In March 2010 HM Revenue & Customs (HMRC) released an update of the guidance in its International Manual on the United Kingdom’s thin capitalisation rules. This guidance is prepared primarily to assist inspectors of taxes in applying the thin cap legislation, but also offers useful insights into HMRC policy to taxpayers and advisers.
The new guidance reflects recent developments in HMRC’s approach to thin cap cases, which is consistent with its recent overhaul of the administration of transfer pricing cases. This is unsurprising as, legislatively speaking, thin cap is no more than one aspect of the transfer pricing code (although various other statutory provisions also potentially disallow intragroup debt deductions). The guidance is important reading for companies seeking to negotiate Advance Thin Capitalisation Agreements (ATCAs) with HMRC; but will also be relevant to companies facing enquiries into their thin capitalisation position, and should be considered by groups headquartered outside the United Kingdom when considering how to structure and capitalise their UK operations.
As HMRC polices thin capitalisation by applying the transfer pricing legislation, determining whether a company is thinly capitalised requires the application of the arm’s length standard. This is, at its heart, an objective test. HMRC makes it clear, however, that it tests not only what a company could have borrowed, but what it would have borrowed in an arm’s length situation. This inevitably involves consideration of the subjective purpose behind the borrowing in question – and much of the guidance is centred on helping inspectors to do this.
Over the last few years, HMRC has sought to overhaul and professionalise its handling of transfer pricing cases with the aim of resolving them more quickly. This has involved an extensive training programme for local inspectors and the establishment of panels of transfer pricing specialists to support their work. The new thin cap guidance reflects a similar development in the handling of thin capitalisation cases. Previously, many thin cap negotiations were handled by the Business International team based in London, but HMRC’s intention is now to transfer this responsibility to locally-based inspectors, supported by transfer pricing specialists.
The Business International team will no longer have day-to-day conduct of individual cases, but will instead take responsibility for ensuring that the legislation is applied consistently. The guidance indicates certain particular areas in which it will continue to take specific interest – such as “upstream” loans from subsidiaries to parent companies, “thinning out” transactions involving the insertion of debt into the United Kingdom in the course of a restructuring, borrowing by UK companies to pay dividends, cases involving treaty shopping and private equity arrangements.
The guidance also envisages an open dialogue between taxpayer and inspector. Inspectors are encouraged to arrange face-to-face meetings with taxpayers, and in particular with representatives of the business. This perhaps reflects a slight ambivalence on the part of HMRC of dealing exclusively with agents and professional advisers, who it seems to see as potentially inhibiting the process.
Specific Points to Note
Considerable emphasis is placed on inspectors being well-informed in advance of meetings with the taxpayer, and extensive new guidance is given on potential sources of information. The guidance notes that “it is surprising how much information can be obtained online”, with inspectors being encouraged to scrutinise the taxpayer’s website for information on how arrangements have been structured, to search for the comments of analysts and other informed observers and, where relevant, to review publically available filings with regulatory authorities such as the US Securities & Exchange Commission.
Representatives of taxpayers should expect inspectors to arrive at a meeting having done their homework – and should therefore be similarly well prepared. This is something for all senior officers of a company to note, not simply tax directors. In particular, employees who have responsibility for a company’s public relations ought to be aware that information they place in the public domain may be scrutinised by HMRC, and may potentially be used against them in the course of thin cap negotiations.
Particular attention and care need to be taken where more complex corporate structures are involved. If a UK group company with intra-group borrowings accumulates surplus cash from its operations, HMRC’s assumption is that it should be used in the first place to pay down that company’s borrowings. If, instead, the cash is placed on deposit with another group company at a lower rate of interest than the company is paying on its intragroup borrowings, then HMRC will probably seek to disallow some or all of the UK company’s interest deductions or impute additional interest receipts on the cash deposits.
Similarly, upstream lending by a subsidiary to its parent is described by the guidance as “inherently uncommercial” unless on a purely temporary basis. Where the borrower is a UK company, HMRC will be inclined to disallow any deduction. Consequently, any such arrangements will need justifying by reference to non-tax reasons if the taxpayer wishes to achieve a satisfactory settlement.
Use of Comparables
The guidance also considers how inspectors should handle comparables provided by the taxpayer to justify its arrangements. The United Kingdom applies OECD principles in considering transfer pricing (and therefore also thin cap) arrangements, so in principle should accept suitable comparables as best evidence of an arm’s length price. The guidance, however, indicates a shift away from the primacy of the comparable uncontrolled price that has been evident both in OECD thinking and in the attitudes of HMRC and the UK courts when handling mainstream transfer pricing matters.
The guidance accepts that comparables must be considered, and that whilst it is easy for an inspector to reject comparables placed before him, it is then incumbent on him to provide an alternative approach to replace them. The guidance also stresses, however, that comparables are less important than understanding the nature and structure of the business itself. This, inevitably, will create suspicion that HMRC is reluctant to accept comparables, particularly when they demonstrate relatively high levels of gearing (as is the case particularly if the comparables are businesses owned by private equity houses, which are often funded by substantial amounts of debt).
Reaching an Agreement
HMRC has historically not published safe harbour ratios for thin cap purposes, and this approach is reaffirmed in the new guidance. It is made clear that an ATCA will normally contain at least two ratios, one normally being an interest cover ratio (i.e., comparing earnings to interest expense), whilst the other will represent a measure of the company’s longer term ability to support its debt. In most cases this will be a gearing/leverage ratio (comparing earnings to indebtedness), although HMRC accepts that a debt to equity ratio may be more relevant for financial and leasing companies.
HMRC accepts that there will often be a “debt spike” on the occurrence of major acquisitions, and therefore this needs to be catered for in negotiating such ratios, but this will be done on the assumption that the company will seek to return to a “steady state” within a relatively short period of time.
Detailed guidance is given on what to do in the case of downturns – although this is explicitly stated to be of specific application and not to refer generally to the current economic situation. HMRC’s view is that a third party lender would normally build some headroom into its financial covenants to enable a borrower to recover from a temporary catastrophe (such as contamination at a food-processing plant), and therefore that it would be inappropriate in most circumstances for a borrower to be able to negotiate a relaxation of the covenants contained in its ATCA.
The new guidance represents an evolution rather than a revolution in terms of HMRC’s approach, as many of the approaches outlined above have been developing in recent years.
The most welcome development is the promise of a more professional, commercially-focused approach on the part of HMRC. Too often in the past, thin cap negotiations have been little more than a horse-trade over ratios, with little consideration of the wider commercial backdrop. The guidance suggests a move away from this approach, which should afford taxpayers a greater opportunity to justify their commercial arrangements and the ability to reach an agreement more quickly with inspectors who have sufficient expertise to reach such a settlement.
These developments do, however, carry dangers. Taxpayer representatives will need to be as well-prepared as HMRC representatives. They will not only need to produce comparables, but provide commercial justifications for their structures; and they should ensure that all parts of their business are projecting the same message in this regard.