INTM578070 - Thin capitalisation: interest cover

The effect of depreciation

There is no doubt that depreciation is not a cash item in the profit & loss account, but what does it represent? At one level it is the calculated loss of value of assets already bought, but at another level it may be regarded as an indication that there will be a need to replace those assets at some time in the future, with a resulting cost to the business. A third-party lender would want to take this into account in arriving at a measure of the business’s ability to service its debt in the future, and the Inland Revenue would generally follow such a practice. The lender would therefore contend that, as a general rule, depreciation should not be added back in the calculation unless a reasonable substitute of capital expenditure is also subtracted. This may be the actual capital expenditure or an agreed series of figures relating to the practice of the type of business. Generally, however, there needs to be a good reason for doing this, since it departs from easily found audited numbers.