U.K. introduces new thin capitalization guidance

The U.K. tax authorities (HMRC) on 9 March updated one of the key parts of their international tax guidance with the release of a new expanded version of the chapter in their International Manual entitled "Thin capitalization: practical guidance."

HMRC have been committed for some time now to updating their international tax guidance, which is contained in their International Manual. Deloitte, along with others, provided HMRC with comments on a draft of this guidance late last year, and many of our points have been incorporated.

We comment below on what is new or significant in this chapter, but the key point to appreciate is that in a growing number of areas HMRC views are now publicly stated, and those grappling with the issue of thin capitalization need to be aware of those views. They also need to bear in mind that the primary function of this guidance is to advise HMRC officers, and so need to be aware where HMRC views may not be accepted by those on the other side of the table.


Credit ratings

The most significant development is arguably the entirely new section on credit ratings. Synthetic credit rating tools, such as the S&P Credit Model or Moody's Riskcalc, have become an essential tool for transfer pricing practitioners in assessing the terms of intragroup debt. However, their use in both loan pricing and thin capitalization has been the subject of much debate within HMRC. The guidance acknowledges the merit of such models in a loan pricing context, thereby allowing the debate to move on to the quality of information. The tax authorities, however, remain skeptical about the use of ratings to support the position that a borrower is not thinly capitalized, questioning whether an independent company "would" choose to borrow if that resulted in a sub-investment grade credit rating.


Advance Thin Capitalization Agreements (ATCAs)

The guidance contains considerable material on ATCAs, but most of this is only new to the manual, and was previously available in the Statement of Practice on ATCAs. Comments are included on how ATCA applications are handled, what the tax authorities want to see in an ATCA application, and what the final agreement should include, with a Model ATCA put forward as suitable for ordinary cases. The use of this model needs to be carefully considered, however, as it is not always appropriate.


Private equity

Another new section covers thin capitalization for private equity-backed businesses, thus acknowledging the sometimes slightly uneasy distinction HMRC has drawn between thin capitalization for inbounds and for private equity owned businesses. The guidance explains the typical funding of private equity deals and indicates that it is shareholder debt (and occasionally vendor debt) that is most at risk of not being arm's length. There is also an emphasis on the importance of deal timing (pre- or post-credit crunch) when considering comparability and a discussion about the importance of reviewing financial covenants when trying to determine debt capacity.


Property lending

The guidance on lending against asset values has been substantially expanded, with a more specific focus on third-party research (the "De Montfort Report"). This research will clearly be the starting point for future discussions with HMRC on real estate debt. While HMRC made reference to the credit crunch, it has, as elsewhere in the guidance, avoided giving any view on what it considers acceptable leverage and pricing in the current market. This avoids the guidance having a very short shelf life and future misunderstandings.


Gearing and cover ratios

There is expanded material on which ratios can be used for determining debt capacity; it is good to see more on common commercial measures such as the leverage ratio (debt-to-EBITDA), or loan-to-value ratios. Unfortunately, the "old" standard measures of debt-to-equity and EBIT interest cover remain alongside these new, more current, measures. There also remains a reluctance to accept that ratios should be calculated in the same way as for banking purposes. Thus, the tax authorities resist concepts such as "netting" (of cash and interest income) and still propose EBITA or EBITDA-Capex as alternatives to the standard straight EBITDA. The idea of having "safe harbor" ratios is dismissed as "a simplistic method of determining tax consequences by reference to publicly-stated formulae, rather than by a precise application of the OECD principles." However, HMRC is also dismissive about the idea of using comparables for gearing, which raises questions as to how the thin capitalization question is to be answered.


"Would" arguments

The new guidance includes a number of HMRC views that those outside HMRC will struggle to reconcile with the legislation. Unfortunately, the guidance does not hint at the existence of contrary views in such areas. Chief among these issues is the subjective 'would' argument about determining when a borrower would borrow, rather than applying the more objective test of whether a lender would lend. This will lead to the traditional debates about whether a borrower would borrow. Despite the best efforts of the modernizers, the old HMRC lives on; the guidance may have been written by a committee wanting to accommodate both views.


Treaty clearances

The guidance has been updated to reflect the April 2007 administrative decision to separate the working of treaty withholding tax claims on interest paid overseas and thin capitalization. The updated chapter sets out the strict HMRC view on appropriate interest and penalties for companies that fail to get the required treaty clearance but still pay interest gross (i.e. fail to withhold). This reflects our recent experience that the tax authorities are becoming increasingly reluctant to compromise in this area.


Conclusion

Overall the new guidance is an improvement on its predecessor. It shows HMRC's efforts to teach its officers how to be more commercial, and the guidance should make a positive contribution to the future discussion of thin capitalization issues. However, interest deductions clearly will remain a key focus area for HMRC, and there is some way to go before everyone involved has a common view of how the U.K.'s arm's length thin capitalization rules work.