Thin capitalisation: practical guidance: interest cover - debt servicing: factors affecting the interest rate
What is the arm’s length interest rate?
The arm’s length test not only applies to the amount of debt; it applies to all the terms and conditions of lending, including the interest rate. It is necessary to determine whether, having regard to all the facts and circumstances, interest is charged at an arm’s length rate. It is said that a price can be put upon even the riskiest, unsecured loan, but it may not be one that a borrower would be prepared to pay.
It is not easy to decide whether a particular interest rate is excessive, since for any particular loan there may be a range of interest rates that can be regarded as being at arm’s length. The proper interest rate for a transaction clearly depends upon the facts and circumstances of a case.
Factors that affect what can be borrowed
A third-party lender will carefully assess the risks involved in a proposed loan. In an intra-group context, such risks should be considered in evaluating the arm’s length interest rate, as well as the amount of the loan. Factors that affect what may be borrowed, which tend to relate to either the nature of the intended investment or the character of the borrower include:
- the purpose of the loan.
- the extent of any existing debt, because a high level of existing debt will reduce the borrower’s ability to take on more and increase its cost. At arm’s length, new debt is likely to be subordinated to existing debt. See INTM519030 in relation to layers or tranches of debt
- security available for the loan, and the quality of these assets
- expected cash flow - a lender will examine the borrower’s cash flow, both historic cash flow and those that are projected
- the borrower’s credit status which may be difficult to establish if a company is not being considered on its standalone merits by a third party lender
- whether a business is well established, its track record
- the state of the market at the time of the deal.
The above factors reinforce the point made in INTM514010: that getting to know the business in a thin capitalisation case is extremely important.
See also the chapter on Loan Pricing and Credit Ratings starting at INTM524100, particularly INTM524170 and INTM524180.
Pushing up the interest rate
A third-party lender will not simply go on increasing the proposed interest rate by an extra margin for each perceived risk, since that increases the risk of the borrower not being able to service the debt. Also, at some point the risk becomes so great, and the interest rate so expensive, that no loan would be offered or taken up. A balanced, common sense approach is needed in each case - there is unlikely to be any single correct answer.
Fixed or floating interest rate
- fixed rate is where the interest rate does not change, for example, a fixed interest rate of 5.5% may apply to a loan, and
- floating rate is where the interest rate fluctuates with a base rate to which it is linked, for example, an interest rate of LIBOR + 2%.
A borrower may prefer a fixed rate that gives certainty of outgoings over a period of time, or go with a floating rate and gamble on the chances of the base rate remaining low or falling. Lenders are prepared to give fixed rates, but usually at a slightly higher rate than the floating rate, to cover the risk of the market moving upwards during the term of the loan. Conversely, if the lender predicts the market rate decreasing over the term of the loan, the premium for the fixed rate will be small.
The exposure to uncertainty which these options provide can be offset by entering into a contract to exchange interest obligations with another party, swapping fixed for floating or vice versa. This is known as an interest rate swap, and is a type of derivative. There is detail about interest rate swaps in the Corporate Finance Manual, with an example at CFM13320. Each borrower is looking for an advantage that they are not in a position to obtain directly.
Influence of the term of the loan
The longer the loan, the greater the scope for something to go wrong, and the greater the risk to a lender. As a result, the interest rate is normally higher for longer-term loans. In practice, many companies relying on third-party borrowing will have a mixture of short, medium and long-term loans, providing flexibility and priced according to purpose, whereas intra-group borrowing is often funded largely with a long-term or open-ended, slab of debt. A substantial UK sub-group may be financed by a single massive intra-group facility. If such a group was funded by third-party debt, it is likely it would have some cheaper, shorter-term debt. It is, however, a questionable exercise to try to create a debt profile consisting of the short, medium and long components seen at arm’s length, but there may be an argument for lowering the overall interest rate to take account of the greater flexibility which would be available at arm’s length.
Long-term or open-ended debt may be treated for thin cap purposes as having an appropriate terminal date, in accordance with what would have happened at arm’s length. This may correspond with the period of the proposed thin cap agreement, or may be an issue that will need to be reflected over the longer term. In practice, longer term funding is often overtaken by events in the shorter term: further acquisitions, refinancing, etc.
It should also be borne in mind that the longer the term, the more the debt takes on the characteristics of equity, with the possibility that there is a transfer pricing risk.
The existence of security for a loan will mean access to cheaper borrowing than unsecured debt, and the quality of that security will also influence the price. See the chapter on lending against assets at INTM518000. Security can have varying degrees of significance, sometimes being no more than a “belt and braces” addition to the other terms.
Currency of the loan
The currency in which a loan is made may present some risk to one of the parties. For example, if there is evidence that the currency in which the borrower operated and held its assets was consistently declining in value against the currency in which the loan was made, then the borrower would want to protect itself against foreign exchange losses. A UK company operating in sterling would need a very good reason (and good forex risk management, which is often neglected entirely in intra group situations) to take out a loan in a currency which was not stable against the pound. It is therefore necessary to consider why a UK company would take out a loan in a currency which leaves it exposed to significant foreign exchange fluctuations, and what it has done to protect itself against that risk. Intra group loans tend not to be hedged against forex risk.
Finding an arm’s length interest rate may be difficult, but the following issues may contribute towards reaching a conclusion:
- Is there a credible comparable uncontrolled price? Tax advisors may quote bond issues by similar companies at similar times, but these need to be scrutinised carefully, particularly when the period in question is one of volatility, or a lack of market confidence exists amongst lenders.
- Does the company have any third party borrowing or has it had any definite offers of third party funding which might provide a starting point for determining an appropriate interest rate?
- Is a challenge to the rate likely to be cost effective, bearing in mind that any adjustment may be a matter of basis points (hundredths of a per cent)?
See INTM516035 for information on LIBOR and details of intranet access to LIBOR rates.