INTM507040 – Intra-group funding: group finance companies and the treasury function

Debt capacity and gearing

In the commercial world financial businesses are likely to be geared at far higher levels than non-financial businesses. The function of equity is different in financial businesses. Its role is to counter catastrophe (defaulting businesses) rather than to act as security or provide secure assets for a business. It is therefore quite reasonable to expect a group finance company to have significantly more arm’s length debt capacity (compared to its equity) than would be expected in respect of the group’s principal commercial activities (assuming that the group itself is not engaged in financial business).

So, where the group finance company of an overseas group is located in the UK, there is a risk that the increased arm’s length debt capacity acceptable for a group finance company could be used to 'gear up' the group’s non-financial activities in the UK. This might be attempted by routeing debt (either from third parties or from non-resident associates) through the UK finance company and into the UK operating companies. This would circumvent the operation of ICTA88/S209(2)(da), prior to its repeal by FA 2004, because the interest payments from the operating companies to the group finance company would be wholly domestic transactions (see ICTA88/S212(1)). However such arrangements may be caught by the 'series of transactions' provision in ICTA88/SCH28AA/PARA1(1)(a). More sophisticated arrangements may be encountered that fall outside of the 'series of transactions' provision. For guidance on tackling avoidance see INTM509000.

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Thin capitalisation

Where:-

• the nature, scale and breadth of the activities of a group treasury company based in the UK are akin to those that would be carried on by an independent entity

and

• there is effective assessment, monitoring and management of the risks (of individual investments as well as that of the entire portfolio or book)

it is reasonable to apply the same kind of thin capitalisation criteria that would be seen for financial businesses dealing with third parties.

However, where the activities are such that the function is little more than a conduit for finance the Inspector should not accept that the existence of a financial entity has the effect of increasing the debt capacity (for thin capitalisation purposes) of the group’s activities. In this case, where the UK finance company together with the UK operating companies form a 'UK grouping' within the terms of ICTA88/S209(8D) it is appropriate to consider the arm’s length debt capacity of the 'UK grouping' as a whole. The Inspector should then establish the arm’s length gearing ratio by reference to the activities of the UK operating companies. From 1 April 2004 FA2004 introduces a ‘single entity’ approach but the effect of guarantees or implicit guarantees modifies this (see INTM560000 onwards).

Where the UK group finance company is carrying out a genuine treasury management function, it will be appropriate to apply thin capitalisation principles to the finance company separately from the rest of the UK activities, but it would be prudent, when entering into any discussions or agreements with regard to the group finance companies’ debt levels, to agree at the same time the tax treatment of the UK operating companies’ borrowings from the group finance company.

Where it is accepted that a group finance company is operating on commercial terms, it will then require a careful analysis of the business activity to establish the appropriate level of equity funding. As with all thin capitalisation cases, it is important to consider both gearing (debt to equity ratios) and profitability levels in determining what would be accepted and expected at arm’s length.