INTM582070 - Thin capitalisation: agreements between HM Revenue & Customs and the group: Covenant breaches and unforeseen circumstances

The thin cap agreement should, wherever possible, contain an explicit statement about possible unusual or unpredictable circumstances which would have a detrimental effect on the business and therefore on the company’s ability to meet its covenants, circumstances which might serve to mitigate or cancel the sanctions which would otherwise apply in the event of a breach of covenant.

It is impossible to give an exhaustive list of the circumstances that might qualify, but in general they include events that might be expected to invoke some sympathy in a third-party lender, such as:

• a catastrophic event, for example a terrorist attack temporarily affecting business
• an unusual event, for example a large acquisition requiring exceptional costs for reconstruction and redundancies (provided it was not anticipated and allowed for at the time the agreement was made)
• A disruptive event - for example, contamination taking a food-producing factory out of production for a significant period
• an unexpected event such as a one-off accountancy provision that, while it has significant impact on the profit & loss account, does not affect the ability to service the debt (i.e. cashflow).

Small-to-moderate reconstructions, particularly if they are internal only, should be regarded as part of normal business. Generally, a ‘force majeure’ clause will cover unusual events, but it should be made as clear as possible what type of event the clause covers, so that the result does not become an exclusion clause for almost every breach.

This is an area where there is room for later dispute, but it should be possible to establish an understanding of what kind of event would merit leniency over a breach. These are events from which a business will recover, by resumption of trade, insurance claim and the rebuilding of damaged premises, completion of the exceptional tasks and return to business as usual, etc. The lender’s forbearance would most likely be inspired by the belief that overdue payments will be made within a reasonable extended period. Any latitude given will include an agreed time within which a borrower will be expected to be back on track. If this time is highly uncertain or distant, or full recovery is doubtful, a new agreement may be needed.