INTM575050 - Thin capitalisation: working a case - the earliest stages: The opening contact
The opening contact in a thin capitalisation enquiry is, as with other enquiries, very important in setting the tone for the whole enquiry. It is also true to say that thin capitalisation enquiries are almost never settled by correspondence alone, unless an initial request for information provides a response that fully satisfies the Inspector that the particular transactions were made on an arm’s length basis.
However comprehensive the information initially supplied, it will almost always be necessary to gather further information, usually about the commercial thinking and the reasons for undertaking the transactions in a particular way. This may be obtained in writing, but a phone call to the company or its agent to discuss the position can often clarify what further written evidence is required and how soon it can be delivered. The agent should be able to understand and appreciate the purpose of the request. When the information has been obtained, a decision needs to be made as to whether it demonstrates that the transactions are on an arm’s length basis. Outstanding questions are likely to be associated with testing the commerciality of the transactions and understanding the reasoning behind the choices made, and a meeting is the ideal way of exploring such matters.
Experience has shown that the answers to the following questions are often important in making progress on a thin capitalisation case (depending on the specific circumstances of the case):
Question |
Comment |
What is the exact nature of the business, or businesses? |
The nature of the business determines how assets and money are used and how cash is generated. |
What was the purpose of the loan, and has the money been used for the intended purpose? |
The purpose of a loan will influence the attitude of a third-party lender. For example, a loan to buy land or property which might be used as security may more easily gain approval than one to be used to buy plant and machinery or to fund speculative R&D, though lenders are more interested in the borrower having adequate cash flow. |
Was any attempt made to obtain the loan from a third party, either at the time the connected loan was made or in the recent past? If so, what are the details? |
Genuine offers of third-party loans are helpful in deciding what is the arm’s length standard. However, documents that purport to be evidence of such offers need to be treated with caution, and assessed for seriousness of both the application and the offer. |
What projections were made of the UK borrower or the UK borrowing unit’s (INTM578050) key ratios over the period proposed (debt:EBITDA or debt:equity ratio, interest cover, or appropriate alternatives), for what purpose were they made and what were the assumptions underlying them? (See the chapters at INTM577000 and INTM578000 for detail on debt and interest ratios) |
Most companies or groups produce projections of the business, but it is important to ensure that, if they are to be considered for thin capitalisation purposes, they are realistic, and not simply an optimistic set of data produced to impress. Business plans include a range of scenarios or outcomes. It is necessary to look in detail at the assumptions made, and pick up on recognised risk indicators such as a high ratio of debt to equity or earnings, or poor income cover. |
What changes, if any, have occurred in the nature of the business over, say, the past five years, for example start-ups, mergers, acquisitions, divestitures? What such changes are planned or anticipated? |
Third-party lenders may be prepared, depending upon the business case made, to allow a little more leeway for new activities or growing businesses, or to those that have just rid themselves of an unprofitable business. |
Have there been any other unusual features of the business, for example unexpected catastrophes? |
Involvement in a highly unusual event, for example a natural disaster, may well distort the true picture of profitability. It may be necessary either to ignore the future effect or accommodate how it will impact on the ability to service debt going forward. The aim is to agree a level of allowable debt which is consistent with sustainable profitability for the future. |
Are there any features of the business that make it markedly different from apparently similar businesses, for example product range, market or management ethos? |
Profitability may be dependent on many factors. For example, the margin on up-market electrical goods may be greater than the down-market equivalents - see the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations. The effect of poor management is also dealt with in the Guidelines.
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Overall, the aim is to obtain sufficient knowledge of the company and its activities to allow a balanced judgement, based upon common sense, as to what an independent entity might provide by way of funding.
