Thin capitalisation: practical guidance: measuring debt: adjusting debt calculations: netting off of debt
Netting in general
As with interest at INTM516040, there are circumstances where the way debt is calculated for the purposes of the thin cap agreement may be redefined. If the new definition is acceptable, it will reduce the figure taken into account in checking that the borrower is compliant with covenants. This reflects commercial practice, but as with net interest, HMRC needs to take account of whether this would happen if an arm’s length relationship existed.
The willingness of a lender to accept covenants calculated on net amounts which are in effect less than the full amount of interest or debt is a sign that the lender accepts that the item to be netted - interest receivable, debt owed, etc - represents a source of income or of funds which in the event of problems would contribute towards meeting the borrower’s liabilities. This would tend to exclude anything which is not potentially realisable to help service the liability, such as items which are no more than book entries, and transitory or unreliable items.
The usual basis is simply to consider net debt: the amount of interest-bearing debt owed by the borrower less amounts of interest-bearing debt owed to the borrower, though it is not necessarily that simple.
A net debt basis allows a business to bring down the absolute level of interest-bearing debt by offsetting funds which it has retained in the form of onward lending, extended trading balances and the like. HMRC is uncomfortable about accepting the netting off of debts, because this may disguise how much debt is really being carried by a borrower, though individual cases may be considered on their merits.
A major concern for HMRC is that where a loan is in place which provides for tax deductions in the UK and is tax efficient in relation to other territories, there may be less incentive to reduce debt than would be found with third party borrowing. Business, Assets & International has seen a number of cases where debt has not been repaid when it could have been, with funds lent back to the parent or around the group, often at a lower rate of return than the company is itself paying. HMRC will wish to examine critically the borrower’s repayment arrangements and the use to which funds have been put.
In addition the borrower may seek to offset cash balances against debt. This is considered at INTM517130.