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HMRC internal manual

International Manual

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HM Revenue & Customs
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Thin capitalisation: practical guidance: measuring earnings: exceptional items and unforeseen events

While companies will have business plans and projections, it is impossible to foresee every eventuality. The question may therefore arise as to whether there should be some flexibility in the calculation of interest cover for an unexpected situation. It is impossible to come up with a list of all eventualities and HMRC’s response to them. The comments below attempts only to give a few guiding principles.

Exceptional Items

In the early years following restructurings, mergers and acquisitions, there may be additional costs associated with integrating businesses, managing closures and redundancies, aligning systems, modifying brands, etc. These are not part of the regular expenditure of the company, but they will be real costs with a significant cash impact. It may be necessary to consider whether a thin cap agreement should take account of substantial additional costs in the early years of the loan, or whether the costs are short-lived and in any case likely to be offset by increased profits arising from the restructuring. There may be a time lag between the expenditure and increased profitability. Advisors may propose disregarding expenditure of this sort on the basis that it represents a temporary expense distorting the longer-term profitability of the company, and this should usually be acceptable. Such costs may occasionally appear in forecasts as remaining at significant levels for several years after the change, in which case their impact on profitability and on relevant compliance ratios should not be ignored.

Exceptional gains should likewise be disregarded in considering profitability for thin cap purposes, unless they form part of a loan repayment strategy.

Downturns in business conditions

These comments do not refer to widespread economic crises. Lenders and borrowers face much starker choices in such extreme circumstances and there is much variation in the effect. Some companies will struggle, while others may even prosper.

Normal downturns in business conditions are part of the risk of the business itself. Some businesses are cyclical in nature, so that the levels of profitability vary over time, though often in predictable ways. A third-party lender would consider the effect of this, and HMRC follows suit. Therefore thin capitalisation agreements (see INTM512000 onwards) will generally be cautious about lending where there is a perceived variability of profits.

Even where there is no cyclical pattern of business, downturns occur. It is therefore important to take into account the commercial direction of the business. This should of course be reflected in realistic business projections, but a general awareness of the business outlook will also help.

Generally, changes in the business cycle would be regarded by a third-party lender as something to take account of in agreeing terms, not to deal with piecemeal as they arise. This is why covenants such as EBITDA interest cover should have some “headroom” built in; neither the bank nor the borrower would expect the latter to bump up against the limit, but will leave some room for manoeuvre, to accommodate setbacks such as a downturn, without breaching the terms of the loan agreement. For example, redundancy costs resulting from a contraction of the business would be regarded as a normal expense to be absorbed by such headroom. Where there is a breach of a thin capitalisation agreement because of normal downturns in business, HMRC will normally expect a disallowance to be made. It will of course depend how severe the downturn is and how directly and how seriously it hits the particular industry in which the company operates.

The use of headroom is somewhat misunderstood. It is not a way of ramping up allowable debt by arriving at the borrowing capacity of the company and then adding a further percentage to increase it.

Catastrophes

By its very nature a catastrophe is unexpected, and it may have a profound effect upon the profitability of the business, so it is not something for which specific provision can be made in the interest cover calculation. A third-party lender might be tolerant of a catastrophic incident if it was temporary. For example, a food factory that was forced to close for a limited period because of contamination might seriously affect productivity and profits, but only as a temporary setback. It might have impact on results for a particular year.

In evaluating the risks of providing a loan, a third-party lender will normally include the potential for catastrophe and incorporate that risk into its calculations for the term and pricing of the loan. This element of risk could also be dealt with by the lender requiring that the risk be insured, with notice given to the insurer of the lender’s interest in the policy.

INTM512010 onwards contains more details on how these issues might be factored into a thin capitalisation agreement. This does not mean, however, that so-called exceptional items in accounts will be ignored. It is necessary to consider any exceptional cost on its merits, and to discuss the practical impact on business finances.