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HMRC internal manual

International Manual

HM Revenue & Customs
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Thin capitalisation: practical guidance: accountancy issues: FRS17: interest cost and expected rate of return on assets

Interest expense under FRS 17 / IAS 19 / FRS 101 adopters applying IAS 19

The defined contribution scheme interest expense represents the adjustment to the present value of pension scheme liabilities because pension benefits are one period closer to settlement.

Interest income: expected return on assets under FRS 17 / IAS 19 / FRS 101 adopters applying IAS 19

This is the expected return on pension scheme assets. (The difference between the actual return on these assets and the expected return recognised in the profit and loss account/income statement is recognised as a gain or loss in the STRGL/OCI.)

Net interest under revised IAS 19 / FRS 101 adopters applying revised IAS 19 / FRS 102

The approach on the net defined benefit liability (or asset) is defined at revised IAS 19 paragraph 8 as “the change during the period in the net defined benefit liability (asset) that arises from the passage of time”. This comprises the expected interest income on plan assets, the interest cost on the scheme obligation and interest on the effect of the asset ceiling (should one be present).

Treatment for thin capitalisation purposes

Operating profit measure: For entities reporting under FRS 17 the interest cost and the expected return on assets should be shown within the interest payable and receivable category in the accounts - that is, after operating profit. These items are considered to be effectively part of the ongoing regular pension costs, so for thin capitalisation purposes an adjustment should be made to deduct them instead from operating profit, so they are included in the “operating profit” measure used for thin capitalisation purposes.

For entities applying one of IAS 19, revised IAS 19 or FRS 102 the interest costs (or net interest in the case of revised IAS 19 and FRS 102) may not be shown within the interest payable and receivable lines. As such, further analysis of expenses may be needed in order to ensure the appropriate adjustments are made for thin capitalisation purposes.

Interest cost measure: As noted above, the pension scheme interest expense for a defined benefit scheme should be treated as part of the ongoing regular pension cost, and therefore treated as an expense deducted from operating profit. It is not treated as being “interest” for thin capitalisation purposes and so should not be included as “interest” for the thin capitalisation interest cover covenants. This adjustment will also be required for entities applying IAS 19, IAS 19 (revised) or FRS 102.

As practices are emerging, it may be that the interest costs are treated differently by the major banks in their covenants, for example, excluding it completely from all of their measures and calculations. As such, the approach taken should be flexible in line with emerging practices.