Thin capitalisation: practical guidance: measuring debt: adjusting debt calculations: netting off of cash
The question is what account should be taken of cash held by the borrower when the terms of the ATCA are being framed. This is only likely to arise when there is a substantial amount of effectively spare cash. Whether a set-off should be made partly depends on how far the cash is committed to a purpose and how vital that purpose is to the success of the business. For example, if £1m has been earmarked for an upgrade of manufacturing machinery which was essential for maintaining a competitive edge, it would not be available for netting.
Businesses may accumulate cash reserves for a number of reasons, including:
- Working capital requirements;
- Investment activities, e.g. acquisitions, capital investment;
- Pension funding requirements;
- Exchange controls or other government policies preventing repatriation of cash from overseas subsidiaries.
Where third party debt is on a net basis, the borrower will often have cash deposits with the same institutions. However, in intra-group situations it is often the case that, for a variety of reasons, cash deposits are held by entities other than the lenders, including the existence of a group cash pooling facility. Although the circumstances of these deposits should be considered, the fact the lender and the deposit holder are not the same entity may not preclude HMRC from considering netting.
It is usual in these cases to reduce the amount that may be set-off in order to recognise that the borrower cannot, as a working business, must retain some working capital. Any cash set-off in a thin cap agreement should be adjusted for amounts representing working capital and other essential purposes of the business. This may be estimated. The test should be what the consequences would be for the business if the committed cash were to be surrendered in settlement of the debt against which it has been netted. It is a matter for negotiation.
Netted amounts will be distinguished from assets and other amounts pledged as security for a debt. Netting implies that the lender is so confident of the ease and readiness of the borrower to part with the amounts involved that they are willing to make the covenants less stringent. These are the lender’s ways of monitoring the ongoing ability of the borrower to service debt or interest, rather than a question of what assets a lender might realise to recover amounts owing, possibly at the cost of the business’s survival.
The following are examples of what sums might be excluded from set off:
- cash held which is committed to similar arrangements with other lenders;
- cash held to satisfy pension trustees where there is a deficit in the borrowing group’s pension scheme;
- Cash required for working capital purposes;
- Cash reserved for non-discretionary capital expenditure.
Cash which is on-lent at an interest rate exceeding that charged to the borrower may be netted off on the basis that the UK should be obtaining a “turn” on the transactions and may be regarded as performing a conduit function rather than bearing the full risk of the loan. If the company cannot make a marginal profit on the lending, it may as well repay the debt.