INTM579110 - Thin capitalisation: debt: equity ratio
Inland Revenue Tax Bulletin 17 of June 1995
Below is the text of the Tax Bulletin, but with the contact
details removed because they no longer apply.
The parts of Section 209 Income and Corporation Taxes Act
(ICTA) 1988 repealed by Section 87 of this year's Finance Act had a
different impact on the tax treatment of cross-border intra- group
interest payments according to whether, and how, the terms of
double taxation treaties interacted with the statute. The law
itself characterised all interest paid to certain non-resident
group members as a distribution. Where no treaty applied or where a
treaty did not restrict the operation of the law, this remained the
result. In other cases, treaty wording prevented the law applying
and intra-group interest could only be characterised as a
distribution to the extent that it was excessive as a result of the
interest rate being too high. In the most frequently occurring
case, however, only the amount of an interest payment which
exceeded, for whatever reason, what would have been paid between
companies acting at arm's length was characterised as a
distribution.
Section 87 puts this arm's length approach into United
Kingdom domestic law. Consequently, it leaves the tax treatment of
most existing intra-group financial arrangements unchanged. It
provides for less harsh treatment in cases where no treaty applies
or where a treaty imposed no restriction on the operation of the
old domestic law. It may also have an impact on some cases where a
treaty prevented the old law applying. This will only be the case
if, and to the extent that, the interest payment exceeds what would
have been paid in the absence of the group relationship.
The new provisions, like their predecessors, are concerned
with payments of interest and similar sums in respect of
securities. For this purpose 'security' has the extended meaning
set out at Section 254(1) ICTA 1988 and therefore covers most forms
of indebtedness. The focus on the existence of certain 75%
shareholding relationships also remains. Unlike the old domestic
law, however, only that part of the interest or similar payment
which exceeds what would have been paid in the absence of the group
relationship is characterised as a distribution. (This could, of
course, be the whole amount.) The previous restriction to non-
resident companies has also been removed. Instead, all intra-group
payments where the shareholding condition is satisfied are within
the scope of the legislation, unless the recipient is within the
charge to corporation tax in respect of the sum or is a charity.
Concerns have been expressed about the complexity of the new
provisions and also the lack of certainty for taxpayers and
potential investors to which some have felt they give rise. This
article outlines the Revenue's approach to the new law and
indicates how guidance on our likely reaction in specific cases may
be obtained. A subsequent Tax Bulletin will deal with some of the
more detailed points which have been raised about the new
Section.
The arm's length approach
The legislation requires taxpayers and Inspectors to consider
what would have happened in the absence of the intra-group
relationship between the issuer and holder of the securities in
question. As a result, the focus is on the facts and circumstances
at the time the actual security was put in place or assigned.
It is worth stressing that the legislation is extremely broad
in its scope. It is capable of applying where, even though a loan
could have been obtained from a third party on identical terms, the
transaction would not have taken place but for the group
relationship. Such a case might arise where, for example, a company
has a fixed-term third-party loan bearing interest at LIBOR + 1.00%
which still has three years to run at the relevant time. This loan
is repaid and replaced by a three-year intra-group loan carrying
interest at LIBOR + 1.50%, but which otherwise has terms and
conditions identical to the third-party loan it replaces. It is
accepted that, arm's length interest rates having increased since
the original loan was obtained, LIBOR + 1.50% is an arm's length
rate for a three year loan at the time the new loan is made.
Nonetheless, given the lack of commercial logic in this change, we
would contend that the arrangement would not have been entered into
but for the group relationship and that the legislation applies
with the result that all of the interest will be a distribution.
This is one reason why there can be no blanket 'let-out' for
intra-group loans satisfying some crude formulaic test. Although we
are aware of the importance to arm's length lenders of ratios of
debt to equity or pre-tax and pre-interest profit to total interest
payable ('income cover') they are insufficient, in themselves, to
determine what would have happened at arm's length. Moreover,
ratios such as these are far from being the only factors which
potential lenders take into account. Among the others probably the
most important are:
- the business sector concerned;
- the nature of, and title to, any assets which might provide security;
- cash flow; and
- the general state of the economy.
Nonetheless, the legislation will most often be relevant in
cases of thin capitalisation (a high ratio of debt to equity) or
insufficient income cover. Consequently it may be helpful to
explain our approach to these two aspects of the arm's length test.
Commentators have suggested that the Revenue has been content
to accept a 1:1 ratio of debt to equity and a 3:1 income cover
ratio. Often the possibility of satisfying us that, in the
circumstances of a specific case, arm's length ratios would have
differed from these is also mentioned. While we understand why our
approach has been construed in this way, it is to some extent
misleading and certainly needs to be considered in context.
As with our approach to the legislation as a whole, when we
consider such ratios, we focus on what would have been expected to
happen at arm's length.
