INTM571030 - Thin capitalisation: practical guidance - introduction: Forms of borrowing

Intra-group funding - the lending of funds between companies within the same group - is the most common form encountered in “mainstream” thin cap work, in contrast with private equity financing which is discussed from INTM580000.

The ultimate parent (or a group finance company) is likely to be funded by shareholder investment and by external borrowings. The latter will usually be from a mixture of sources, with layers of debt on varying terms serving different purposes, short- and long- term, flexible- and fixed-rate. Lending within the group is likely to be much more straightforward; usually a series of loans made according to need and on simple terms, sometimes with a third-party bank overdraft. There are numerous examples of major corporations, which themselves have complex and multi-layered borrowing at ultimate parent level, funding substantial UK sub-groups using a single facility that supplies everything from long-term acquisition funding to everyday working capital.

What would a bank do - is this the right question?

This question seems to be asked often in thin cap work - whether with reference to the UK company undertaking new borrowing, refinancing existing debt or struggling to honour loan or thin cap agreements. The question, certainly in the case of corporates big enough to fall within the transfer pricing legislation, ought more properly to be: what would an independent lender do, and which sort of lender is that likely to be? The arm’s length transaction which should, for tax reasons, stand in the place of the non-arm’s length actual deal may be one that involves a bank either as an intermediary or not at all.

Bank borrowing

Banks do not lend their own money (certainly not to major corporates). They have to borrow it and therefore need to make a “turn” on the money when they lend it on to their customer. Banks are regulated, have capital requirements, etc, so are (or should be) a safe bet and can themselves borrow cheaply, but it is much more likely that companies looking to borrow substantial sums will look to capital markets, i.e. markets for securities where companies can secure long-term financing. The buzzword is disintermediation, or in plainer terms, cutting out the middleman - going to the market and borrowing from the investor directly.

Banks may be preferable to some borrowers; bank debt is more flexible than, say, corporate bonds, which have a defined term and repayment date, whereas bank debt is more likely to feature earlier repayment and is therefore more flexible. Banks are also more willing to lend based on an ongoing relationship with a group, so that companies can benefit from the wider commercial relationship between bank and client and their shared history. Banks also provide a wide range of associated services. Banks are good at providing money services, and this is how they make their profits.

Companies will regularly use banks for overdraft facilities and for bridging finance; there is often a pattern in mergers and acquisitions, where the immediate purchase is made using short-term debt sourced by a bank or syndicate of banks, with that debt being replaced within months by longer-term funding, perhaps through the bond market.

Bond markets

Bonds take a variety of forms and are issued for a specific period of time, at the end of which they are repayable. The borrower is known as the issuer of the bond and the lender is the bond holder. Bonds carry a fixed rate of interest or are issued at a discount and redeemed at face value. The bond issue takes place in the primary market, where the bond passes from issuer to investor. However, there is a thriving secondary market within which bonds may change hands once they have been issued. This means that the borrower retains the money generated by the issue, but the investor does not necessarily have to keep their money tied up - they can sell the bond. The issuer pays interest to whoever holds the bond when payment falls due.

A syndicate of banks will underwrite the bond issue; they will distribute the bond issue and buy any part of the bond issue not taken up by the market. Bonds are rated by the credit rating agencies, the main ones being Standard & Poor’s, Moody’s and Fitch Ratings. This rating will indicate the agency’s assessment of the company’s ability to make the interest payments and repay the principal, the choice of ratings running between “triple A” AAA (investment grade) through BB or lower (speculative grade) to D (default grade). The full range of ratings and their definitions is set out for two rating agencies at INTM586140. The work of the rating agencies is considered in more detail from INTM586000 onwards.

A bond with a floating rate is known as a floating rate note (FRN). If it is secured, it is called a debenture.

According to the Investment Management Association in May 2009, the minimum permitted investment in the UK is typically £50,000, whilst in Europe it may be only 5000 Euros.

Commercial paper

This is the term for debt instruments with a duration of less than a year, usually sold by large companies and banks to finance short-term obligations. They can serve as a cheaper alternative to a bank overdraft facility.

Private placement

This is a more restricted exercise than that described above for the bond market. It is the issue of debt to a single buyer or a small number of investors, usually with an investment bank acting as broker. It is not offered to the public generally and not registered on any exchange.

The above examples are mentioned not to give a comprehensive guide to borrowing types and conventions - the Corporate Finance Manual from CFM11060 onwards gives much more detail - but to underline that there are alternatives available to an arm’s length borrower, and that a company free to make its own choice of lender will choose the one which suits its current and expected future circumstances best. This is not the place to attempt to explain the complexities of money markets, but there are plenty of books and a wealth of online information covering the topic, including publicly available information on the terms of many large (multi-billion) bond issuances.