INTM579040 - Thin capitalisation: debt: equity ratio

What is an acceptable arm's length standard?

An arm’s length transaction is one that takes place between independent persons. 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, and the lending/borrowing transaction is no exception. If a lender thinks that taking into account the debt:equity ratio of a company is important, it will have to weigh up a number of factors. In doing so, judgement has to be exercised and decisions made. Confronted with the same facts, two different lenders may come to different decisions, although they may not be very far apart.

ICTA88/S209(2)(da) applied to any interest or other distribution paid on or after 29 November 1994 until its repeal by FA04 in respect of accounting periods commencing on or after 1 April 2004, and in June 1995 the Inland Revenue (now Her Majesty’s Revenue & Customs) published an article in one of its Tax Bulletins to explain its approach (TB17). For convenience, the full text of the article is reproduced in INTM579110, except that contact details provided at that time are no longer applicable and have been removed.

Since the publication of the June 1995 Tax Bulletin, very many cases have come to the attention of HM Revenue & Customs, both at CT & VAT, International CT (‘IntCT’) and elsewhere. The Bulletin itself has proved something of a mixed blessing both for HM Revenue & Customs and for taxpayers, particularly with regard to the figures for debt:equity ratio and interest cover. This is because they have come to be regarded by some as thin capitalisation 'safe harbours'. In fact, HM Revenue & Customs does not operate safe harbours, the Tax Bulletin confirms that, and every case needs to be considered on its merits.

Nevertheless, the Tax Bulletin has often formed the starting point for negotiations for the more straightforward thin capitalisation cases, and many settlements have been agreed after further negotiation. It must be stressed, however, that the HM Revenue & Customs approach remains one of pursuing the arm’s length standard for each individual case: there are no formulaic answers.

It follows from the above paragraphs that it is impossible to give concrete, lasting figures for debt:equity ratios for particular types of case. Just as for interest rates, the factors listed in INTM573060 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:

• For a particular type of business in a steady state (that is, neither expanding nor contracting rapidly) there will be a fairly narrow range of debt:equity, or other equivalent, ratios that third-party lenders will be prepared to accept. The ratio tells a creditor what security he may have in event of default. If equity is greater than debt and is supported by tangible assets, the creditor has some comfort in the event of default. In general, businesses in the UK are conservatively funded, with lower debt:equity ratios than many other parts of the world.
• Debt:equity ratios vary considerably between business type. An insurance company, for example, may be thinly capitalised at a debt:equity ratio of 1:1 whereas a finance leasing company may not be thinly capitalised at 10:1: these ratios should not be taken a prescriptive for the named business type, nor as ones that will automatically be accepted by HM Revenue & Customs. Comparison with similar businesses that have substantial amounts of third-party debt may help in coming to a decision. Equity plays different roles in different businesses. In 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 an increased debt:equity ratio for a few years. The amount of the increase will, of course, depend upon the lending risks involved, but UK lenders are generally fairly conservative in their preparedness to take such risks. The amount of increase will be determined by the projected speed of return to steady state.
• Publicly-quoted UK companies are confronted with market pressures 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. Research has shown that a debt:equity ratio greater than 0.6:1 is rare in most publicly-quoted companies.

IntCT has had experience of dealing with thin capitalisation cases in which the debt:equity ratio was regarded as important, and will be able to give advice in particular cases. Do not expect definitive answers, however.