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 INTM584010 - Thin capitalisation: third-party loan agreements: The general form of third-party loan agreements

The term ‘third-party loan agreement’ means an agreement with an unconnected party. Whether it actually constitutes an arm’s length agreement depends on whether the borrowing is guaranteed by members of the borrower’s group. It is possible that agreements between connected parties may also be entirely on terms that would be seen at arm’s length, but it is likely that there will be differences reflecting a controlled or special relationship. If nothing else, a connected party deal may leave much to the imagination, while a third-party agreement will define everything and leave few scenarios uncatered for. Such differences may mean that the agreement is not at arm’s length.

A familiarity with third-party loan agreements is useful, since it increases understanding of the terms under which such lenders are prepared to make loans available. Some of the arm’s length terms may also be appropriate when drawing up a thin capitalisation agreement (see INTM582000 onwards).

Third-party loan agreements vary considerably in detail and complexity. At the one extreme there is the simple one-page loan, or promissory note. At the other there is a long, complex document involving many parties, for example a loan facility provided by a syndicate of lenders, administered by a separate syndicate manager and guaranteed by one or more members of the borrowing group. This chapter does not intend to examine third-party loan agreements in detail, but seeks to point out some of the more interesting features which may be of relevance to a thin capitalisation case.

By contrast, intra-group agreements tend to be much more brief, as little as one page, or even a few lines in the minutes of a management meeting, recording the facts.

All third-party loan agreements will contain most or all of the following terms:


Feature

Comments

Loan Terms

 

The capital amount of the loan

Drawdown conditions, including:

  • what pre-conditions have to be met, and how.
  • the amounts and dates of drawdown(s)

The purpose of the loan

  • This may be generally described i.e. “for working capital”, or may be specific, e.g. the purchase of a particular asset. This clause is important as it allows the lender to “follow the money” into the asset acquired, if appropriate, to obtain security attachment to the underlying asset. If the borrower does not use the funds for the stated purpose typically a default clause will be immediately triggered.

Repayment

  • amount and timing of repayments

Interest

  • calculation, e.g. % above LIBOR, and when and how payable.

Security

  • what security is to be given, how and by when. Effectively enforceable security is normally a pre-condition to drawdown.

Fees

  • who pays what and when. Many agreements contain Review or Renewal fees.

Costs

  • who is responsible for what costs? This typically relates to legal, accountancy, and valuation fees.

Default clauses

As a minimum these relate to:

  • non payment if interest or of capital repayments
  • insolvency, or similar
  • breach of covenants (see below)

List of participants

  • typically, participants will include the borrower(s), lender(s), facility arranger, facility manager, and guarantor(s).
  • it may seem that the loan is entirely third-party, but if there are group guarantors then ICTA88/SCH28AA will apply.
  • third-party lenders often require explicit cross-guarantees from affiliates, preferring not to rely on the implicit control through shareholding where cross-border relationships exist. Nevertheless, the possible existence of implicit guarantees should be considered
  • it is also not always clear whether apparent third-party lenders have, in fact, taken a shareholding in the group - a possibility that should be considered. Apart from simple shareholding, the possibility of a special relationship and also the “acting together” rules may need to be considered - see INTM542030 and INTM542040.

List of definitions

  • particular attention will need to be paid to the definitions if there are financial covenants in the agreement, since they will indicate any particular variations in, for example, the way in which the debt:equity ratio, interest cover, etc, are defined.
  • if there are to be variations in the interest rate, this may well be defined here, for example in relation to changes in credit rating during the term of the loan or in relation to improving or declining covenant ratios.
  • the interest rate may be pegged to a benchmark rate such as LIBOR, and the definitions should contain an indication of which LIBOR or other rate is to be used (one month, three month, etc) and of the margin on top of that.

Financial and other covenants

This is essential reading. It records in detail the conditions of the loan and the terms under which the borrower and guarantor may enter into other financial arrangements.

Typical types of covenants include:

Financial 

  • Profit & Loss Account ratios, e.g. interest cover
  • Balance Sheet ratios, e.g. gearing, liquidity
  • cash flow ratios, e.g. cover for interest and loan repayments, restrictions on investments, etc.

Operational 

  • limitations on the borrower’s ability to deal in its assets.
  • provision of financial information, what and by when. This typically gives power to the lender to obtain the information at the cost of the borrower if not provided.
  • nature of the business or market of the borrower
  • make up of the management
  • changes of ownership
  • changes to group companies and limitations regarding acquisitions or new group companies.
  • if the agreement is between connected parties, it is necessary to decide whether the covenants constitute arm’s length terms.
  • if the agreement is between unconnected parties, but there is a guarantee by one or more affiliates, consideration needs to be given to the way in which the guarantee has affected the terms the third party has allowed.
  • some of the covenant terms are not easy to understand. HM Revenue & Customs has a number of banking specialists and an HMRC Accountant may be able to help. Failing that, the Transfer Pricing Team at Business International can be consulted.
  • details of the financial conditions themselves may be found here, including any obligations on a guarantor, for example to maintain insurance. The figures for numerical financial conditions may be found here, with the definitions of the ratios found in the definitions section.
  • limitations on liens (a form of security over an asset) on property or assets may also be listed, along with restrictions on the ability of the borrower or the guarantor to transfer assets outside the group or to acquire assets on conditional sales agreements or other title retention devices.
  • limitations on the payment of dividends during the term of the loan may be imposed, indicating the possibility that the ability of the borrower to service the debt may be in doubt. More likely, it is there to maintain a level of security for the debt and maintain or increase the net worth of the company through the life of the loan.
  • particular types of investment during the term of the loan may be restricted.

Monitoring conditions

  • the loan agreement will normally indicate how often and in what form information, particularly of a financial kind, will need to be provided.
  • it will also prescribe the procedures in the event of an officer of the borrower or guarantor becoming aware of a default.

Mergers and consolidations

  • restrictions regarding mergers and consolidations may be imposed by the agreement, in such a way as to protect the existence of the borrowing or guaranteeing entity, to ensure that the result of the change is not default on the loan or to allow the lender to keep track of ownership changes. It is a mechanism whereby the lender ensures that the borrower talks to him about such changes.

Transactions with affiliates

  • the agreement may contain a clause to provide that transactions with affiliates may only take place under arm’s length conditions, including capital transactions. Since third-party lenders will normally require specific documentation to demonstrate that this the case, it may be useful.

While it is true to say that, in general, loan agreements need to be read carefully, the sections covering the items mentioned in the table above may well, if examined first, give an overall idea of the shape of the agreement and allow one to form an initial opinion of the thin capitalisation position.