In our experience, third party lenders in the United Kingdom
market almost always look at the consolidated debt to equity ratio
of the group of companies to which the borrower belongs and the
resources on which it could draw within that group to fund interest
charges and capital repayments. Consequently, in the overwhelming
majority of cases, we too look beyond the company issuing the
security to the wider company grouping to which it belongs. Of
course, the legislation is designed to protect the United Kingdom
tax base. Accordingly, it limits the extent to which the wider
group is taken into account by specifying that, for certain
purposes, relationships with connected companies which are not part
of the (defined) UK grouping as well as with the holder of the
securities (except in respect of the securities in question) are to
be disregarded.
It is also our experience that arm's length lenders in the
United Kingdom revise their view of an acceptable level of gearing
or income cover for particular groups at different times --
although the variation has not been large in recent years. As a
result, we may be able to say that a particular debt to equity
ratio meets the arm's length standard today. We could not say that
the same ratio would meet that standard even a year from now.
We are also aware that the relative importance of debt to
equity ratios and other factors such as income cover or cash flow
varies over time and between industries. In recent years, we have
detected a trend away from simple debt to equity ratio criteria,
perhaps reflecting the realisation that balance sheets can show
flattering snapshots which are not representative of the position
as a whole. This has been coupled with increased evidence of the
continuing availability of loans being made subject to satisfying
certain covenants -- including meeting gearing and income cover
targets at specified intervals. Our approach endeavours to reflect
such trends.
As for the precise ratios themselves, arm's length lenders
have always applied different standards when lending to different
industries at any one time. So, for example, financial concerns and
property holding groups have always been able to gear up to a
greater extent than most other borrowers. Here too we follow the
market pattern.
Despite the industry spread of acceptable ratios and the
variation over time, we understand that the average debt to equity
ratio of United Kingdom quoted companies has historically ranged
around 0.6:1. It remains in that region at present. Similarly, we
are aware of comment that lenders are currently concerned when the
level of operating profit is less than four times the interest
payable. Partly because an average is a point between the high and
low positions and partly as a result of a desire to use our
resources most effectively, we have in recent years tended to
accept that, where a loan otherwise meets the arm's length test, if
the United Kingdom grouping remains geared at something less than
1:1 and its income cover is at least 3:1, its financing should be
regarded as satisfying the test as a whole. If not, further
consideration would be appropriate. It must be stressed, however,
that there are no hard and fast rules in this area and each case
has to be considered on its own facts.
The negotiation process
Where detailed consideration of the position is necessary, we
generally endeavour to advance matters by way of discussion with
the group and its advisers, with a minimum of correspondence. This
speeds the resolution of our enquiries and enables groups to
understand the tax position at an early stage. We recognise that
applying the arm's length test can never be a precise science. We
are, therefore, able to show some flexibility in the course of the
discussions, provided we are satisfied that the result is about
right at the end of the day.
As a consequence of these discussions, groups sometimes
restructure their investment entirely by putting in additional
equity finance as well as the debt or by replacing part of the debt
with an equity injection. In some cases, however, we are content if
they simply make part of the loans interest-free: provided
interest-bearing debt is repaid in preference to interest-free
debt.
Procedural matters
In the past, enquiries have often been triggered either by an
Inspector's examination of accounts showing the intra-group funding
or by receipt of a tax treaty claim for exemption from, or
reduction in, withholding tax on the payment to the non-resident
group member. No doubt this will continue.
In future, when consideration of the legislation is triggered
in one of these ways, the Inland Revenue will normally issue a
letter commenting on the relevance of Section 209(2)(da) ICTA 1988
to the specific intra-group arrangement. If companies are concerned
about the position and do not receive such a written notice they
should contact us at the address given below.
Although the new legislation makes no difference to most
existing intra-group funding arrangements, there could be some
change where the funds have come from one of a dozen countries.
These are:
Austria;
Barbados;
The Faroe Islands;
Fiji;
Germany;
Israel;
Japan;
Kenya;
Luxembourg;
South Africa;
The Sudan; and
Zambia.
We have attempted to identify such arrangements and have
written to the groups concerned commenting on the legislation's
impact in each case. Companies who have not received any
communication from us about existing advances from group members in
one of the above countries and who are concerned about the possible
impact of the new legislation, should also contact us at the
address below.
More generally, in recent years groups and their advisers
have increasingly taken the initiative by approaching International
Division at the time when finance is being put in place to obtain
guidance on their plans. Where sufficient information to reach a
view has been available, we have normally been able to give groups
some certainty as to the tax treatment likely to apply to what they
propose. (The Financial Secretary to the Treasury drew attention to
this during the Committee Stage debate on this provision of the
Finance Bill.) It is our intention to continue to offer this
service to groups considering investment or reinvestment in the
United Kingdom.
