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HMRC internal manual

International Manual

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Thin capitalisation: practical guidance: third-party loan agreements: the general form of third-party loan agreements

A third-party loan agreement is likely to be a thorough and detailed document, intended to leave no ambiguity or doubt as to the obligations of the parties and what significant words actually mean.

It is helpful to be familiar with third-party loan agreements, since this will increase understanding of the terms under which lenders are prepared to make loans available. Some of the covenants used in an arm’s length agreement may also be appropriate when drawing up a thin capitalisation agreement (see INTM520000 onwards).

Third-party loan agreements vary considerably in detail and complexity. At the one extreme there is the simple one-page loan, or promissory note. At the other there is a long, complex document involving many parties, for example, a loan facility provided by a syndicate of lenders, administered by a separate syndicate manager and guaranteed by one or more members of the borrowing group. This chapter does not intend to examine third-party loan agreements in detail, but seeks to point out some of the more interesting features which may be relevant to thin capitalisation cases. By contrast, intra-group agreements tend to be brief, perhaps as little as one page or a few lines in the minutes of a management meeting.

All third-party loan agreements will contain most or all of the following terms:

Feature Comments
   
Loan Terms  
  The value of the loan

Drawdown conditions, including:

  • what pre-conditions have to be met.
  • the amounts and dates of drawdown(s).

The purpose of the loan

  • This may be generally described, for example, “for working capital”, or may be specific, for example, “for the purchase of a widget machine”. This clause is important as it allows the lender to “follow the money” into the asset acquired, and if appropriate, to obtain security over the underlying asset. A default clause may be triggered if the borrower does not use the funds for the stated purpose.

Repayment

  • amount and timing of repayments.

Interest

  • how it is calculated, for example, 5% above LIBOR.
  • when and how payable.

Security

  • what security is to be given, how and by which date. Effectively enforceable security is normally a pre-condition to drawdown.

Fees

  • who pays what and when. Many agreements contain review or renewal fees.

Costs

  • who is responsible for what costs? This typically relates to legal, accountancy and valuation fees.

Default clauses

As a minimum these relate to:

  • the non-payment of interest or capital repayments.
  • insolvency, or similar.
  • breaches of covenants (see below).    
      List of participants * typically, participants will include the borrower(s), lender(s), facility arranger, facility manager, and guarantor(s).
  • it is also sometimes unclear whether apparent third-party lenders have, in fact, taken a shareholding in the group - a possibility that should be considered. Apart from simple shareholding, the possibility of a special relationship and also the “acting together” rules may need to be considered - see INTM413030 and INTM519040.    
      List of definitions * particular attention will need to be paid to the definitions if there are financial covenants in the agreement, since they will indicate any particular variations in, for example, the way in which the debt:equity ratio, interest cover, etc, are defined.
  • if there are to be variations in the interest rate, this may well be defined here, for example, in relation to changes in credit rating during the term of the loan or in relation to improving or declining covenant ratios.
  • the interest rate may be pegged to a benchmark rate such as LIBOR (see INTM516035), and the definitions should contain an indication of which LIBOR or other rate is to be used (one month, three month, etc) and of the margin on top of that.    
      Financial and other covenants This is essential reading. It records in detail the conditions of the loan and the terms under which the borrower and guarantor may enter into other financial arrangements.

Typical types of covenants include:

Financial 

  • Profit and loss account ratios, for example, interest cover.
  • Balance sheet ratios, for example, gearing, liquidity.
  • cash flow ratios, for example, cover for interest and loan repayments, restrictions on investments, etc.

Operational 

  • limitations on the borrower’s ability to sell assets.
  • provision of financial information, what and by when. This typically also gives the lender the power to obtain the information at the borrower’s expense if it is not provided.
  • restrictions on changes to the nature of the business or the market of the borrower.
  • notification of changes of ownership.
  • changes to group companies and possible limitations on acquisitions or new group companies.

Some of the covenant terms are not easy to understand. HMRC has a number of banking specialists and compliance accountants may also be able to help.

Other features will include:

  • details of the financial conditions, including any obligations on a guarantor, for example, an obligation to maintain insurance. The figures for numerical financial conditions may be found here, with the definitions of the ratios found in the definitions section.
  • limitations on liens (a form of security over an asset) on property or assets may also be listed, along with restrictions on the ability of the borrower or the guarantor to transfer assets outside the group or to acquire assets on conditional sales agreements or other title retention devices.
  • limitations on the payment of dividends during the term of the loan may be imposed, in order to ensure the borrower is able to service the debt.
  • particular types of investment during the term of the loan may be restricted.    
      Monitoring conditions * the loan agreement will normally indicate how often and in what form information, particularly of a financial kind, will need to be provided.
  • it will also prescribe the procedures in the event of an officer of the borrower or guarantor becoming aware of a default.    
      Mergers and consolidations * restrictions on mergers and consolidations may be imposed by the agreement, ensuring that the borrower talks to the lender about such changes.
      Transactions with affiliates * the agreement may contain a clause to provide that transactions with affiliates - including capital transactions, may only take place under arm’s length conditions. This term may be useful, since third-party lenders will normally require specific documentation to demonstrate that this is the case.

Loan agreements need to be read carefully, however, the sections covering the items mentioned in the table will give an overall idea of the shape of the agreement.