INTM516030 - Thin capitalisation: practical guidance: interest cover - debt servicing: factors affecting the interest rate

What is the arm’s length interest rate?

The arm’s length test not only applies to the amount of debt; it applies to all the terms and conditions of lending, including the interest rate. It is necessary to determine whether, having regard to all the facts and circumstances, interest is charged at an arm’s length rate.

It is not easy to decide whether a particular interest rate is at the appropriate commercial level, since for any particular loan there may be a range of interest rates that can be regarded as being at arm’s length. The proper interest rate for a transaction clearly depends upon the facts and circumstances of a case.

Factors that affect what can be borrowed

A third-party lender will carefully assess the risks involved in a proposed debt. In an intra-group context, such risks should be considered in evaluating the arm’s length interest rate, as well as the amount of the debt. Factors that affect what may be borrowed, which tend to relate to either the nature of the intended investment or the character of the borrower include:

  • the purpose of the debt
  • the extent of any existing debt, because a high level of existing debt will reduce the borrower’s ability to take on more. At arm’s length, new debt is likely to be lower in rank to existing debt. See INTM519030 in relation to layers or tranches of debt
  • security available for the debt, and the quality of these assets
  • expected cash flow - a lender will examine the borrower’s cash flow, both historic cash flow and those that are projected
  • the borrower’s credit status which may be difficult to establish if a company is not being considered on its standalone merits by a third party lender
  • whether a business is well established, its track record
  • the state of the market at the time of the deal

The above factors reinforce the point made in INTM514010: that getting to know the business in a thin capitalisation case is extremely important.

See also the chapter on Dept Pricing and Credit Ratings starting at INTM524010, particularly INTM524070 and INTM524080.

Pushing up the interest rate

A third-party lender will not simply go on increasing the proposed interest rate by an extra margin for each perceived risk, since that increases the risk of the borrower not being able to service the debt. Also, at some point the risk becomes so great, and the interest rate so expensive, that no debt would be offered or taken up. A balanced, common sense approach is needed in each case - there is unlikely to be any single correct answer.

Fixed or floating interest rate

  • Fixed rate is where the interest rate does not change, for example, a fixed interest rate of 5.5% may apply to debt.
  • Floating rate is where the interest rate fluctuates by means of a benchmark base rate to which it is linked, for example, an interest rate of overnight SONIA + 2% (see INTM516035 for information on SONIA and its replacement of LIBOR).

A borrower may prefer a fixed rate that gives certainty of outgoings over a period of time, or go with a floating rate and take the chance of the base rate remaining low or falling. Lenders are prepared to give floating rates, but only for shorter maturities than that possible on fixed rate and usually at a slightly higher rate than the fixed rate, to cover transaction costs associated with intermittent re-basing of the benchmark and also the lack of certainty during the term of the debt.

Influence of the term of the debt

Under normal macroeconomic growth conditions, the longer the maturity of debt, the greater the scope for something to go wrong, and the greater the risk to a lender. As a result, the interest rate is normally higherfor longer-term debt (as reflected in the upward sloping then plateauing yield curve). In practice, companieswith third-party debt generally obtain a mixture of short, medium and long-term debt, providing appropriate flexibility.

By contrast, intra-group borrowing may consist of a single intra-group debt, with contractual terms that may not reflect the accurate delineation of the transation. For example, the contract might stipulate a 10-year maturity, when in fact the debt was not expected to remain in place for such a long period and was actually repaid after three years. Intra-group debt must be treated for thin cap purposes as having an appropriate terminal date, in accordance with what would have happened at arm’s length.

Security

The existence of security for debt will mean access to cheaper borrowing than unsecured debt, and the quality of that security will also influence the price. See the chapter on lending against assets at INTM518000. Security can have varying degrees of significance, sometimes being no more than a “belt and braces” addition to the other terms.

Currency of the debt

The currency in which debt is made may present some risk to one of the parties. For example, if there is evidence that the currency in which the borrower operated and held its assets was consistently declining in value against the currency in which the debt was made, then the borrower would want to protect itself against foreign exchange losses. A UK company operating in sterling would need a very good reason (and good forex risk management, which is often neglected entirely in intra group situations) to take out debt in a currency which was not stable against the pound. It is therefore necessary to consider why a UK company would take out debt in a currency which leaves it exposed to significant foreign exchange fluctuations, and what it has done to protect itself against that risk. Intra group debt tends not to be hedged against forex risk.

Conclusion

Finding an arm’s length interest rate may be difficult, but the following issues may contribute towards reaching a conclusion:

  • Is there a credible comparable uncontrolled price? Tax advisors may quote bond issues by similar companies at similar times, but these need to be scrutinised carefully, particularly when the period in question is one of volatility, or a lack of market confidence exists amongst lenders.
  • Does the company have any third party borrowing or has it had any definite offers of third party funding which might provide a starting point for determining an appropriate interest rate?
  • Is a challenge to the rate likely to be cost effective, bearing in mind that any adjustment may be a matter of basis points (hundredths of a per cent)?