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HMRC internal manual

International Manual

Thin capitalisation: practical guidance: accountancy issues: FRS 17: pension deficits and surpluses

The impact of FRS17 on thin capitalisation cash-flow financial covenants - pension deficits and surpluses

The difference between a pension scheme’s liabilities and its assets gives rise to a surplus or a deficit. These will impact on the amount of future contributions payable by the employer. In light of falling investment returns, pension deficits are frequently seen on company balance sheets.

Immediate correction of surpluses and deficits is rare. To eliminate a pension deficit may require a large one-off payment or a reduction in employees’ benefits. To eliminate a pension surplus may require a large refund, producing a number of possible problems:

  • the refund is taxable, and
  • pension fund trustees are reluctant to agree to release refunds in case there is a downturn in the markets.

Alternatively, the position could give rise to improved pension benefits, something groups are reluctant to do in case investments subsequently under-perform.

Treatment for thin capitalisation purposes

In assessing what impact the surplus/deficit should have on thin capitalisation covenants it is necessary to understand how reducing/eliminating the deficit or surplus would impact on a group’s borrowing capacity. For example, if there was a long term increase/decrease in contributions payable as a result of a scheme deficit/surplus, this may be reflected in the pension service costs in the accounts. If so, there may be no need to make any additional adjustment to operating profit for the interest cover covenant. If, however, there were significant differences between the contributions payable for a given period of time, say five years, and the accounting charges, we may want an adjustment to the operating profit to reflect this position. The treatment for thin capitalisation purposes around pension surpluses and deficits is very much fact dependent and specific to each case and will likely need input from your tax specialist and a compliance accountant.

Experience to date is that pension deficits are typically excluded from net debt in banking covenants and that there are similarly no adjustments made to the profit and loss account transactions in respect of scheme surpluses or deficits.