HMRC's Updated Thin Capitalisation Guidance
HM Revenue & Customs (HMRC) have released updated thin capitalisation guidance. Since the last guidance was released significant changes have occurred in borrowing trends and the wider economic environment. HMRC have taken the opportunity to establish their views on these issues.
The guidance marks a change in the approach taken by HMRC with a shift in emphasis away from quantitative rules of thumb and definitive ratios (e.g. 1:1 debt to equity) to a more traditional detailed transfer pricing analysis based on the business plan, position within the industry sector, economic environment and rationale for debt financing. This new guidance clarifies HMRC's position that they see thin capitalisation as an area that warrants greater scrutiny and a detailed transfer pricing examination of the facts and circumstances of each individual taxpayer.
John Neighbour, Daniel Head and Trevor Danks from KPMG in the UK explain how the guidance raises new challenges for taxpayers that have borrowed from connected parties.
Background
HMRC initiated an extensive review in 2008 with the intention of ensuring their guidance reflected the changes that had occurred in the capital markets subsequent to publication of their previous views on thin capitalisation. Anyone with prior experience of dealing with thin capitalisation issues may be familiar with HMRC's 1:1 debt to equity and 3:1 interest cover benchmarks that were published in 1995 and have subsequently been loosely regarded as notional arm's length safe harbours. Whilst some taxpayers may have felt it inappropriate to apply standard measures to their own position, other businesses may prefer the degree of certainty afforded by having published benchmarks against which to verify their own position.
The guidance is therefore HMRC's attempt at addressing the problem of the rapidly evolving state of the global economy and credit markets and as a result, it necessarily discusses thin capitalisation in a different way to previous guidance and this may raise significant issues for many taxpayers.
Furthermore, partly due to HMRC's new, diversified and regionalised structure of thin capitalisation specialists, and partly due to the increased volume and complexity of thin capitalisation cases being discussed with HMRC, KPMG have observed a number of different approaches to thin capitalisation being rigorously adopted by different officials at HMRC. Many of these approaches have been presented as HMRC "standard practice” and/or latest thinking, but without published commentary to support the rationale for the position being promoted. The updated guidance can to some extent be seen as HMRC's opportunity to set the record straight and establish their views on the ground rules when applying the arm's length principle to thin capitalisation. However, in light of our previous experiences we have already adapted our methods to deal with the challenges being presented by HMRC.
Legislative background
The UK transfer pricing legislation applies where a UK entity has borrowed from a connected party. The basic requirement is that such a transaction should be treated, for tax purposes, as if it had taken place on an arm's length basis between independent enterprises. Specifically, the legislation requires that the particular facts and circumstances of a transaction should be considered in order to determine the arm's length interest rate that should be applied to the arm's length amount of debt. For completeness, it is worth mentioning that for these purposes the concept of control is widely drawn, as a consequence of the acting together rules introduced in Finance (No 2) Act 2005.
Although the arm's length requirement is established by legislation and upheld in the European Court of Justice's (ECJ) recent judgment on the Thin Capitalisation Group Litigation Order (C-524/04), there is otherwise a distinct lack of case law that dictates how this principle should be applied. This means that thin capitalisation, in law and in practice, remains a subjective area that should be assessed with reference to the facts of a transaction rather than rigid calculations, as there are no reliable objective tests. KPMG's wide ranging experience means we take a flexible approach to analysing each transaction in order to optimise the presentation of the taxpayer's borrowing case.
HMRC's re-drafted guidance
Because of the uniqueness of every individual transaction, it would not be possible to prepare comprehensive thin capitalisation guidance with indicative measures that can apply in a diverse set of circumstances. HMRC have therefore taken a principles based approach that observes the legislative requirement of applying the arm's length principle. HMRC's new guidance is therefore predominantly fact based, setting out the relevant terminology, the range of possible structures and the key factors to consider, but leaving the application of the arm's length principle to a specific fact pattern of a case open to interpretation.
This will be a mixed blessing for taxpayers. Some companies will welcome the move to a principles based approach to application of the arm's length principle and KPMG are well placed to assist with preparation of bespoke transfer pricing documentation to support the maximum possible amount of debt. Other taxpayers may have preferred the degree of certainty afforded by published indicative reference points, however we can assist you to maintain certainty by negotiation of an Advance Thin Capitalisation Agreement ("ATCA”).
