INTM582050 - Thin capitalisation: agreements between HM Revenue & Customs and the group: Covenant conditions

A thin cap agreement should clearly state the financial conditions under which it is made, and what will be the consequences if they are not complied with. This is a vital aspect of the agreement.

The following points should be covered:

• target ratios debt:EBITDA, (or the debt:equity ratio) and interest cover, or any other appropriate measures of the ability to support and service the debt. There should be at least two ratios. An absolute debt cap, i.e. a monetary limit on borrowing, is unlikely to be regarded as a main covenant, but may be included as a quid pro quo for a longer agreement.
• the years for which the ratios will apply
• an explicit statement of what will happen in the event that the company fails to comply with one or more of the financial conditions, including the circumstances and means of calculation of any resultant disallowance of interest for corporation tax purposes and any withholding tax consequences. See INTM582060 for the text of a recent paper issued by the Transfer Pricing Team at Business International setting out HM Revenue & Customs’s views on what should happen in the event of a breach of covenant.
• If more than one covenant is breached, and both lead to a disallowance, it should be specified in the agreement that it is the greater disallowance of the two that will apply. Draft agreements have been received by HMRC that set out a proposal for a disallowance based on an “average” between the two breach amounts. HMRC sees no basis for this.
• explicit statements of the methods of calculation of the financial ratios, for example whether EBIT or EBITDA (see INTM577050 and INTM577060) will be used and how any interest receivable will be treated. Where there is any complexity to the calculations, it may be useful to append to the agreement a worked example in hypothetical figures which can serve as the model for the annual compliance report.