INTM581030 - Thin capitalisation: practical guidance -comparison of lending in the UK with other countries: The arm's length standard and other models of lending

As with most markets, lending switches between being a buyer's and a seller's market. Unless a lender is prudent, he goes out of business. For example, if a company wants to borrow £100m to modernise its factory, it may obtain offers of loans from a number of different types of lender, under varying terms, but the most competitive offers are likely to be under similar terms and from similar types of lender. Perhaps there will be slight differences in interest rates, in repayment conditions or in the financial covenants, with credit rating being the main determinant for price. The company will be unlikely to accept the more expensive offer, for example at a significantly higher interest rate than other options.

If a loan is encountered that appears to be significantly different from what might be expected at arm’s length, but which is claimed as arm’s length equivalent, closer scrutiny is essential. Such loans may come from overseas lenders, and particularly from the category of lender known as the venture capitalist, or more commonly, the private equity house.

Venture Capital

Venture capital is sometimes defined as a pool of risk capital, typically contributed by large investors, which is gathered together and invested on their behalf by specialist firms of venture capitalists. This is not passive investment, but active involvement in the management and direction of the investment. They specialise in young companies with growth prospects, which are not well-enough established or large enough to secure funding in their own right; or older, declining companies with prospects of a turnaround by restructuring or expansion. In some cases, small investors can buy new issues of, or participate in, mutual funds that specialise in the supply of capital. Clearly, there is a higher risk in lending venture capital than in the more run-of-the-mill loans, and so a higher return will be expected.

Private Equity

Venture capital is in fact a subcategory of private equity investment, which also includes leveraged buyouts, and which has seen a massive increase in activity in recent years, extending to major corporations. Private equity tends to take a stake in established businesses, whereas venture capital tends to get involved in the early development of a business.

Private equity is now a significant element of transfer pricing work and is addressed in some detail from INTM508000 onwards.