INTM583030 - Thin capitalisation: breaches of agreement between HM Revenue & Customs and the group: Remedying a breach for future periods
If a breach of one or more covenants of a thin capitalisation agreement has occurred, one of the possible consequences is that treaty clearance ceases - see INTM583020.
In order to allow treaty clearance to continue, the UK group needs to restore its position to the arm’s length standard. One way of doing this is to renegotiate the agreement going forward. This does not mean simply lowering the standards of the financial conditions, but establishing a new set of conditions, appropriate to changed circumstances, that are themselves equivalent to the arm’s length position.
If the debt:EBITDA ratio for a particular year is higher than that agreed, a likely consequence is that not all the interest in that year will be deductible for tax purposes, but there is then the issue of what is appropriate in future years. Further disallowances? Renegotiation of the agreement going forward may simply involve agreement that the quantum of debt which will be treated as interest-bearing will be reduced, with the balance being treated as equity. Alternatively, it may be agreed that an additional amount of equity will be injected into the UK borrowing unit, to rebalance the ratio and reduce the debt.
In the face of a disallowance, the lender and the borrower’s group may be able to claim under Para 6C or 6D of Sch 28AA. See INTM542180 and INTM542190.
HM Revenue & Customs considers each year of a thin capitalisation agreement on its own merit. It will not agree to an average position spread over several years. For example, if there is a breach of the covenant, requiring a disallowance, but in the following year the UK grouping pays less interest than the agreement permits, HMRC will not agree to carry over disallowed interest from the first year to be deductible in the second or thereafter. Nor will it agree to an averaging of the effect of the covenants; each covenant is applied separately and the appropriate disallowance made to give effect to each.
As indicated in INTM583010, the conditions agreed might not equate to those which would exist between the borrower and a third-party lender, because it is impossible and inappropriate for HMRC to put itself precisely in the same position as a commercial lender. Nevertheless, it expects the other party to the agreement to adhere to those conditions once they have been agreed, although it may be prepared to renegotiate conditions going forward.
In all cases, the aim in renegotiating an agreement is to produce a new set of conditions that are as close as possible to the arm’s length standard so that treaty clearance may continue. However, HMRC will not enter into such an agreement unless it believes there is a reasonable chance of adherence to the new conditions.
