CTM15525 - Distributions: general: ratchet loans
ICTA88/S209 (3B) & ICTA88/S209 (2)(e)(iii)
Historically, securities were usually issued for fixed terms at fixed rates of interest but new forms of security have been developed where the rate of interest on the security is continuously variable. One type of variable rate security is a ratchet loan. If the performance of the borrower improves, the interest rate will fall; if the performance of the borrower declines, the rate of interest will rise. Such securities are known as ratchet loans because the variable returns reflect the decreased risk to the lender of losing the capital loaned as the profitability of the borrower improves and the increased risk as the borrower’s performance declines.
Payments under securities made before 21 March 2000
Payments under this kind of security fall within ICTA88/S209 (2)(e)(iii) because the consideration given by the borrower for the use of the principal secured was clearly linked to the results of the business. ICTA88/S209 (2)(e)(iii) applies, notwithstanding that the link was the reverse of the relationship normally met with equities. Equity dividends would be expected to increase with when the company’s profits increased.
Payments under securities made on or after 21 March 2000
ICTA88/S209 (3B) provides that for the purposes of ICTA88/S209 (2)(e)(iii), payments under securities are not treated as to any extent dependent upon the results of the company’s business, or any part of it, if the only reason for its application would be that the payments were inversely related to the results of the business.
To the extent that interest would have been within the scope of ICTA88/S209 (2)(e)(iii), where the consideration falls within ICTA88/S209 (3B), it will fall within the exclusion applied by that section.
Where a borrowing company pays any interest or other distribution to another company that is within the charge to CT, ICTA88/S212 will usually apply. ICTA88/S212 provides that any interest or other distribution within ICTA88/S209 (2)(e)(iii) and which does not fall within ICTA88/S209 (2)(d) will not constitute a distribution. ICTA88/S209 (2)(e)(iii) will be relevant, however, where the interest etc due on a security is paid to a lender who is either an individual or a company not within the charge to CT.
The terms of a commercial ratchet loan and the interest rate payable may reflect the lender’s credit risk assessment of the borrower and include a rate margin adjustment element which provides for an increase in the rate of interest payable on the loan as the results of the borrower deteriorate and a decrease in the rate of interest where the results of the borrower improve.
Guidance on ICTA88/S209 (2)(e)(iii) is at CTM15520 and emphasises that the section is wide in its potential with ‘results’ having a broader meaning than ‘profits’. The terms and conditions of a commercial ratchet loan commonly restrict the ability of the borrower to increase indebtedness without the consent of the lender and the interest rate margin adjuster may not be based purely on the profits or results of the borrower but on a ratio of debt : adjusted earnings. An example of such a ratio might be:
Net debt : EBITDA (earnings before interest, tax, depreciation & amortisation).
In circumstances where:
- the advance of a ratchet loan constitutes a bona fide commercial transaction between unconnected parties acting at arm’s length, and
- where such a ratio is an accepted indicator of credit risk,
the use of a ratio of borrowings to profits (such as EBITDA) in the interest rate terms will be acceptable as a measure of ‘results’ for the purposes of ICTA88/S209 (3B) so that ICTA88/S209 (2)(e)(iii) will not apply.
Furthermore, where:
- a ratchet loan is advanced in bona fide commercial circumstances between unconnected parties acting at arm’s length and
- the terms of the loan include provision for the margin ratchet to be adjusted by reference to the results of a group of companies which includes not only the borrower and its subsidiary companies but also the borrower’s parent and intermediate parent companies and their other subsidiary companies then
- the provisions of ICTA88/S209(3B) may be applied to the borrowing company as if the meaning of the phrase ‘the results of the company’s business or any part of it’ were extended to the consolidated results of companies with which the borrowing company has the necessary group relationship in accordance with CTM80150.
Inspectors should consult with CTIAA (Technical) before making enquiries under the legislation applying prior to the introduction of ICTA88/S209 (3B) in respect of ratchet loans.
