INTM583040 - Thin capitalisation: breaches of agreement between HM Revenue & Customs and the group: Breach of covenant: disallowing the interest deduction

An advance thin capitalisation agreement may contain a clause indicating that one of the consequences of breaching the financial conditions is a disallowance of interest for tax purposes. Unless agreed otherwise, the disallowance will occur in the year of the breach.

Consider, for example, the situation in which the agreement includes a covenant limiting debt:EBITDA to a (purely illustrative) ratio of 8:1, but for some reason the debt component turns out to be greater than the agreement allows, resulting in an actual debt:EBITDA ratio of 10:1. If some of the debt is regarded as non-arm’s length and the interest on that tranche is disallowed, sufficient to reflect what would have happened at 8:1, it achieves the effect of restoring the agreed ratio. The tax disallowance in the year will be the amount of interest on the non-arm’s length portion of the debt.

If there has been a breach of this sort, it may be important not only to calculate the disallowance, but to discover the reason for the breach, and if necessary take steps to rectify the position more fundamentally for future years by renegotiating the thin cap position and making a new agreement.

Similarly, where the interest cover condition is breached there will be a disallowance of the interest equal to the proportion that is not covered by the covenant, and once again attention needs to be given to the reason for the breach and to the likelihood of it recurring in the future.

In the face of a disallowance, the lender and the borrower’s group may be able to claim under ICTA88/SCH28AA/PARA6C or 6D. See INTM542180 and INTM542190.