Interest rates video series

00:00 – Sarah Howarth

So Mark as in previous tough economic times. I guess we’ve seen some big high street names go bust recently, as well as, I’m sure, countless small businesses. What kind of things are banks looking out for as providers of debt, and how quickly can things go south?

00:15 – Mark Ellis

So things can go south for a business very, very quickly, particularly when there’s a huge economic shock such as COVID-19 pandemic, but in general it only takes the loss of a big customer if you’ve got a high degree of customer reliance. But in respect of what banks are looking for, they’ll have a whole host of things that they’ll monitor on a fairly continual basis, and these are things like interest coverage. So they’ll look at the amount of interest being paid in comparison to the profits being generated. It might consider leverage, might consider all the financing that they’ve got and how the bank’s debt is secured against various assets in the business or maybe in personal guarantees.

00:58

So when the red flag starts to show, I think it’s very much having a look on a month by month basis. And are you seeing a declining trend in the business in terms of profitability, cash flow, are there genuine worries about being able to pay the staff, for example? That’s a pretty clear sign. But beyond that you will start to see a general slip and most businesses, if they manage well, should have resources on hand to withstand a couple of months at least, ideally a fair few more, of bad economic times. But I suppose that that’s with a third party looking over your shoulder. What are the things to consider when you’ve got related party debt there?

01:42 – Sarah Howarth

So whenever we’re looking at kind of related party transactions, we’re thinking about the transfer pricing rules. So transfer pricing is kind of an international tax concept which says that wherever you have related party transactions, whether they are trading or funding in nature, for tax purposes they must be priced on an arm’s length basis or adjustments made if they are not. So I suppose to speak to a couple of points that are relevant here, perhaps if we’ve got a situation where a third party lender is no longer prepared to provide debt and we’re looking to replace that with related party debt, interest will only be deductible for our borrower from a tax perspective to the extent it is arm’s length. So is the amount being provided by the related party at an arm’s length interest rate? And is the quantum arm’s length? So is it equivalent to what a third party would have provided?

02:35

And I suppose the point there is that the third party is no longer prepared to lend on that basis. So we should expect some level of interest restriction because the parent or group member is providing funding over and above what a third party would have supported. The other thing to touch on briefly is guarantee fees. So we might have a situation where a bank is only prepared to continue to lend if a parent or other group entity provides a guarantee, so provides additional security. Obviously, in a third party situation you would expect to pay for that guarantee and the transfer pricing rules says that that must be imputed. So if, for example, a UK company is providing a guarantee to say a French subsidiary, we would expect to get an arm’s length return for that and have documentation to support that that is arm’s length, perhaps supported by benchmarking.

03:31 – Mark Ellis

Sure, and how are these benchmark studies done? Are they done by an advisor? Can it be done internally?

03:41 – Sarah Howarth

Really depends on the size and sophistication of the business. It’s certainly something we can assist with. Benchmarks are generally generated from huge databases of either agreements or financial information, which you then filter down to get appropriate comparables. The main thing that’s going to be important obviously, given huge changes we’ve seen in the last couple of years is that we’re pulling recent comparables. They’re going to be very different to what was possibly available three, four years ago.

04:11 – Mark Ellis

And is this something that is to be kept on file for future review, or is it something that can actually be agreed with HMRC?

04:20 – Sarah Howarth

So good question, and it kind of depends. HMRC and also certain other tax authorities around the world will have kind of advanced assurance facilities, but generally things need to be of a certain quantum for it to be worth their while. Otherwise, in the UK it’s simply a case of holding the documentation on file and having it available for inspection if requested. Other territories will require that it’s submitted annually. So for any business operating internationally it’s really important to know what the requirements are in your local jurisdictions.

04:53 – Mark Ellis

And are there any tax consequences of none or late repayment of interest?

05:00 – Sarah Howarth

So I think what we’ll sometimes see, and I guess it can happen in third party situations as well, is that interest will switch from being paid to being accrued and it might be rolled up for three or four years until there’s the cash flow there to support actual payment. So for the most part, interest is deductible on an accrual basis, but with a couple of important exceptions, being when the lender is a shareholder. So the parent or one of several shareholders, and that parent is resident in a kind of tax haven type territory. So in those specific circumstances interest is only going to be deductible when it is actually paid. So that’s quite important for businesses to be aware of, because if you’re assuming you’re going to get a deduction of maybe half a million each year and actually you’re not you’re just going to get a deduction of 2 million four years down the line when you actually pay that interest. That’s going to make quite a big difference to your tax charge and your cash flow.

05:58 – Mark Ellis

I suppose the final point, Sarah, is what should our clients or potential clients be considering from a tax perspective on transfer pricing if they’re looking to reorganise their debt?

06:10 – Sarah Howarth

So again, I think, just trying to think ahead be proactive. The main issue is going to be a potential disallowance of interest expense, the impact that’s going to have on your tax charge and your cash flow. So just trying to think that through sooner rather than later, and certainly before you kind of get into the point where you need to prepare your tax note for your accounts. You know commerciality comes first. The funding is needed to allow the business to operate. That’s fine. Tax tail mustn’t wag the dog. But just understanding how that flows through into the numbers for the current year and future years is really important.

06:46 – Mark Ellis

And is it always helpful to try and seek third party debt at the time of real crisis? And those finances from a third party, just a bolster that evidence that you’re going to put an end to your tax note.

06:56 – Sarah Howarth

I mean, I think you have to do what’s right for the business, whether that’s related party debt or third party debt. But of course, if there has been an application for third party debt which has been successful and you’ve just chosen not to proceed with that, that’s going to be really helpful on your kind of defensive documentation. If you do decide to proceed with related party debt, making sure you’ve got adequate documentation on your file to show that that is arm’s length will be crucial to support the filing position for the tax return.