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HMRC internal manual

International Manual

HM Revenue & Customs
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Thin capitalisation: practical guidance: measuring earnings: the effect of accounting issues

A number of accounting issues will affect the calculation of a borrower’s interest cover. Some particular issues to consider are as follows:

If the borrower produces consolidated accounts, or consolidated figures prepared presentation to HMRC in thin cap discussions, these should always start with the audited figures for the UK borrowing unit (the UK borrower and its 51% subsidiaries - see INTM515050). Whether company law requires presentation on a consolidated basis or not, the borrowing unit will need to be considered on a consolidated basis. HMRC cannot demand full consolidated accounts, but it is reasonable to ask the borrower to carry out a limited consolidation exercise to bring the relevant figures together.

generally, if the effect of an accounting standard on the profit & loss account is of a non-cash type, it is unlikely it is to be of concern to third-party lender, unless it points to a future cost which the lender would want to take into account. When in doubt, consult an HMRC accountant.

Frozen GAAP - if there is a change in a accounting standard - a change from UK GAAP to International Accounting Standards, for example - then when monitoring compliance using covenants year by year, computational adjustments should be made to reinstate the accounting position upon which covenants were based when they were agreed (so-called “frozen GAAP”, which is used in third-party loan agreements). The thin cap agreement should confirm this explicitly. Whatever the case, both parties should understand which set of standards are to be applied and these should then be applied consistently over the life of the agreement.

An example, which has impact on cash flow:

Financial Reporting Standard 15 (‘FRS 15’) - Tangible Fixed Assets

FRS 15 sets out the principles for accounting for tangible fixed assets, except for investment properties. Its objective is to ensure that tangible fixed assets are accounted for on a consistent basis.

FRS 15 permits a company to choose whether its tangible fixed assets are stated at cost or a revalued amount. Where the revaluation basis is used, all assets with similar nature, function or a suitably qualified independent party must revalue use, and the valuations must be kept up to date. It acknowledges that in a limited number of cases no depreciation charge may be made, because it would be immaterial. If this is the case, or if depreciation is calculated on a basis that assumes that the useful economic life of an asset is greater than fifty years, the standard requires that annual impairment reviews be performed, to ensure that the ‘carrying amount’ of the asset is not overstated.

FRS 15 may therefore lead to an impairment being charged to the profit & loss account in a particular year, apparently reducing the interest cover for that year. If the debit is significant, it is likely to be shown as an exceptional item. The question is: what account should be taken of this when calculating the interest cover?

The possible financial impact of the impairment should be discussed with the company, but unless there is something peculiar about a particular case, the debit is a non-cash item. It will not normally affect the ability of the company to service its debt. If that is the case, it can be ignored for the purpose of calculating interest cover, where the aim is to look at the cash flow ability to service debt.

There is a wider discussion of the impact of accounting standards and in particular the effect of FRS 17 (Retirement Benefits) on pension scheme accounting, starting at INTM523000.