INTM516040 - Thin capitalisation: practical guidance: interest cover - debt servicing: other measures of interest cover: netting
There are variations on the measures of interest cover which have already been explained, including:
- Earnings Before Interest and Tax (EBIT - see INTM515020) and
- Earnings Before Interest, Tax, Depreciation and Amortisation (EBITDA - see INTM515030).
Although they modify the way interest cover is calculated, the aim is always the same: to determine the ability of the borrower to service the debt and to be quite clear about what is being measured and why.
Netting of interest receivable against interest payable.
HMRC does not generally agree to the netting of interest in thin capitalisation agreements without some further exploration of whether it is appropriate. HMRC is frequently told that banks regularly adopt covenants on a net basis, but thin cap agreements are made in relation to non-arm’s length relationships where normal commercial pressures may not apply.
Revenue & Customs Brief 01/09 addressed this issue in the following terms, advice which still stands:
Whether net debt or interest is acceptable in a thin cap agreement
Over the years there have been discussions about HMRC’s attitude towards using net interest or net debt as a suitable measure in a thin cap agreement. The debate has often been simply whether HMRC accepts netting or does not accept netting. The answer is that HMRC is prepared to examine the arguments for employing a net position, looking at issues such as the security, consistency and durability of the offsetting source, but will not accept netting without being satisfied that it is appropriate. HMRC sees instances of UK sub-groups of multinational enterprises which are subject to group pressure from outside the UK to retain borrowed funds that no longer serve their original purpose, do not form part of the company’s working capital, and which the UK grouping is unable to exploit to its own advantage.
It is frequently proposed, even assumed, in applications for Advance Thin Cap Agreements that when calculating interest cover it is acceptable to net interest receivable against interest payable. The effect can be considerable. Consider the following figures:
| 20XX | |
|---|---|
| £m | |
| Turnover | 56.5 |
| Cost of sales | (15.7) |
| Gross profit | 40.8 |
| Administrative expenses | (20.7) |
| Operating profit | 20.1 |
| Interest receivable | 2.4 |
| Interest payable | (7.6) |
| Operating profit on ordinary activities before taxation | 14.9 |
| Tax on profit on ordinary activities | (3.5) |
| Operating profit for the financial year | 11.4 |
The value of EBIT (operating profit) is £20.1m, so EBIT/interest payable ratio is 2.6 (£20.1m/£7.6m).
If, however, the figure for net interest payable is used, the figure for EBIT/(interest payable - interest receivable), becomes 3.9 (£20.1m/(£7.6m-£2.4m).
The difference in the two figures is significant, and taken at face value might make the difference between accepting cover as adequate and regarding it as weak. There are a number of questions to ask when considering the netting issue:
- is the ratio of 3.9 a better reflection of the company’s ability to service the debt than 2.6?
- what is the source of the interest receivable, how reliable and enduring is it?
- is the source of the interest receivable closely linked to the source giving rise to the interest payable? For example, is it a deposit on which the lender has first call or right of set off?
- the presence of borrowing and lending within the same company is hardly unusual, but it is worth further enquiry if the borrower is accumulating significant amounts of cash while remaining highly geared; companies with group funding may accumulate and on-lend cash rather than applying some of it to reduce debt, in order to preserve group tax advantages. Where interest flows are between group companies, it may not matter to the group whether a UK borrower is managing its net interest position efficiently.
- netting of debt or of interest not only improves debt or interest cover ratios, assuming the cash is earning interest, it may disguise an accumulation of cash which may not be bringing much of a return and which, if the lender had been third party, might have been used to reduce debt.
- cash deposits can be transient and fugitive, while loans are generally for the longer haul.
The overall deciding factor in choosing a covenant is its effectiveness in tracking the ability of the company to service its debt, not the (arguably) cosmetic effect of netting.