Thin capitalisation: practical guidance: breaches of agreements between HMRC and the group: breach of covenant: disallowing the interest deduction
An advance thin capitalisation agreement is very likely to include a clause indicating that one of the consequences of breaching the financial conditions may be a disallowance of interest for tax purposes. Unless agreed otherwise, the disallowance will occur in the year of the breach.
Consider, for example, the situation in which the agreement includes a covenant limiting debt:EBITDA to a (purely illustrative) ratio of 8:1, but for some reason the debt component turns out to be greater than the agreement allows, resulting in an actual debt:EBITDA ratio of 10:1. If a decision is made to treat some of the debt (2 out of the 10) as non-arm’s length and the interest on that amount is disallowed, this can be sufficient to reflect what would have happened at 8:1, it achieves the effect of restoring the agreed ratio. The tax disallowance in the year will be the amount of interest on the non-arm’s length portion of the debt.
If there has been a breach of this sort, it may be necessary not only to calculate the disallowance for the current year, but to consider whether there is a fundamental reason for the breach which would make it advisable to negotiate a new agreement.
A similar calculation is made when the interest cover condition is breached; there will normally be a disallowance of interest sufficient to cancel the tax effect of the “excess” interest which caused the breach.