INTM583010 - Thin capitalisation: breaches of agreements between the HM Revenue & Customs and the group: Introduction to breaches of covenant

Breach refers to a company’s failure to comply with one or more of the covenants in a thin cap agreement. See INTM576050 on covenants and the structure of agreements.

Companies do not wish to breach the conditions of third-party loan agreements. It is expensive, awkward, may put the company in a precarious position, damage the company’s reputation and give more power to the lender than the borrower would like. Companies are more likely to breach a thin capitalisation agreement with HM Revenue & Customs than they are to breach the covenants in their loan agreements. Companies tend to want to leave less headroom between their planned borrowing and the maximums reflected in HMRC covenants, so they are more likely to get close to or exceed limits agreed with HMRC than they are with a third-party lender. However, just as a third-party lender will have a clear policy for dealing with a breach of covenant, so it is important that all parties to an HMRC agreement understand what will happen in the event of a breach.

Although the UK thin capitalisation legislation is based on the arm’s length principle, it is impossible for HMRC to put itself precisely in the position of a third-party lender at the time when a breach takes place. A thin cap agreement is not equivalent to a third-party banking agreement, though it may use some of the elements seen in such agreements. A thin cap agreement provides a way of measuring the arm’s length amount of interest for each year of the agreement. Any “excess” interest identified using the agreed measures is by definition non-arm’s length and therefore disallowable. A thin capitalisation agreement therefore typically contains conditions which, although they may not extend to the full range of terms seen in third-party loan agreements, are designed to give both HMRC and the other parties represented in the agreement a degree of certainty. For example, if a breach occurs in a third-party loan agreement the lender might decide to recall part or the entire loan. HMRC cannot insist that the loan in question be repaid, but may seek a computational adjustment in order to refuse a tax deduction for the interest. Alternatively or additionally, it may be agreed that equity will be injected into the company in order to reduce debt or improve the debt:EBITDA balance.

A major part of any strategy for dealing with a covenant breach is to ensure that the agreement is framed in such a way as to make clear exactly what will happen in the event of a breach and what are the options for resolving the problem, so that the options are understood and the appropriate action is taken should the time come. Common conditions include:

• an agreement to notify HMRC as soon as a breach becomes apparent or likely, or within a prescribed time.
• a clear statement of the consequences in the event of a breach
• circumstances in which the breach might be disregarded or treated more leniently
• potential ways in which a breach may be rectified

These points are dealt with from INTM583020 onwards.

The importance of early notification cannot be over-emphasised. It is often much easier to deal with a potential breach, or one that has just occurred, than one that is two years old.