INTM517100 - Thin capitalisation: practical guidance: measuring debt: groups with mixed activities

In order to arrive at the arm’s length amount that could be loaned to the borrower it is necessary to work out debt and interest cover ratios which are appropriate for the whole of the borrowing unit (explained at INTM517050). However, the mixed nature of some groups means that a general value does not sufficiently take account of the differing borrowing abilities and requirements of the individual members of the group. This may not be a problem unless unusually high levels of debt are contemplated, in which case it will be necessary to consider whether all parts of the business would at arm’s length attract the higher levels of debt which are claimed. A third party lender would look at the borrowing capacities and needs of the individual companies making up the borrowing unit, and either add them together to get an overall capacity or enter into separate arrangements suiting each business needing funds. A third party lender is likely to try and take account of the following activities:

• Insurance sub-group. In general, UK insurance groups do not have high debt:equity ratios - the ratio is typically significantly less than 1:1 (see INTM517060). However, an insurance-broking company - while it may be regulated as to its activities, will not be regulated in the same way as an insurance company with regard to its capital. Its borrowing capacity will have to be looked at separately. Insurance brokers do not generally borrow heavily because the nature of their balance sheet assets mean that the net worth of the company is all that is available to support debt. It is advisable to consult financial sector specialists when looking at insurance and other regulated businesses.
• Finance leasing sub-group. Typically, such groups may have high debt:equity ratios, however, a third-party lender may wish to ensure that, in so far as the loan is made on the basis of such a ratio, it is genuinely funding the leasing business and not other parts of the grouping, and this may be specifically address in the loan agreement.
• Trading sub-group resident in France. It may be appropriate to look at the borrowing capacity of a French sub-group, to see if it would be able to obtain terms that are more favourable than in the UK. If so, that higher level of borrowing would have to be attributed to the French group, not to the UK.
• Manufacturing sub-group. If there is nothing special about it, such as start up or rapid expansion, then a “steady state” treatment will be appropriate.
• Company with a treasury function. See INTM503000.

Any of these may be carved out and made the subject of a separate agreement, if they have a distorting effect which cannot be accommodated by adjustments to a single agreement. Alternatively, it may be possible to agree a methodology for arriving at a “blended ratio” for each covenant, a single ratio reflecting the various group components. Some thought should be given to what happens in the event of the breach of a ratio. A blended ratio may fail where one or more separate agreements would have succeeded, or it may succeed where one or more of the separates would have failed. This is a risk to be weighed up on a case-by-case basis and suitable rules recorded.