Thin capitalisation: practical guidance: measuring debt: the UK borrowing unit
The “borrowing unit” is the largest grouping whose assets and liabilities are considered in assessing whether or not a borrower is thinly capitalised. It represents (subject to certain provisos) the sum of the borrower’s assets and liabilities.
Before 1 April 2004, the borrowing unit for thin cap purposes was defined at ICTA88/S209(8A) as the UK parent company and all its 51% subsidiaries, wherever they were situated. Other group companies, whether in the UK or elsewhere, were excluded.
The position on or after 1st April 2004
The transfer pricing legislation requires that the borrowing company is considered without regard to guarantees from connected companies; in effect borrowing capacity is determined on a “separate entity” or standalone basis. However, it is accepted that even when assessing a potential borrower on a standalone basis, a third-party lender would take into consideration the assets and liabilities of the borrower’s own subsidiaries, so in practice, the post-2004 borrowing unit is (subject to the provisos below):
the borrowing entity + its subsidiaries
The borrower is the “top” company of the borrowing unit. In contrast to the pre-2004 position, if the borrower is itself a subsidiary within a UK group, the assets and liabilities of any company “above” it will be disregarded, since to do otherwise would be to recognise guarantees from outside the borrowing unit, which the legislation does not allow.
The stand alone basis means that guarantors are excluded, and that refers to any support from outside the borrowing unit. The definition of guarantee at TIOPA10/S154(4) is very wide, including a reference to a surety, and
“a reference to any other relationship, arrangements, connection or understanding (whether formal or informal) such that the person making the loan to the issuing company has a reasonable expectation that in the event of a default by the issuing company the person will be paid by, or out of the assets of, one or more companies.”
It is vital to identify the extent of the borrowing unit, so that the thin cap position can be accurately assessed from a consolidation of relevant figures drawn from the correct companies. The ATCA application should clearly identify what has been included.
Putting together figures on a consolidated basis for the borrowing unit can be a difficult and costly exercise for a multinational group, if different currencies and sets of accounting principles are involved. Prior to entering into a thin cap agreement, it may be wise to discuss the methodology and the extent of the exercise, for example, what to do where the accounts of subsidiaries are produced using foreign accounting principles or where the business is organised by division rather via companies with distinct businesses. If the company is entering into a thin cap agreement with HMRC it will need to be able to measure the performance of the borrowing unit against the conditions agreed, so the borrower must be able to produce the relevant figures on an agreed basis both for the negotiation of the agreement and for its smooth operation.
The provisions at TIOPA10/S182 and S192 allow UK lenders and UK guarantors to claim compensating adjustments where the borrower has suffered a disallowance of interest on transfer pricing grounds. S182 allows the simple elimination of double taxation where an expense has been disallowed. See INTM413000 onwards for details. These claims are separate from the transfer pricing adjustment to disallow the borrower’s interest.
Because the borrower is now either considered in isolation (if it has no subsidiaries) or as head of a sub-group (the borrowing unit), there can be complexities if there are a number of borrowing entities. This can produce borrowing units within borrowing units. It may be possible, if the group is small, self-contained and compact, to look at it on a composite basis. This is the usual treatment for private equity cases, where money may come in at different levels within the group, each forming part of the deal. This is a practical means of avoiding duplication of effort and unnecessary complexities, not an opportunity to expand the borrowing unit and artificially increase borrowing capacity.
In practice, some overseas subsidiaries of the borrower may need a closer look. There may be problems such as restrictions on the repatriation of profits or income to the UK, or there may be exchange difficulties, which mean that a third-party lender may be reluctant to accept the assets or income stream of the subsidiary as reliable security. Assets or income may simply not be accessible to the borrower. It may be preferable to exclude such companies, although they may represent a real liability or risk to the borrower which would need to be recognised as something which a lender might take account of.