INTM524080 - Thin capitalisation: practical guidance: the use of credit ratings: further considerations when using credit ratings in thin capitalisation cases
When the rating was carried out
The influence of an overseas parent
Problems that have occurred with independent credit ratings
Assessments of credit risk by a bank
The ‘would’ test in the UK thin capitalisation legislation
The need for financial covenants to protect the tax position
The need for a prudent borrower to have a buffer against adversity
The importance of the investment grade/non-investment grade distinction
Before weight can be given to an independent credit rating in a thin capitalisation case, there are a number of factors that should be considered:
- The entities being rated
- When the rating was carried out
- The influence of an overseas parent
- Problems that have occurred with independent credit ratings
- Banks’ own assessments of credit risk
- The ‘would’ test in the UK thin capitalisation legislation
- The need for financial covenants to protect the tax position
- The need for a prudent borrower to have a buffer against adversity
- The importance of the investment grade/non-investment grade distinction
The entities being rated
The first question to ask about the entities that have been credit rated is: are they the same as the borrowing unit we need to look at for tax purposes, and if they are, are they subject to influences from outside that unit which have not been fully adjusted for?
The rules in Part 4 of TIOPA10 use the separate entity principle or standalone basis, which broadly means that the borrowing unit consists of the borrower plus its 51% subsidiaries (the borrowing unit is defined in more detail at INTM517050).
There are potentially many situations in which the credit rating of the entity does not match the position required by the UK legislation. Consider, for example, a UK grouping comprising three sub-groups, one of which is regulated by the Financial Services Authority (‘FSA’). The regulated sub-group will be likely to have an acceptable independent credit rating, but the other two sub-groups may both be thinly capitalised.
When the rating was carried out
It is important to know at what date the figures were computed, and what has happened since then.
The influence of an overseas parent
When considering whether a UK borrower is thinly capitalised, any support received from an overseas parent or any other overseas affiliate (apart from subsidiaries of the borrower) must be disregarded - TIOPA10/S152(5). This needs to be borne in mind when independent credit ratings are presented in support of funding, because it can be unclear when looking at the headline rating to what extent the presence of an overseas parent has had an influence.
The involvement of a parent, or other affiliates, can usually only be ascertained by looking at the detailed reports underlying the rating itself. These reports will typically give two or even three different ratings, only one of which (the one we need to consider for thin cap purposes) will be the rating for the UK borrower as a stand-alone entity. The others will be the ratings for other groupings, such as:
- the UK borrower where another party, most commonly the overseas parent, has guaranteed the bond or debt instrument (where the rating will be equivalent to that of the guarantor), or
- the UK borrower where the parent, say, has not provided a formal guarantee but is held to be likely to support its UK subsidiary in the event that the latter has difficulty meeting its interest payments.
Problems that have occurred with independent credit ratings
The ratings agencies generally have a good record of predicting the likelihood of default on particular rated instruments, but on occasions they have been criticised for failing to identify the financial problems within major corporations. It may seem unfair to blame the ratings agencies for failing to spot frauds based on audited accounts, however, their critics point out the credit agencies maintained investment-grade credit ratings even when the worst was suspected and the share price had slumped markedly. The criticism is perhaps one of failing to move quickly enough to downgrade failing companies.
There was further criticism in the wake of the financial crisis of 2007-2008, particularly relating to large losses from asset-backed collateralised debt obligations (CDO) and the failure of the sub-prime mortgage market. The underlying assets bundled up into the CDOs were typically mortgages of variable quality, whilst the CDO was given an overall investment-grade rating. Widespread mortgage default by borrowers meant that many CDOs had to be downgraded significantly. The Oxford English Dictionary included sub-prime for the first time in 2008, referring to the term as “a credit or loan arrangement for borrowers with a poor credit history, typically having unfavourable conditions such as high interest rates”.
Assessments of credit risk by a bank
When deciding whether and on what terms to lend, banks and other lenders will carry out their own assessments of the credit worthiness of commercial borrowers. This is done even where a potential borrower has a strong independent credit rating.
The Transfer Pricing Team at CSTD Business, Assets & International has seen third-party agreements which indicate that, whether or not a company has an independent rating, a third-party lender will still insist on carrying out its own assessment of credit worthiness. It will also insist on having covenants based on interest cover and balance sheet strength and on being able to monitor the borrowing by reference to those covenants.
A third-party lender may take into account independent credit ratings in terms of fixing the level of interest on a particular loan (a higher rating resulting in a lower interest rate). However, these ratings will not replace the need for covenants whereby the lender can carry out its own assessment of the performance of the business to protect its position.
Independent credit ratings, while they may be able to contribute to the assessment of creditworthiness, are unlikely to be sufficient to satisfy a potential lender without the provision of other information.
The ‘would’ test in the UK thin capitalisation legislation
A credit rating, even if independently produced and resulting in an investment grade scoring, does not lead to an automatic conclusion that the borrower should necessarily obtain interest deductions on the full amount of the debt. Thin capitalisation requires consideration not only of whether a company “could” have borrowed the sums in question from a third party but also whether at arm’s length it “would” have done so - TIOPA10/S152(2).
Debt funding is cheaper than equity funding because:
- it produces a more certain return and is therefore less risky, and
- there are tax advantages associated with debt as opposed to equity funding.
However, as the amount of debt in business increases, so the cost of debt goes up, and this means that the cost of equity also goes up because the shareholder expects a greater return than the loan creditor to compensate for increased risk. High interest costs resulting from high debt levels can push up the overall cost of capital to an unsustainable level. This is why prudent businesses will seek a balance between debt and equity funding.
The need for financial covenants to protect the tax position
Even with an independent credit rating which is of investment grade at the onset of a loan, HMRC will expect the usual financial covenants with respect to the borrower’s debts.
It is sometimes suggested that HMRC should simply accept that interest deductions should be allowed unless a company loses its independent investment grade status. We cannot accept this.
It has been noted at INTM521010 that it is impossible for HMRC to put itself precisely in the position of a third-party lender when negotiating thin capitalisation agreements involving intra-group funding. That would apply here. HMRC is not operating an investment portfolio, but attempting to agree parameters within which the borrowing activity of a company may be accepted as arm’s length.
The need for a prudent borrower to have a buffer against adversity
As mentioned in INTM524030, credit ratings can change, and a UK borrower that only just meets investment grade status as a result of an independent rating exercise may be unable to exploit its maximum borrowing capacity because this may result in it losing its investment grade status. It is therefore necessary to look very closely at borrowers that are rated just above non-investment grade at the onset of a funding negotiation. These borrowers are likely to avoid taking on new debt that results in the borrower being relegated to speculative grade status.
The importance of the investment grade/non-investment grade distinction
The distinction between investment grade and non-investment grade credit ratings is important in the thin capitalisation context when an application for an advanced thin cap agreement is received. In this context, it is difficult to accept that at arm’s length a borrower with a non-investment grade credit rating could and would rack up greater levels of debt. It is also unlikely a company would take on additional debt if doing so would result in it being downgraded to a non-investment grade rating.
There is a market for debt which does not meet the quality standards for investment grade rating, because there are third-party investors who are prepared to subscribe for such debt and take higher risks for higher levels of return. However, as stated in INTM524050, the vast majority of borrowers and lenders are not interested in speculative grade debt.