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HMRC internal manual

International Manual

Thin capitalisation: practical guidance: breaches of agreements between HMRC and the group: introduction to breaches

A “breach” refers to a company’s failure to comply with one or more of the covenants in a thin cap agreement, for example, because profits fall below the level necessary to maintain an interest cover ratio. See INTM520010 onwards on covenants and the structure of agreements.

Companies will strive to avoid breaching the covenants of third-party loan agreements. Doing so will result in increased interest rates, extra fees, and damage to the company’s reputation and credit standing. At the extreme it may put the company’s business in a precarious position, and leave the lender calling the shots.

Companies are arguably less concerned about breaching an agreement with HMRC. They are less likely to leave headroom between their planned borrowing and the limits which they agree with HMRC. Also, borrowing from within the group will shield the borrower from the consequences of breaching a third party agreement. Whatever the case, just as a third-party lender will have a range of policies for deterring and dealing with a breach of covenant, so it is important that all parties clearly understand what will happen in the event of a breach of an Advance Thin Capitalisation Agreement (ATCA).

Although the UK thin capitalisation legislation is based on the arm’s length principle, it is impossible and unnecessary for HMRC to put itself precisely in the position of a third-party lender at the time when a breach takes place. To suggest that it should do so ignores the fact that loan agreements and ATCAs serve two different purposes. The ATCA may have some characteristics of third-party banking agreements, but its purpose is quite specific.

The purpose of the ATCA is to provide a way of measuring the arm’s length amount of interest for each year of the agreement. Any “excess” interest, that which falls outside whatever parameters are put in place, is by definition non-arm’s length and therefore disallowable. A thin capitalisation agreement uses some features of third-party loan agreements, but in a modified way. Breach of a third-party loan agreement might result in recall of all or part of the loan; an ATCA will include a provision to disallow the tax deduction representing the non-arm’s length interest which created the breach. This “restores” compliance with the covenant. There may be additional or alternative consequences, such as an agreement that equity will be injected into the company in order to reduce debt or improve the debt:EBITDA balance.

A breach is not considered by reference to the arm’s length position at the time of the breach, but by reference to the agreement. This is a matter of statute (TIPA10/S220(2)). Since an ATCA is an advance pricing agreement, tax treatment is determined according to the agreement not according to the transfer pricing legislation at Part 4 of TIOPA 2010.

It is much easier to deal with a covenant breach if the agreement makes clear exactly what will happen in the event of a breach and what are the options for resolving the problem. If this is understood, the appropriate action is more likely to be taken if the time comes. Common conditions include:

  • an agreement to notify HMRC as soon as a breach becomes apparent or likely, and in any case within a prescribed time.
  • a clear statement of the consequences of a breach
  • a description of the circumstances in which the breach might be disregarded or treated more leniently
  • ways in which a breach may be rectified, with disallowance as the default option but not necessarily the only one.

These points are dealt with from INTM521020 onwards.

The importance of early notification cannot be over-emphasised. It is often much easier to deal with a potential breach, or one that has just occurred, than one that is two years old.