Thin capitalisation: practical guidance: interest cover - debt servicing: what is an acceptable arm's length standard?
Unlike many jurisdictions, the UK does not operate safe harbours. A safe harbour in this context is a legislative limit on interest deduction by reference to fixed ratios, such as a debt:equity ratio of 3:1 applicable to all company funding. Instead, UK legislation operates by direct reference to OECD principles and guidance, and although UK thin cap agreements use covenants expressed in the form of debt and earnings based ratios, these ratios are used because they are appropriate to the particular company based on a close analysis of the facts and circumstances of the individual case.
The thin capitalisation legislation, as part of the transfer pricing regime, applies the arm’s length principle in accordance with OECD guidance (See INTM422130)
When deciding what constitutes an arm’s length level of interest cover for a particular business, the factors to consider include:
- Information indicating the level of interest cover which a particular type of business will be likely to agree with third-party lenders, as interest cover figures vary considerably between business type
- If a group of companies is in the process of acquiring a new business, company or group, then a third-party lender may be prepared to accept lower interest cover for several years. The amount of the reduction in cover will, of course, depend on the lending risks involved, and thin cap agreements usually aim to chart the change in ratios from those of a company in “acquisition mode” to those of one in a “steady state”.
- Publicly-quoted UK companies are confronted with market pressures if they fall below their expected ability to pay dividends, and their debt must be serviced before dividends can be paid. Third-party lenders will therefore look particularly closely at the debt-servicing ability, although the existence and availability of realisable property as security may mean lenders are more relaxed about interest cover.
Commercial databases can be used to obtain details of debt levels for companies of a similar size and character in a particular industry.