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HMRC internal manual

International Manual

Thin capitalisation: practical guidance: measuring debt: what is debt?

Debt is generally understood to refer to the situation where an amount owed by one person to another.

Thin cap is often about loans between connected parties, where the agreements governing them can be informal or lacking the detail found between parties acting at arm’s length. The nature of debt and interest are topics looked at in the Corporate Finance Manual (CFM), available online at the HMRC website.

The reference to a ‘provision’ in Part 4 of TIOPA10 includes transactions involving debts, so financial transactions are fully within the transfer pricing legislation. See INTM432040.

Agreements drawn up by third-party lenders will often define debt very carefully. For example, the following is taken from a real agreement:

  1. money borrowed or raised, including capitalised interest
  2. any liability under any bond, note, debenture, loan stock, redeemable preference share capital or other instrument or security
  3. any liability for acceptance, documentary credits or discounted instruments
  4. any liability for the acquisition cost of assets or services payable on deferred payment terms where the period of deferment is more than 90 days (except trading credit where the liability can reasonably be regarded as the subject of a bona fide dispute)
  5. any liability under debt purchase, factoring and similar agreements and capital amounts owed under financial leases, hire purchase or conditional sale arrangements
  6. any liability under any guarantee or indemnity (except product warranties)
  7. any liability under any foreign exchange or interest rate contract net of liabilities owed by the counterparty

Intra-group agreements seldom go into this detail.

In order to avoid disagreements over how terms are defined, great care should be taken when drafting thin cap agreements to define terms like “interest-bearing debt”. As well as identifying what should be included, such definitions can also exclude items - for example, trade creditors on normal commercial terms.

A useful starting point for a definition might be consideration of entries found in a set of UK accounts. In particular, Schedule 1 of The Large and Medium-sized Companies and Groups (Accounts and Reports) Regulations 2008 prescribes the balance sheet format for company accounts. The table below contains some examples of entries which might feature in an agreement’s definition of debt.

Type of Creditor Comment
Debenture loans A debenture clearly creates and acknowledges debt, and should be included in the definition of debt.
Bank loans and overdrafts Generally, these are interest-bearing debts and should be included. Revolving credit facilities should also be included.
Bills of exchange payable Companies may use a bill of exchange as an alternative form of finance to bank borrowing. If these are interest-bearing, they should be included in the calculation.
Other creditors that qualify as a financial liability in accordance with UK GAAP or IFRS, for example, preference shares that qualify as a financial liability These have the characteristics of debt and therefore should be included as such.
Trade creditors Unless these are interest-bearing, they should be excluded.
Payments on account These are unlikely to be interest-bearing, so should be excluded from the calculation of debt.
Amounts owing to group undertakings These should be excluded from the calculation of debt unless they are interest-bearing.
Amounts owing to undertakings in which the company has a participating interest These are amounts owed to associated entities and should be included in the calculation of debt if they are interest-bearing.
Other creditors including taxation and social security Debts involving HMRC come within the loan relationship legislation and they are interest-bearing. However, they are not normally significant enough to be included.
Accruals and deferred income These should not be included in the calculation of debt.

The following items may also need to be considered when measuring debt and equity for thin cap purposes:

Item Comment
Any interest-free loans As long as it remains so throughout the period of agreement, an interest-free loan may be treated for thin cap purposes as if it was equity. It is advisable to record in the thin cap agreement exactly what terms will apply for the duration of the agreement.
Finance lease creditors For accountancy purposes, a finance lease is treated as an interest-bearing loan. Ordinarily, finance lease creditors should be treated as debt. In cases of doubt it will be necessary to consult a compliance accountant.