Thin capitalisation: practical guidance: measuring debt: what is an acceptable arm's length standard?
An arm’s length transaction is one that takes place between independent persons, each of whom is acting in their own best interests. As with all transactions at arm’s length, there may be a range of terms and prices that persons acting independently might agree, all of which might be arm’s length but which vary from each other because of a range of influences, such as:
- the other terms and conditions of the deal
- the past/present/future state of the local/regional/national/global market/economy
- the long/short amicable/hostile business relationship between the parties
- the long/short term business strategies of the parties
Lending/borrowing transactions are no different. Presented with the same borrower, different third-party lenders may come to different decisions, all of which would be accepted as arm’s length. The borrower will often be able to shop around and negotiate.
UK legislation and practice adheres to the arm’s length principle, and does not use safe harbours, as a number of other tax regimes have done. Each case is considered on its merits.
The ratios used as covenants in third party loan agreements serve as triggers to alert the lender to poor performance, decline in asset value, etc. They have only an indirect relationship to the amount which the lender actually lends. The ratios in a thin cap agreement determine the limits of arm’s length borrowing, that is, if a ratio is breached, the “excess” is treated as non-arm’s length and will be disallowed.
It is impossible and undesirable to try to provide debt:EBITDA or debt:equity ratios which apply across the board as measures of arm’s length debt. Just as with interest rates, the factors listed in INTM516030 under the heading ‘lending risks’ are just some of those that may need to be considered. Nevertheless, there are some broad principles that are worth considering in relation to debt ratios:
- For a business in a “steady state” (that is, neither expanding nor contracting rapidly) there will be a fairly narrow range of offers from third party lenders. In a steady state, the borrower is able to demonstrate whether it is able to service a particular level of debt, and the lender therefore has comfort both for present and (so long as it is maintained) future performance and some assurance of recovery of debt in the event of default.
- The levels of Debt:EBITDA and debt:equity ratio required by lenders vary considerably between business types. Debt:EBITDA is favoured as a ratio more often than debt:equity, because of its link to cash, but financial trades find a debt:equity measure more appropriate. Businesses such as motor finance companies are highly geared because money is in a sense the trading stock of the company, while the interest cover will be less than that of a non-financial business, because the finance company’s profit comes out of the margin between its borrowing costs and its return on lending. At one end of the scale, an insurance company or a dot.com company may be thinly capitalised even on ratios that might be quite sustainable for other businesses, while a finance leasing company is likely to be able to obtain and sustain much higher multiples of debt.
- Companies in a particular business sector may tend towards a typical borrowing profile but those ratios should not be taken as prescriptive in all circumstances. Comparison with similar businesses that have substantial amounts of third-party debt may help in coming to a decision, but they are at best indicative of possible debt levels, and if they are part of a group the borrowing may be supported by guarantees (which would be disregarded in considering what the company could and would borrow at arm’s length). Equity plays different roles in different businesses. In regulated financial businesses, for example, capital is used to support catastrophic circumstances rather than as security for borrowing.
- If a group of companies acquires a new business, company or group, then a third-party lender may be prepared to accept a “debt spike” of increased gearing for a few years following the acquisition, provided the lender is persuaded that increased productivity, new income streams, streamlined processes, etc, will provide the funds to service and manage the extra debt. The amount of the increase will, of course, depend on lending risks, and will be determined by the strength and reliability of projections demonstrating that the group can manage the debt and meet repayment terms as well as meeting its obligations to trade creditors, shareholders, etc. The thin cap agreement will tend to set ratios which gradually, year by year, squeeze allowable debt back towards steady state levels.
- The business model will be a factor. Private equity type ventures are likely to be more highly leveraged than more “traditional” types of business (see INTM519000)
- Publicly-quoted UK companies face market pressures and adverse analysts’ comments if they move out of an accepted range of debt:equity ratios (or other equivalent measures), and so tend to stay within an appropriate range except in circumstances such as those outlined above. Reviews of major corporations have shown that a debt:equity ratio greater than 0.6:1 is rare in most publicly-quoted companies.
Within HMRC there are specialists with experience of dealing with thin capitalisation cases in different business sectors. Transfer Pricing Group members and International Issues Managers should be able to either offer advice or identify a relevant specialist.