Thin capitalisation: practical guidance: measuring earnings: measuring borrowing capacity
A vital part of settling a thin cap enquiry or finalising an application for an Advance Thin Capitalisation Agreement is to agree with the taxpayer how to measure the borrowing capacity for each period. Borrowing capacity in this context refers not only to what a company could borrow, but also to what it would borrow. Even if it is adequate for current periods simply to consider amounts in the accounts, a formulaic approach will usually apply when agreeing what is arm’s length debt for future periods, for example, an ATCA may state arm’s length debt may be no greater than a specified multiple of annual profit. Terms such as “debt”, “profit”, etc, will also need careful definition so that a consistent measure is applied for each year of the agreement.
This approach is similar to that of lenders incorporating covenants into loan agreements to help them monitor the continuing ability of the borrower to service the debt. A covenant may provide that profits should exceed a multiple of the interest expense. If the borrower fails to satisfy that test, the lender may take action to protect their investment. Similarly, thin cap covenants measure the maximum amount of arm’s length debt for a period, so if they are breached there will normally be a disallowance. Sufficient interest will be disallowed so that the remaining interest debit constitutes no more than the covenant allows. The covenant is restored. Disallowance is the usual solution under an ATCA, but there may be other remedies (see INTM520070).
Lending covenants and thin cap covenants serve different purposes, and there is no reason why they should mirror each other. One provides an early warning of financial difficulty; the other represents the border between the arm’s length and the non-arm’s length.
This chapter is about the way in which debt and interest are defined and measured to establish the arm’s length result for the company. The manual then looks at the following related topics:
Interest Cover INTM516000
Debt and Equity INTM517000
The usual starting point for measuring profits is EBIT - Earnings Before Interest & Tax. In the profit and loss account (UK GAAP) or income statement (IFRS) this is usually referred to as ‘operating profit’, the profit remaining after the deduction of administrative costs.
Further adjustments may then be made to adjust this profits figure, so it is closer to actual cash flow, usually by adding back the profit and loss account deductions for depreciation and amortisation, both being significant non-cash items. This produces EBITDA - Earnings before Interest, Tax, Depreciation & Amortisation, a measure commonly used for covenants in third-party lending agreements and adopted for HMRC thin cap agreements.
Different ways of calculating the accounts profits and the reasons for opting for a particular method are discussed from INTM515020 onwards.
Cash flow is of particular importance to third-party lenders (see INTM516070). This is because a lender is interested in the borrower’s ability to meet interest and repayment obligations, not accounting adjustments that may have no cash flow effect. A cash flow measure shows the extent of that ability, by excluding non-cash accounting adjustments.
Where the borrower does not prepare a consolidated cash-flow position, perhaps because it is part of a larger group, then a computation based on the borrower’s operating profit can be an acceptable substitute.
However, there is a risk in eliminating accounting adjustments and focusing too exclusively on cash flow. This is because while some annual accounting entries, such as depreciation, may not feature in a cash flow calculation, they may still indicate the need for significant expenditure at a future date. See INTM515040.
It is important to a potential lender to know that the borrower manages cash efficiently, since cash flow problems can cause even a profitable business to struggle or fail.