INTM579020 - Thin capitalisation: debt: equity ratio
What is debt?
A debt is much easier to recognise than to define but may be
regarded as anything giving rise to the payment of interest or
simulated interest (such as in a lease). See, however, INTM585350
for the treatment of interest cost with respect to pension schemes.
The UK legislation contains various definitions with regard
to debt, although it should be noted that the legislation at
ICTA88/S209 refers specifically to securities, so that ICTA88/S254
is important:
‘'security' includes securities not creating or evidencing a charge on assets, and interest paid by consideration given by a company on money advanced without the issue of a security for the advance, or other consideration given by a company for the use of money so advanced, shall be treated as if paid or given in respect of a security issued for the advance by the company.'
There is no doubt that the reference to a
‘provision’ in ICTA88/SCH28AA includes transactions
involving debts.
In their agreements, third-party lenders may often define
debt in a particular way. For example, in one third-party agreement
seen by the CT & VAT, International CT (‘IntCT’)
the term ‘borrowings’ was used, and was defined as:
- money borrowed or raised, including capitalised interest
- any liability under any bond, note, debenture, loan stock,
redeemable preference share capital or other instrument or security
- any liability for acceptance, documentary credits or discounted
instruments
- 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)
- any liability under debt purchase, factoring and similar
agreements and capital amounts owed under financial leases, hire
purchase or conditional sale arrangements
- any liability under any guarantee or indemnity (except product
warranties)
- any liability under any foreign exchange or interest rate contract net of liabilities owed by the counterparty
Working a thin capitalisation case is not an exact science, and it is perhaps helpful to look at some examples that might be included in debt calculations 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 4 of the Companies Act 1985 prescribes the balance sheet format for company accounts. The table below contains such examples, with comments.
| Creditors accounts entry | Comment |
| Debenture loans | A debenture clearly creates and acknowledges debt, and should be included in the consideration of debt. |
| Bank loans and overdrafts | Generally, these are interest-bearing debts and should be included. Revolving credit facilities are also included here. |
| Payments received on account | Unless significant interest is being paid on these, it may be appropriate to ignore them. |
| Trade creditors | Unless significant interest is being paid on these, it may be appropriate to ignore them. |
| Bills of exchange payable | Companies may use a bill of exchange as an alternative form of finance to bank borrowing. If they are interest-bearing, they should be included in the calculation. |
| Amounts owing to group undertakings | These should be included in the calculation |
| Amounts owing to undertakings in which the company has a participating interest | These should be included in the calculation |
| Other creditors including taxation and social security | There is no doubt that debts involving the Inland Revenue come within the loan relationship legislation and they are interest-bearing. However, they are not normally significant enough to be included. |
| Accruals and deferred income | Not included in the calculation. |
There are other items that may be implicitly included in the
headings given in the table above but not explicitly named:
| Item | Comment |
| Interest-free loan | An interest-free loan may have characteristics of both debt and equity. For example, an interest-free loan that will last for a substantial number of years may be treated as equity. The question is whether such amounts form part of the permanent capital or not. They must not form part of the distributable reserves and agreed not to be repaid until immediately before equity. Such conditions may be written into the thin cap agreement. |
| Capital contribution | See INTM503050. |
| Finance lease | Generally, the finance charge in finance leases is treated as if it were interest, and the accounts can be followed in their treatment. In cases of doubt it will be necessary to consult an HMRC accountant. |
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.
