INTM578040 - Thin capitalisation: debt ratios - debt repayment: What is an acceptable arm's length standard?
An arm’s length transaction is one that takes place between independent persons, each looking to get the best deal for themselves. As with all arm’s length situations, in any particular case there may be a range of terms that independent people would be prepared to agree, all of which might be arm’s length but which are subject to variations in price which reflect a huge range of influences:
- the other terms and conditions of the deal,
- the past/present/future state of
- the local/regional/national/global market/economy,
- the long/short amicable/hostile business relationship between the parties, etc.
The lending/borrowing transaction is no exception. Presented with the same borrower, two different third-party lenders may come to different decisions, both of which are by definition at arm’s length. Otherwise shopping around would be pointless.
UK legislation and practice adheres to the arm’s length principle, and does not use safe harbours in the way that a number of other tax regimes have done - see INTM581010. Every case needs to be considered on its own merits. However, that does not mean that ratios are not useful tools for measuring a company’s ability to borrow and service debt and for expressing an agreement on levels of debt and interest. HM Revenue & Customs’ approach remains one of pursuing the arm’s length standard for each individual case, not relying on safe harbours or formulaic answers.
It follows that it is impossible to provide debt:EBITDA or debt:equity ratios which may be absolutely relied on in any given case. Just as with interest rates, the factors listed in INTM573045 under the heading ‘lending risks’ are just some of those that may need to be considered. Nevertheless, there are some broad principles that are worth considering in relation to debt ratios:
- For a particular type of business in a “steady state” (that is, neither expanding nor contracting rapidly) there will be a fairly conservative range of debt:EBITDA or debt:equity ratios which third-party lenders will be prepared to accept. The ratio tells a creditor what security he may have in event of default. If the borrower is demonstrably able to service the interest payments, to meet repayment terms and other commitments, and if the borrowing is supported by tangible assets, then the creditor has comfort both for present and (so long as these are maintained) future performance and some assurance of recovery of debt in the event of default.
- Debt:EBITDA and debt:equity ratios vary considerably between business types. Debt:EBITDA is favoured as a ratio more often than debt:equity, because of its link to cash, but financial trades may find a debt:equity measure more appropriate. Businesses such as motor finance companies are highly geared because money is in a sense the trading stock of the company, while the interest cover will be less than that of a non-financial business, because the finance company’s profit comes out of the margin between its borrowing costs and its return on lending. At one end of the scale, an insurance company or a dot.com company may be thinly capitalised even though the ratios may be quite sustainable for other businesses, while a finance leasing company is likely to be able to obtain and sustain much higher multiples of debt. Companies in a particular business sector may have a typical borrowing profile but those ratios should not be taken as absolutely prescriptive for that business type. Comparison with similar businesses that have substantial amounts of third-party debt may help in coming to a decision, but they are at best indicative of possible debt levels. Equity plays different roles in different businesses. In regulated financial businesses, for example, it is capital used to support catastrophic circumstances rather than security for borrowing.
- If a group of companies is in the process of acquiring a new business, company or group, then a third-party lender may be prepared to accept a “debt spike” of increased gearing for the few years immediately following the transaction(s), provided the lender is persuaded that increased productivity, new income streams, streamlined processes, etc, will provide the wherewithal to service and manage the extra debt. The amount of the increase will, of course, depend on the lending risks involved, and will be determined by the strength and reliability of projections for a gradual return to a steady state.
- Publicly-quoted UK companies are confronted with market pressures and adverse analysts’ comments if they move out of the accepted range of debt:equity ratios (or other equivalent measures), and so tend to stay within the range except in circumstances such as those outlined in the bullet point above. Reviews of major corporations have shown that a debt:equity ratio greater than 0.6:1 is rare in most publicly-quoted companies.
Within HMRC there are specialists with experience of dealing with thin capitalisation cases in different business sectors. Transfer Pricing Group members and International Issues Managers should be able to either offer advice or refer the enquiry to a relevant specialist. The homepages for Business International, the LBS and Local Compliance should meet internal needs in this respect.
