INTM583050 - Thin capitalisation: breaches of agreement between HM Revenue & Customs and the group: Disallowance of interest deductions in future years

A thin capitalisation agreement will usually contain a clause indicating that one of the consequences of a breach of financial conditions is a disallowance of interest for tax purposes. Unless agreed otherwise, the disallowance will normally occur in the year of the breach - see INTM583040.

However, It is open to the parties to agree and record in the agreement that the proper way forward is to introduce further equity into the group, using it to reduce debt, or to make a repayment of debt. This will strengthen the balance sheet and reduce the likelihood of a recurrence.

ICTA88/SCH28AA is put into effect by tax adjustments, not by changing the underlying figures, but it is often appropriate to try to gain agreement to actual changes such as the introduction of equity, or some debt reduction, since breaches of covenants may recur year after year unless the balance sheet is bolstered up by fresh capital or the underlying problem otherwise remedied.

Where a solution other than a disallowance is, exceptionally, agreed, that solution must be real and executed as agreed; otherwise the borrower avoids a real disallowance by making only hypothetical changes.