INTM577020 - Thin capitalisation: interest cover - debt servicing: What is interest?

In thin capitalisation cases there is rarely any dispute about what constitutes interest, and those that do occur tend to be about whether the interest in question is short or annual. Technical enquiries about the nature of interest should be referred to specialists within CT & VAT, rather than to Business International and there is advice on the subject in the Corporate Finance Manual (CFM).

The starting point for consideration of interest cover is the interest payable (or receivable) in the period as shown in the profit and loss account of the borrower. In straightforward cases, the interest payable and interest receivable shown in the profit and loss account or income statement of the company or group can be accepted. However, HM Revenue and Customs does not accept that interest payable and interest receivable can automatically be set against each other to provide a net figure for the purpose of calculating interest cover - see INTM577110 for more information on netting and why it may be questioned.

It is important to be aware that, particularly for large companies, the amounts shown in accounts as finance costs or income will not simply equate to the cash interest payable on the company’s debts, or receivable on its investments. There are two main reasons for this.

• Although a very common way of recompensing a person who has lent money to a company, or who has subscribed for a security, is by paying them interest at regular intervals, there are other ways. A company may issue debt securities at a discount, or redeem its debt at a premium, so that the “profit” element for the lender is in the greater amount received when the security is redeemed, not in regular payments during the life of the loan. Less frequently, companies may issue securities that are convertible into, or exchangeable for, shares. CFM11000 onwards gives an overview of the ways in which a company may raise finance through borrowing.
• Particularly where a company accounts for its financial instruments under International Financial Reporting Standards (IFRS), or the UK standards based on them, there may be considerable divergence between the accounts figures for finance costs and the interest that the company actually pays (or becomes liable to pay) and between finance income and the interest it receives in the period. CFM16000 onwards explains how loans and other financial instruments are accounted for under IFRS.

INTM577030 looks at discounted debt and convertible debt in more detail.

Where a company or group has adopted IFRS (or UK standards moving towards convergence with IFRS), the cash flow statement may provide more readily usable information about ability of the company to service debts than the income statement. IAS7 sets out what information a cash flow statement should contain and how it must be presented. In complex cases, HMRC staff should seek the help of a compliance accountant in interpreting the accounts information. The chapter at INTM585000 gives some advice on the impact of accounting standards.