INTM575025 - Thin capitalisation: working a case - the earliest stages: Risk Assessment 2 - the issues and where to look for them

There are a number of issues which fall within (or sit alongside) thin cap considerations:

• Thin capitalisation - the transfer pricing of debt, either from connected persons, or with their support by way of guarantees (ICTA88/SCH28AA)
• Other transfer pricing issues - outward lending to connected persons - on terms which are not arm’s length, possible leading to imputation of interest on loans made by the UK company. (See INTM502010) 
• Borrowing for an unallowable purpose -borrowing which may or may not transgress acceptable thin capitalisation ratios but which includes a purpose which is not a business purpose of the company (See INTM509030)
• Arbitrage - exploiting difference of treatment between tax regimes (See INTM509130 on the concept in general, and guidance starting at INTM590000 for material on the 2005 legislation)
• Treaty issues - treaty shopping i.e. where finance is sourced in a territory which does not allow for full (or in the case of havens, any) relief from withholding tax, routing the money through an intermediate territory with which the UK has a treaty granting full relief. This can happen in relation to a tax haven, or a country such as Canada or Belgium where withholding tax is not reduced to nil by the operation of the treaty. See advice on Beneficial Ownership at INTM332000.

Evidence of intra-group borrowing (or borrowing with group support)

• Evidence of merger or acquisition activity, particularly involving the establishment of a new UK holding company
• Unusually high group creditors and/or debtors, perhaps trading or other balances between group companies which have been allowed reach disproportionate levels (a possible reason to impute interest on debtor balances or review interest charges on creditor balances?)
• Guarantee fees, commitment fees, etc, in the profit and loss account
• Sudden changes in debt levels, suggesting changes in commercial activity
• Significant acquisitions during the year
• The nature of the company itself - perhaps a new entity which has become the holding company for a pre-existing UK group, or which has gathered a number of scattered group companies under its ownership.

Evidence of non-arm’s length borrowing

• Calculate the value of the equity in the Balance Sheet. Equity for thin cap purposes means shareholder’s funds i.e. share capital, retained earnings, share premium and reserves (definitions are discussed at INTM578030).
• How does value of what is owned measure up against the weight of what is owed?
• Have accumulated losses eroded the value of equity? A company may be in negative equity because of losses.
• If assets have been revalued, do revaluation reserves represent genuine increased tangible asset value, recently and independently valued)?
• On the other hand, is there a goodwill reserve or other intangible reserve inflating shareholder’s funds? This would normally be excluded from equity for thin cap purposes, being the first thing to disappear when a company is in difficulties?

• Apply the ratios discussed elsewhere in this chapter:
• interest cover - how capable is the company of meeting its interest obligations as well as its other liabilities (present and future), or does it appear to be largely trading for the privilege of servicing its debts? (INTM577010 onwards)
• Debt/profits - how long will it take the company to pay back its debt at its current level of profitability? (INTM578010)

Have there been mergers or significant acquisitions within the global group and how have they affected the UK group?

Is the company a new holding company, or an existing group company which has been adopted as a holding company, borrowing significant amounts of debt to make the acquisitions? Merger and acquisition planning always has a tax aspect. Groups will not carry out even the most commercially driven of transactions without also spending time and money enabling them to carry through those transactions in a tax efficient manner, and transactions take place for whatever mixture of debt and equity the group chooses.

Is there evidence of the acquisition by the UK group of companies which are already within wider group ownership

This may take place in conjunction with genuinely third-party acquisitions. Companies may be transferred around within the same group for a number of reasons, but one would expect strong commercial reasons for a UK company to incur debt liability in acquiring a company which was already under common ownership. Explanations for this may be convincing, but they often seem a little flimsy against the fact of the major debt liabilities taken on to achieve the change.

Top level mergers/acquisitions without significant debt

Mergers and acquisitions may take place by cash acquisition or by share exchange. In the latter case, the shareholders in the target group are offered shares in the acquirer in return for their existing shares. Very few genuine mergers take place, in the sense of the coming together of equals, so the reality is usually that one group buys out the other, whatever the public presentation. The buy-out is for cash or shares, or some of both. The question is: if the merger is achieved by share exchange, why, when the regional integration takes place should the UK incur substantial debt in acquiring its allotted part of the global acquisition?

Even when ownership is transferred by means of share exchange, debt may indirectly be involved in the top level merger, since the acquirer may embark on a programme of buying back its own shares to counterbalance the shares which it issues to the shareholders of the target group, and it may borrow to finance the buy-back programme. If this is not done, the share issue for the merger simply increases the total number of issued shares in the acquiring group and reduces the earnings per share - the shareholding is diluted.

Sources such as US corporations’ 10-K returns on the US Securities & Exchange Commission’s EDGAR Database may help in determining how mergers/acquisitions took place at the global level, while commentators on the internet may well indicate the nature and method of mergers/acquisitions.