INTM576050 - Thin capitalisation: working a case - knowledge and negotiation: Setting up a thin capitalisation agreement

A negotiated solution is eventually achieved in the vast majority of thin capitalisation cases, even where there is initial disagreement between HM Revenue & Customs and the UK group as to what would have happened at arm’s length (see INTM576040). The agreement will contain financial covenants (formulae by reference to which the arm’s length amount of debt can be measured for each period of the agreement) or conditions which are often missing from agreements between connected parties and which are similar to - if usually simpler than - those negotiated with arm’s length lenders such as banks.

The agreement should record accurately and comprehensively what has been agreed. Experience shows that unless this is done, a substantial amount of time may be spent later on, arguing about precisely what had been agreed, particularly if the terms agreed are spread over a number of pieces of correspondence and meeting notes. The whole of the terms should be gathered in one place, within the agreement and its appendices. The Advance Thin Capitalisation Agreement (ATCA) process, explained from INTM573000, requires this comprehensive approach. If there is anything that is left ambiguous or in need of further explanation, that sows the seeds for disputes later on over how the agreement is interpreted.

There is now a Model ATCA agreement (the text of which is included from INTM582100) which may serve virtually unaltered in straightforward cases and which can be adapted to suit the individual circumstances of specific cases. HMRC is not likely to insist on this template being used, but it may be convenient to adopt those elements which are relevant to the specific case. The Model does indicate what might be broadly acceptable as a format, and what elements HMRC would like to see in the agreement.

It is preferable that the applicant draws up the agreement. They are better resourced for the task and it is better that they express what they want the agreement; a draft can be passed back and forth and fine-tuned until the wording is agreed.

It is almost impossible to cover every eventuality in a particular case, and very specific clauses have been crafted to deal with the requirements of individual situations. If an unusual feature is requested by either party to the agreement, it can be discussed with a specialist, but broadly whatever works for both parties is acceptable.

Experience has shown that there are certain elements which, if they are not included in the agreement, tend to cause difficulties if there is a potential breach the agreement. Therefore an agreement should normally include:

• a statement of the maximum amount of total borrowing - a debt cap. This is particularly useful since treaty clearance applications are now separate from thin cap considerations and CT caseworkers may not be made aware of further borrowings, after the agreement has been signed off. In any case, new borrowing does not provide the opportunity for review of finances which it once did - see INTM573070 
• Alternatively, the ATCA may be limited to debt in existence at the time of the agreement, and these may be specified within the agreement. This may be appropriate where funding is at a maximum in the wake of a major acquisition, or where there is uncertainty about the financing of major outlay in future. Certainty about further borrowing would require a further application.
• the interest rate - see INTM573060 
• the duration of the agreement, usually 3-5 years - see INTM572000 onwards, INTM574000 onwards
• definitions of the financial covenants which will set the limits of arm’s length borrowing each year, with a year-by-year list of the covenant values - see INTM578000 onwards, INTM578000 onwards
• the agreed consequences of each covenant being met each year - see INTM582100 
• the agreed consequences of a breach in one or more covenants - see INTM583000 onwards and INTM582060.
• the process for monitoring an agreement, with, if appropriate, an example of how the evidence will be presented and calculations made each year - see INTM582080.