INTM579090 - Thin capitalisation: debt: equity ratio

Groups with mixed activities

Consider a group with the following structure, in which all shareholdings are 100%:

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If the US parent wishes to make a loan to its UK group, either including the French sub-group or not, it may do so by lending to the UK treasury company which then takes on the responsibility of distributing funds throughout the group. The UK legislation provided at ICTA88/S209(8D) (repealed by FA04, see INTM560000, but the principal thin capitalisation rules are preserved largely unchanged in ICTA88/SCH28AA/ PARA 1A. ) that the UK grouping or ‘borrowing unit’ that needed to be considered when looking at the potential borrowing capacity comprised UKCo European Holdings Ltd and all its 51% subsidiaries.

Although the “UK grouping” rules are not retained by ICTA88/SCH28AA/ PARA 1A, in practice much the same effect is preserved for inward loans through the operation of the guarantee rules in ICTA88/SCH28AA/PARA1B and 6B. In order to arrive at the arm’s length amount that could be loaned to the borrower it is possible to arrive at a debt:equity ratio for the whole grouping. However, the heterogeneous nature of the group means that a general value such as this does not take into account the borrowing ability or needs of individual parts. This may not be a problem unless unusually high levels of debt are contemplated, in which case it would be appropriate to ask: what would a third-party lender be likely to do? The answer is that it might look at the borrowing capacities and needs of the individual parts of the borrowing unit, add them together to get an overall capacity, and then consider how the fact that there is a group, rather than separate entities, affects the overall result. Among the factors that it would take into account are the following.

• There is an insurance sub-group. In general, UK insurance groups do not have a high debt:equity ratio – it is typically significantly less than 1:1. However, the insurance- broking company, while it may be regulated as to its activities, will not be regulated in the same way as an insurance company with regard to its capital. Its borrowing capacity will have to be looked at separately, and in the light of the fact that insurance brokers do not generally borrow highly because the nature of the balance sheet assets mean that the net worth of the company is all that is available to support debt.
• There is a finance leasing sub-group. Typically, such groups may have high debt:equity ratios. However, a third-party lender may wish to ensure that any part of a loan made on the basis of such a ratio genuinely goes to the leasing group and not to other parts of the grouping, and so may specify it explicitly in the agreement.
• There is a French holiday and travel group. It may be appropriate to look at the borrowing capacity of this sub-group in France, to see if it would be able to obtain terms that are more favourable than in the UK, but it needs to be borne in mind that the UK legislation requires the whole borrowing unit to be considered, so the capacity in France alone needs careful consideration.
• There is a manufacturing sub-group. If there is nothing special about it, such as starting up or rapid expansion, then a debt:equity ratio up to 1:1 may be appropriate.
• There is a company with a treasury function. See INTM504060.