Of particular note the new guidance does not include any references to any indicative ratios, numbers or terms that HMRC may consider to be consistent with an arm's length position. This avoids the confusion that arose over the status of the old 1:1 debt to equity and 3:1 interest cover references and leaves the reader to consider the fact pattern of each case on its own merits. The events of the last 18 months will have demonstrated that the amounts of debt lent and the terms applied by independent lenders can vary widely and it is therefore encouraging that HMRC chose to issue guidance that is informative rather than prescriptive.
This guidance sets out HMRC's views on how arm's length pricing should be determined when dealing with a thin capitalisation enquiry or when negotiating an ATCA. The guidance also explains HMRC's operational structure, how these processes should work and the suggested form of an ATCA and the consequences of breaching a financial covenant. Our view is that the decision between preparing thin capitalisation documentation to support the tax return and submitting an ATCA application is an important choice of strategy that should be taken with reference to the facts and circumstances of the transaction, with regard for the taxpayer's appetite for certainty versus risk.
Specific new areas of guidance
In light of the changes in the economy, credit markets and forms of financing available, and as a consequence of the new approaches to thin capitalisation documentation being taken by tax advisors, there are a number of completely new areas of guidance. Notable sections include:
- various references to the credit crisis throughout and consideration of the potential impact on a funding transaction;
- use of synthetic credit scoring techniques to support a thin capitalisation analysis;
- commentary on the impact of adoption of IFRS;
- discussion of the special characteristics of funding transactions in the Private Equity sector; and
- an explanation of the importance of considering whether a transaction would have been conducted at arm's length, rather than merely assessing whether a transaction could have occurred.
Although the guidance covers a wide range of issues and is more comprehensive than before, a number of issues have not been considered, such as the implications for the status of senior debt when a bank exchanges debt for equity in a distressed business. Assessment of unusual transactions will therefore continue to be dependent on experience.
In summary, what do the new guidelines mean for my business?
The new guidance establishes the principles based approach to be taken by HMRC and the greater degree of scrutiny that thin capitalisation will now attract. There are a number of key themes which occur throughout the guidance highlighting a change in focus away from a purely quantitative analysis to a more rounded, commercial and market focused approach based on a more detailed understanding of the specific facts and circumstances relating to the transaction. Overall the new guidelines indicate HMRC taking a harder line to allowing interest deductibility.
The guidance has eliminated any perception of safe harbour reference points operating in the UK and instead sets out broad principles under which HMRC will seek to determine the arm's length level of debt. These broad principles apply throughout the guidance setting the scene for how HMRC will seek to resolve thin capitalisation disputes in future. The new guidelines place greater emphasis on the importance of thin capitalisation experience when determining the arm's length position. Unlike previous negotiations we are unlikely to see arguments presented on a purely financial basis, instead, HMRC will require a thorough understanding of the business, its markets and drivers affecting the borrowing decisions and requirements. It is from here that we will then see HMRC forming a view on the arm's length nature of debt.
This approach will mean that taxpayers will have to be prepared to fully document their decision processes in relation to debt financing and provide corroborative evidence to support the borrowing position. We can expect to see HMRC targeting certain sectors where it is widely thought that excessive interest deductions may have resulted from the capital structure adopted by businesses within these sectors. For HMRC, the success of the new guidance will depend on their ability to dedicate appropriate resource to dealing with thin capitalisation.
KPMG's approach
KPMG has a dedicated team of transfer pricing professionals that have significant experience dealing with thin capitalisation issues. Our approach is to work with you to determine the most appropriate approach to take in relation to your thin capitalisation position. Ultimately, we will advise you on whether the most advantageous position for your business will be to obtain upfront clearance with HMRC under the ATCA process or to prepare detailed documentation to support the filing position taken in the tax return.
In order to obtain the best results for our clients we review each company's position on a case by case basis. Our approach is tailored to your business in order to complete robust documentation supporting the position or to maximise the deductions available by negotiating the most favourable position possible through an ATCA with HMRC. A recurring theme which echoes throughout HMRC's new guidance is the need to understand the business, its growth strategies, wider economic conditions and lending case and to link this through to the arm's length nature of the debt. Without undertaking a thorough qualitative analysis to support the borrowing position we consider that value may be lost upon negotiation with HMRC.
The UK KPMG team is led by John Neighbour, the UK Head of Global Transfer Pricing Services and assisted by Daniel Head. Prior to joining KPMG, John was a senior official at HMRC, where he ran the department charged with the implementation and application of thin capitalisation. The team is therefore well placed to determine the most appropriate route for you to take in order to help enhance your interest deductions.
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If you would like to discuss this further, please speak to John Neighbour | 020 7311 2252, Daniel Head | 0161 246 4742, , Trevor Danks | 020 7694 1516 or your usual transfer pricing contact.