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HMRC internal manual

International Manual

HM Revenue & Customs
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Thin capitalisation: practical guidance: opening a case: risk assessment - indicators of risk

Indicators of intra group borrowing

  • Unusually high intra-group creditors and/or debtors which are not formalised as loans , but which may be trading or other balances which have been left outstanding for longer than would be the case at arm’s length. Part or all of the balance may be a de facto loan
  • Guarantee fees, commitment fees, etc, in the profit and loss account
  • Sudden changes in debt levels, suggesting changes in commercial activity
  • Significant acquisitions during the year
  • Changes to the nature or structure of the group - perhaps the borrower is a new entity which has become the holding company for a pre-existing UK group, or has gathered a number of scattered group companies under its ownership.

Indicators of non-arm’s length borrowing

  • Calculate the value of the equity in the Balance Sheet. Equity for thin cap purposes means shareholder’s funds i.e. share capital, retained earnings, share premium and reserves (definitions are discussed at INTM517030).

    • How does the value of what the borrower owns (assets) measure up against the weight of what it owes (liabilities)?
    • Have accumulated losses eroded the value of shareholders’ funds? A company may be in negative equity because of a history of losses.
    • If assets have been revalued, do revaluation reserves represent genuine increased tangible asset value? Have the assets been recently, professionally and independently valued?
    • Is goodwill or other intangible being used to inflate asset value? This would normally be excluded for thin cap purposes, being the first thing to disappear when a company is in difficulties.
  • interest cover - how capable is the company of meeting its interest obligations as well as its other liabilities (present and future), or does it appear to be largely trading for the privilege of servicing its debts? Is it actually paying interest or is the interest being rolled up? (INTM516010 onwards)
  • Cash flow - if the accounts include a cash flow statement, does the company have the liquid funds to pay interest and repay principal?
  • Is the debt sustainable, in the light of what the ratios reveal?

It is unlikely that such a review will prove definitive, but should indicate whether there is a problem or not.

Mergers and acquisitions

Mergers, acquisitions and restructurings are opportunities for groups to maximise the tax effectiveness of their funding structure.

Mergers and acquisitions may take place by cash acquisition, share exchange, or a mixture of the two. The target’s shareholders may be offered shares in the acquirer as well as a cash element as an incentive to surrender or exchange their existing shares. Very few genuine mergers take place, in the sense of the coming together of equals, so the reality is usually that one group buys out the other, whatever the public presentation.

Following acquisition at holding company level, newly acquired subsidiaries may be passed on to the appropriate regional or local holding companies, so that a UK European holding company may take ownership of the acquired group’s European subsidiaries. If the top level merger takes place wholly or partly by share exchange, it is questionable whether integration at regional or local level would be achieved using debt. This may be difficult to challenge from a pure thin cap point of view, and may require the unallowable purpose legislation at CTA09/S441.

Previous thin cap agreements 

if an agreement was in place previously, was it complied with? How did the company deal with any problems?

Private Equity backed buyouts (INTM519000)

These are typically highly leveraged. If there is no ATCA in place the funding will require close consideration to ensure that appropriate adjustments have been made in the tax computations to achieve an arm’s length position, whether in terms of the amount of debt, the interest rate or the treatment of interest (PIK notes, etc).