INTM578020 - Thin capitalisation: debt ratios - debt repayment: What is debt?

Debt is generally defined in dictionaries as an amount owed by one person to another; anything such as money, goods, or service which one person is under obligation to pay or render to another. In thin capitalisation terms, what is owed is money or conceivably money’s worth. Money debt usually gives rise to a charge of interest or an interest equivalent, such as a discount. See INTM577020 on the subject of “What is interest?”

The reference to a ‘provision’ in ICTA88/SCH28AA includes transactions involving debts, so that financial transactions are fully within the transfer pricing legislation. See INTM542060.

Agreements drawn up by third-party lenders will often define debt in a very specific way. For example, in one third-party agreement seen by the Transfer Pricing Team at Business International, the term ‘borrowings’ was used for debt, and was defined as:

1. money borrowed or raised, including capitalised interest
2. any liability under any bond, note, debenture, loan stock, redeemable preference share capital or other instrument or security
3. any liability for acceptance, documentary credits or discounted instruments
4. any liability for the acquisition cost of assets or services payable on deferred payment terms where the period of deferment is more than 90 days (except trading credit where the liability can reasonably be regarded as the subject of a bona fide dispute)
5. any liability under debt purchase, factoring and similar agreements and capital amounts owed under financial leases, hire purchase or conditional sale arrangements
6. any liability under any guarantee or indemnity (except product warranties)
7. any liability under any foreign exchange or interest rate contract net of liabilities owed by the counterparty

Agreements between members of the same group of companies are unlikely to go into such detail, and it is recommended that some care be taken to define debt and other significant terms whilst drawing up a Thin Cap Agreement, rather than risking disagreement over meaning afterwards. As well as attempting to be inclusive, such definitions can also exclude items - for example, interest-free debt. It is usual to record within the body of the thin cap agreement the conditions on which interest-free debt is excluded, the obvious one being that it remains interest-free for the duration of the agreement.

Working a thin capitalisation case is not an exact science, and it is perhaps helpful to look at some examples of what might be included in debt calculations to be incorporated into an agreement, rather than trying to find an all-embracing definition. A useful starting point might be a consideration of entries found in a set of UK accounts, since Schedule 1 of The Large and Medium-sized Companies and Groups (Accounts and Reports) Regulations 2008 prescribes the balance sheet format for company accounts. The table below contains some examples of entries which might feature in an agreement’s definition of debt, with comments.

There are other items that may implicitly fall within the headings above, but which may not be explicitly identified:

As a general rule, if it is likely that a third-party lender would take an item into account when considering the ability of the borrower to service the loan, it should be included in the calculation of debt. Payments in connection with shares are, however, excluded from such consideration.