INTM541060 - Introduction to thin capitalisation (legislation and principles)

Use of indirect funding methods

Multinational groups will commonly lend into the UK directly, usually from the parent company or intermediate parent company, or from a specialist finance company within the group, but they may also seek to introduce interest-bearing debt into the UK through indirect funding methods. This is where the immediate lender is unrelated to the UK borrower but where another group member has provided some form of security, typically a guarantee, for the lending. The independent lender then bases his lending decision on the strength of a wider unit (which can be as wide as the global unit) and not on the borrowing capacity of the UK group as a stand-alone entity or the borrowing company as a stand-alone entity. This can be harder to identify than the direct funding provided by a fellow group member because it is necessary to ascertain on what basis the third party lender advanced funds to the UK borrower and this may not always be immediately evident.

The simplest form of security is a guarantee, whereby another group member, usually the parent, often in conjunction with other group members, offers to reimburse the lender in the event of any default in payments of interest and/or repayments of principal by the UK borrower. The presence of a guarantee should be relatively easy to identify, as it will normally be referred to in the relevant loan agreement. Additionally the presence of a guarantee should be shown in the accounts of the guarantor as a contingent liability.

However, there may be other forms of comfort provided to the lender by borrowers who are outside the UK group, such as matching collateral or back-to-back loans, or understandings which may in some cases fall short of contractual obligations. These may not be referred to in the formal loan agreements but their existence should be considered in any case where it appears that the UK borrower is thinly capitalised and there are no obvious guarantees in the loan documentation. In such circumstances the Inspector should first raise his concerns with the UK company but there may be circumstances where he will not be satisfied with the responses received. In such circumstances it may be advisable to request access to the lender’s records and possibly to interview personnel at the bank involved in making the lending decision, in order to verify or exclude the possibility of hidden forms of comfort. . This should only be considered in exceptional circumstances, and not undertaken without first referring for advice to the Thin Cap/Arbitrage Group at CT & VAT, International CT.

Inspectors need to be alert to the possibility of indirect finance and should not assume that because the immediate source of a loan is a third party, say a bank, that the amounts lent and other terms are arm’s length, especially where the levels of borrowing and associated interest deductions appear excessive.

Inspectors should note that with effect from 1 April 2004 the UK’s thin capitalisation legislation applies to borrowing which is wholly within the UK. For details see INTM560000 et seq.