INTM571020 - Thin capitalisation: practical guidance - introduction: The aims of thin cap work

To assess whether (and to what extent) a company is thinly capitalised, it is essential to understand the activity of the company, its longer-term plans and prospects and how it manages and structures its money. The object of the exercise - if it is not an enquiry into a return - is usually to negotiate a forward agreement (an Advance Thin Capitalisation Agreement or ATCA- see INTM582000) to give a group certainty about the amount of interest deductible by the borrower each year. This is usually expressed by formulae (for example, the ratio between debt and earnings) which can be applied to company results each year to determine the arm’s length amount of interest (see INTM573000 onwards). This is best achieved face-to-face with people who know the company inside out. Groups want certainty about tax, and will have requested the agreement, so a high degree of co-operation should be expected. The goal is normally to agree parameters (ratios, values, formulae) that can be applied every year for up to five years in order to work out the allowable amount of interest and identify any excessive (non-arm’s length) interest. The company then makes its annual return on the agreed basis, at the same time clearly demonstrating whether it fell within the parameters and how it arrived at any adjustment in the tax computations for “excessive interest”. The whole of this process is tackled in the following chapters. An HM Revenue and Customs enquiry into a return will do much the same, though with a retrospective element; much forward agreement work takes place in real time, or close to it.

In looking at potentially thinly-capitalised companies, each aspect of the financing needs to be considered, so although thin capitalisation strictly refers to the gearing or leverage of the company (the balance of debt to equity or earnings), in practice the considerations for a thorough international financial health check will include:

• Working out the arm’s length amount of debt
• Considering whether the interest rate is greater than would be charged at arm’s length rate (in practice, an integral part of thin cap)
• Ensuring there are no other non-arm’s length terms to loan agreements
• Checking that the company is getting an arm’s length return on any money which it is lending out (perhaps to a connected company) and that it has good commercial reasons for retaining cash while carrying a burden of debt
• Checking for financial avoidance, such as loans with a non-business purpose, or use of arbitrage opportunities
• Watching for issues such as treaty shopping, where benefits such as nil withholding tax on interest paid are obtained when there is no entitlement.

This module deals with a number of broad themes:

• Understanding the business and recognising problems with the funding structure;
• Understanding the terms and methods for measuring thin capitalisation;
• Understanding the format which agreements take, and framing an acceptable and workable agreement;
• Negotiating terms which will set the parameters for measuring the arm’s length amount of interest each year for the duration of the agreement;
• Understanding what to do when an agreement runs into trouble or agreement cannot be reached.