INTM578120 - Thin capitalisation: interest cover

What is an acceptable arm's length standard?

In June 1995, the Inland Revenue (now Her Majesty’s Revenue & Customs) published Tax Bulletin 17 in connection with the change in legislation that brought into effect ICTA88/S209(2)(da) (later repealed with effect from 1 April 2004). The text of that Bulletin can be found at INTM579110. Since its publication it has been extensively used as a starting point for thin capitalisation negotiations, with some success.

The Tax Bulletin contains a discussion of the general impression that HM Revenue & Customs will accept an interest cover figure of about 3:1 as part of the arm’s length requirement for connected party debt. It must be stressed that HM Revenue & Customs does not operate by using such safe harbours. While income cover of around 3:1 may, in a particular case, indicate the ability to service debt (based as it is on payment of debt capital, interest and dividends), it is certainly not appropriate in all cases.

Among the factors that need to be considered when deciding what is an arm’s length interest cover figure for a business are:

• For a particular type of business there will be a minimum interest cover figure that third-party lenders will be prepared to accept
• Interest cover figures vary considerably between business type
• 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 lower interest cover for several years. The amount of the decrease will, of course, depend upon the lending risks involved, but UK lenders are generally fairly conservative in their preparedness to take such risks.
• Publicly quoted UK companies are confronted with market pressures if they fall below their expected ability to pay dividends, and they have to service debt before paying dividends. Third-party lenders will therefore look particularly closely at the debt- servicing ability, although if there is distrainable security available to lenders, they may be more relaxed about interest cover.

In general, some information should be publicly available from commercial databases about the ability of companies to service debt, so that for a particular business it may be possible to obtain some rough comparables as a starting point in a case. The Thin Cap/Arbitrage Group at CT & VAT, International CT may be able to assist with this.