INTM577030 - Thin capitalisation: interest cover - debt servicing: What is the correct interest rate?

The interest rate

It is not only the amount of debt which might be non-arm’s length; the interest rate on a loan can create or contribute towards a non-arm’s length deal. It is necessary to determine whether, with regard to all the terms and circumstances of the loan, interest is charged at a reasonable commercial rate. It is said that even the riskiest, unsecured loan can be priced, but there comes a point at which the borrower would find the terms unacceptable and unsupportable and would seek another form of finance, or a lower level of borrowing matched by an equity injection.

It is not easy to decide whether a particular interest rate is excessive, since for any particular loan there may be a range of interest rates that can be regarded as being at arm’s length. So what is a proper interest rate for a transaction? Clearly, the answer is dependent upon the facts and circumstances of a case, and it is only possible here to list the most obvious ones.

The lending risks

A third-party lender will carefully assess the risks involved in a proposed loan. Such risks might include:

• the purpose of the loan.
• the current level of debt of the borrower and the type of debt - a high level of existing debt means that the capacity to service new debt is reduced. In addition, senior debt (which takes priority over other unsecured debt) is less risky than subordinated (lower priority debt).
• security for a loan.
• cash flow - a lender might well examine the cash flow for a number of previous years, both retrospectively and as projections.
• the past borrowing/repayment record - although this may not often be available and may not be indicative of the future position.
• The credit status of the company - often difficult to establish for a company which is not considered on its standalone merits
• the type of business - the risk of lending to one type of business will be different to another type. A blue-chip company will be able to borrow much more cheaply than a high risk business.
• the state of development of a business - a company within the first year or so of start-up may well be a greater risk than one with a trading record - in fact start-up companies often find it difficult to obtain loans at all. Similarly, a business which is undertaking a programme of rapid expansion may become a riskier proposition. Whatever the state of development, a lender would expect to see firmly-grounded trading projections for a business, and would expect to examine the assumptions on which they had been drawn up.
• the net worth of the company.
• the state of the market at the time of the deal.

The above factors reinforce the point made in INTM576010: that getting to know the business in a thin capitalisation case is extremely important.

Pushing up the interest rate

It is often argued that the existence of several factors that tend to increase risk justify a particularly high interest rate. The fact is, however, that a third-party lender will not simply go on increasing the proposed interest rate for each perceived risk, since that begins to create or exacerbate another risk: that of the borrower not being able to service the debt. There is a risk level for each set of circumstances where no loan would be offered at all rather than simply increasing the rate. From the point of view of the borrower, there comes a point where the interest rate becomes unacceptably high. The risk of the borrower not being able to pay the interest is not answered by increasing the amount the borrower has to pay. At some point the issue becomes self-defeating. A balanced, common sense approach is needed in each case - there is no single correct answer.

Variation of the interest rate with time

At least two obvious possibilities exist with respect to the variation of interest rate over time: fixed rate (where the interest rate remains the same in absolute terms e.g. 5.5%) and floating rate (an interest rate that fluctuates with the base rate to which it is linked e.g. LIBOR + 2%). There are risks to both lender and borrower with either. A borrower may prefer a fixed rate that gives certainty of outgoings over a period of time, or gamble on the chances of the base rate falling. Lenders are prepared to give fixed rates, but usually at a slightly higher rate than the floating rate, to take into account the risk of market variation over the period of the loan. Obviously, if the lender sees the market rate decreasing over the term of the loan the premium will be small.

The exposure to uncertainty which these options provide can be offset by entering into a contract to exchange interest obligations with another party, an interest rate swap. This may be fixed for floating, or short-term for long-term. There is detail about interest rate swaps in the Corporate Finance Manual, with an example at CFM13320. Each borrower is looking for an advantage that they are not in a position to obtain directly.

The term of the loan

The longer the term of a loan, the more the scope for something to go wrong and the greater the risk to a lender. As a result, the interest rate is normally higher for longer-term loans. In practice, many companies relying on third-party borrowing will have a mixture of short, medium and long-term loans, providing flexibility and priced according to purpose, whereas intra-group borrowing is often funded largely with long-term, expensive debt. It is not unusual to see a substantial UK sub-group financed intra-group using a single massive facility. If such a group had been funded by third-party debt, it would have had at least some cheaper, shorter-term debt. A company cannot be obliged to actually divide up its single, long-term debt into short, medium and long components, but there may be an argument for lowering the overall interest rate to take account of what would happen at arm’s length.

The longer the term, also the more the debt takes on the characteristics of equity, with the possibility that there is avoidance present.

Security

The existence of security for a loan may cause a lender to offer a reduced interest rate. See, however, the chapter on lending against assets at INTM579000.

Certainly the interest rate needs to be looked at carefully, but there is no single answer in a particular set of circumstances. In some cases it may be more appropriate to question the amount of the loan rather than the rate - see INTM573070. See also INTM584000 onwards - third-party loan agreements - interest rates.

The Transfer Pricing Team at Business International may be able to give advice on excessive interest rates.

Currency

The currency in which a loan is made may present some risk to one of the parties. For example, if there was evidence that a particular currency was consistently declining in value, a lender would want to protect itself against the likelihood of foreign exchange losses. If a UK company which operates in sterling obtains a dollar loan, then for each quarterly $500 interest payment it will need to obtain dollars to settle the liability. The number of pounds required will vary, depending on the £/$ exchange rate. If the value of the pound against the dollar falls, the 31/12/08 instalment may cost £345.48 while the 31/03/09 cost £351.89. A UK company would need a very good reason (or very efficient forex risk management) to take out a loan in a currency which was not stable against the pound.

It is clear that determination of an arm’s length interest rate is not easy, but there are some other considerations that may contribute towards a conclusion:

• Is there a comparable uncontrolled price for such borrowing?
• What did the lender pay for the money and was it from a third party?
• Is there a bank overdraft in existence?
• Is it sufficient to question the amount of the loan?

Some LIBOR interest rates can be found on the Internet website of the British Bankers Association: www.bbalibor.com, and Business International is putting historical data on the thin cap part of its website.