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HMRC internal manual

International Manual

HM Revenue & Customs
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Thin capitalisation: practical guidance: creating agreements between HMRC and the group: consequences of a covenant breach

In early 2008, a document was published on the HMRC website entitled “The consequences of a breaching the financial covenants set by an Advance Thin Capitalisation Agreement”. This was intended to set out HMRC’s thinking on a matter which had become a significant area of interest for tax payers and their advisers.

It is reproduced here (note that INTM521010, mentioned below, has been deleted):

The recent Statement of Practice (04/07) [now SP01/12] explains how the legislation covering ATCAs will be applied in practice. Some practitioners have questioned HMRC’s approach in requiring what they perceive as an automatic disallowance of interest if the terms of the ATCA are breached.

A company that borrows from (or with the support of) a connected party has to take account of Schedule 28AA ICTA 1988 when making its CTSA return each year. This means self-assessing its borrowing capability in line with the arm’s length principle. An ATCA allows a company to enter into a forward agreement with HMRC setting out the terms on which HMRC will accept that the company’s interest payments represent an arm’s length cost of borrowing for a period of (usually) three to five years.

An important feature of the agreement is the means by which the company’s profits can be adjusted for any year in which the interest payable exceeds the amount which would be payable at arm’s length. Section 9 of the model ATCA which accompanied the Statement of Practice provides for a way of calculating a disallowance in the event of a breach of the terms of the agreement. Section 10 then provides the opportunity for the company to set out circumstances in which the disallowance would not automatically apply.

INTM521010 says that the UK legislation dealing with thin capitalisation is based on the position of an independent, third-party lender. In negotiating an ATCA an inspector will draw on the practices of a third-party lender in agreeing parameters within which the borrowing will be accepted as representing an arm’s length price. However, it is impossible for HMRC to put itself precisely in the position of such a lender, especially at a time when a breach takes place.

When dealing with the potential breach of an ATCA (or any thin capitalisation agreements made pre-ATCA), HMRC does not advocate an approach based on what a third-party lender might do if the terms of a loan agreement were breached. This is because the relationship between a third-party lender and the borrower is different from that between HMRC and the taxpayer. A borrower will be very aware of the likely consequences of breaching the terms of the loan agreement; the most likely of which is an increase in the cost of borrowing, in some cases amounting to a complete refinancing. Other potential consequences might include a requirement for increased security, increased support from the borrower, such as a right issue, or ultimately foreclosure on the loan or the appointment of Receivers. Wider consequences might include negative publicity denting market confidence and leading to fall in share price, a falling off of orders, tightening of terms by other creditors, etc. Borrowers and lenders both recognise these potential threats and the amount being lent will take account of them. The borrower will model the potential outcomes of a business downturn, while the lender will scrutinise plans and forecasts and will be kept closely aware of business performance. Both the lender and the borrower will build in headroom between the limits set by the financial covenants and the amount borrowed. A borrower will not expect or want to borrow an amount that leaves no headroom.

Contrast this with the potential downside if a taxpayer breaches the terms of an ATCA. From a group perspective, there may be no additional cost in an increased interest charge; indeed in a lot of cases it may actually reduce the overall amount of tax the group pays. Nor are taxpayers and their advisors generally concerned to build in headroom; instead they may push for financial covenants that effectively dictate the level of borrowing. It is a different relationship altogether, and HMRC cannot and would not try to replicate the close monitoring or the range of corrective measures and penalties available to the lender.

If there is a breach of an ATCA, it is most likely to occur because the business does not perform in line with forecasts provided when the ATCA was negotiated, the nature of trading is different from what planned, or the balance sheet structure has been changed. It is sometimes suggested that in the event of a breach, the remedy should be to renegotiate the ATCA to reflect the current position, rather than refer back to the position as predicted say three years prior. This may be appropriate for future years, but not in our view relevant retrospectively, just as it is most unusual for an arm’s length lender to retrospectively amend loan covenants. In practice, this suggestion of simply revisiting the terms appears to imply that the ATCA should be renegotiated using looser financial covenants based on an assumption that a third-party lender will relax the existing terms. It is highly questionable whether a third-party lender would react in this way, given the headroom built in to third-party lending to prevent such occurrences, and the fact that there will be more triggers for breaches and a greater range of remedies than an ATCA can sensibly allow. In the event that such flexibility was offered, it would very likely be over a short time-scale, for example a single quarter’s covenant being missed. Given the likely third-party approach, and the lack of headroom within ATCAs, there is little reason for HMRC to agree an approach based on renegotiation of covenants in the event of a business downturn.

A taxpayer has a responsibility when entering into an ATCA, just as a borrower has a responsibility when entering into a loan, to ensure that the business plan underlying the agreement actually reflects the forward intentions of the Directors and the business. Lenders do not willingly tolerate unexplained variances from a business plan, and on the basis that an ATCA and associated monitoring is not as finely tuned as a loan agreement process, there is no reason why HMRC should be different.

This does not mean a taxpayer is worse off by entering into an ATCA rather than reviewing the thin capitalisation position each year. Examining the position each year would mean assessing the borrowing capability each year by reference to the results for that year. Under an ATCA the borrowing capability is assessed at set intervals against the results at that time.

Thin cap agreements are intended to provide certainty and administrative convenience for both for companies and HMRC. As far as possible these should be self-administering, with the company knowing what it needs to do to report the annual position and both sides clear on what will happen in the event of problems. That requires commitment on both sides towards framing terms in such a way as is likely to promote these aims, and then as far as possible adhering to them.

The basis for the remedies included in the Model ATCA is a two stage one: if a computational disallowance is made, sufficient to eliminate the effect of the breach, the only further consequence is the obligation to report the problem and its solution for monitoring purposes. It is only if the company decides not to accept the disallowance that a breach is properly recognised and will need to be discussed with HMRC. It is obviously the company’s decision whether to absorb the breach in this way or to bring it to the discussion stage.

HMRC expects the company to take matters to the discussion stage only in the event of an unusual, unexpected or catastrophic event or set of circumstances. No examples have been included in the Model ATCA, though there are several at INTM520070. HMRC aims to be reasonable in its approach to breaches of agreements. If, say, production at a UK manufacturing business is unexpectedly halted for an appreciable period, so that production is severely disrupted and anticipated performance is undermined, we are likely to listen. However, if the agreement provides that a proportion of earnings be applied to reduce the debt each year, and used for some other purpose, that represents an intentional breach and persuasion may be more difficult.

If a breach has occurred which the company feels justified in bringing to the table, then the sooner it notifies the appropriate office, the greater the chance of a useful discussion.

If a taxpayer is looking to use an ATCA to obtain certainty that it can have interest relief, even if the financial results don’t materialise as anticipated, there is little point in HMRC entering into the agreement.

Very little of this is new or unique to the ATCA process, but reflects our continued position on thin cap agreements and in particular on an issue which has been causing difficulty in a number of working enquiries.

End of paper

Care is needed to ensure the consequences of a breach are clearly considered in the ATCA. The following points should be included in the agreement:

  • a requirement to inform the HMRC office responsible for monitoring the agreement (usually the company’s corporation tax office) as soon as a breach becomes apparent (whether or not it has technically taken place).
  • a statement of the consequences of not rectifying a breach in the agreement in whatever time has been agreed.
  • a provision covering the circumstances in which the breach may be discussed.
  • identification of the accounting period in which any disallowance of interest for corporation tax purposes will occur. This will normally be in the year the breach occurs.