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HMRC internal manual

International Manual

HM Revenue & Customs
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Thin capitalisation: practical guidance: interest cover - debt servicing: matters of interest

In thin capitalisation cases there is rarely a dispute about whether a debit or credit should be characterised as interest. When a disagreement occurs it tends to be about whether the interest in question is short or annual. Technical enquiries about the nature of interest should be referred to financial specialists at Business Income Tax, after referral to the Corporate Finance Manual (CFM).

The starting point for consideration of interest cover is the interest payable or receivable in the period as shown in the profit and loss account of the borrower. HMRC does not accept that interest payable and interest receivable can automatically be set against each other to provide a net figure for the purpose of calculating interest cover - see INTM516040 for more information on when netting may be appropriate.

The amounts shown in accounts as finance costs or income may not simply equate to the cash interest payable on the company’s debts or receivable on its investments. This is particularly true for large companies.

The main reason for this is that accounting standards require the cash flows that relate to a financial instrument to be spread over the instrument’s term, and relevant cash flows do not just include interest payable, though paying interest at regular intervals remains a very common way of recompensing a lender. For example, a company may issue debt at a discount (face value £100: issued for £90 and redeemed for £100), or redeem it at a premium (issued at face value of £100, redeemed for £110), so that the return for the lender is in the greater amount received when the security is redeemed. Discounts and premiums will affect what is recognised as a finance expense. CFM20000 onwards explains how loans and other financial instruments are accounted for under IFRS.

Companies may also issue securities that are convertible into or exchangeable for shares. The difference between values is spread over the loan period using accounting policies to produce the equivalence of an annual interest charge. The Corporate Finance Manual gives an overview of the ways in which a company may raise finance through borrowing, starting at CFM11000.

INTM516030 looks at discounted and convertible debt in more detail.

The cash flow statement may provide more information than the profit and loss account or income statement about the company’s ability to service debts. It is important to make sure the cash flow statement relates to the same companies as make up the UK borrowing unit for thin cap purposes (see INTM517050). This will generally only be the case where the borrower is the group parent.

International Accounting Standard 7 sets out what information a cash flow statement should contain and how it must be presented. In complex cases, HMRC staff should seek the help of a compliance accountant in interpreting accounts information. The chapter at INTM523000 gives some advice on the impact of accounting standards.