Thin capitalisation: practical guidance: creating agreements between HMRC and the group: covenant conditions
A thin cap agreement should clearly state the financial conditions under which it is made and the consequences if they are not satisfied. This is a vital aspect of the agreement.
The following points should be covered by the agreement:
- the specific ratios used in the agreement and the values by reference to which arm’s length interest will be determined. Examples of appropriate ratios include: debt/EBITDA, debt/equity, interest cover, or any other appropriate measures of the borrower’s ability to support and service the debt. There should normally be two ratios in an agreement, one debt related, the other governing interest. A debt cap, that is, an absolute monetary limit on borrowing, is not regarded as a main covenant, but may be an additional feature.
- A statement of the years for which the ratios will apply, clearly identifying the value applicable for each period.
- an explicit statement of what will happen in the event that the company fails to comply with one or more of the financial conditions, including how disallowed interest is calculated and any withholding tax consequences. See INTM520060 for the text of a paper issued by Business International setting out HMRC’s views on what should happen in the event of a breach of covenant.
- if more than one covenant is breached, and both lead to a disallowance, it should be specified in the agreement that it is the greater disallowance of the two that will apply. HMRC has received proposals for a disallowance based on an “average” between the two breach amounts. There is no basis for this.
- explicit statements of the methods of calculation of the financial ratios, for example, whether EBIT or EBITDA (see INTM515020 and INTM515060) will be used and how any interest receivable will be treated. Where there is any complexity to the calculations, it may be useful to append to the agreement a worked example in hypothetical figures which can serve as the model for the annual compliance report.