intra group debt may not recognise such changes.