INTM567000 - Thin capitalisation: FA2004 legislation - conduit finance

Many groups include companies, sometimes called treasury companies, whose purpose is to borrow in order to lend the funds to the wider group. These companies typically have very little equity funding, and their borrowing will usually be supported by a guarantee provided by another group company, often a holding company. Thin cap aspects of “treasury” companies are considered in more detail from INTM570000 onwards.

We might expect to see a margin between interest received and interest paid as a reward for the conduit company’s role in procuring finance for the group, depending on the nature and extent of its activities.

The guarantee often replaces equity for the purpose of giving security to the conduit’s lenders, and so the conduit may be thinly capitalised. However, secure on-lending can substantially reduce the risk retained in the conduit and therefore correspondingly reduce the need for equity, especially if the conduit’s on-lending is secured against the assets of its borrowers.

The overall profit attributed to a conduit company should be proportionate to the activity it undertakes and the risks it retains. This principle should be borne in mind in applying the thin capitalisation and transfer pricing legislation, so as to avoid either insufficient or excessive profit being realised in the conduit.

As noted above, secure on-lending can reduce the conduit’s retained risk, and this is especially true if the conduit takes a charge on the on-loan. The charge allows the conduit to take possession of the assets of the ultimate borrower in order to enforce its rights under the loan contract. Although the charged assets are those of the borrower, the charge does not constitute a guarantee within the meaning of paragraph 1A(7) because it is no more than a means of enforcing rights that already exist under the loan contract.

In some cases, the conduit may pass on the right to enforce the charge to its lender. This often happens in the case of securitisations. This arrangement allows the lender (or the lenders’ trustee in a securitisation) to take enforcement action against the ultimate borrower if it defaults on its loan to the conduit, in order to allow the conduit to meet its obligations to the lender. Provided the arrangement does not grant new rights of recovery to the lender (beyond the right to enforce the conduit’s rights under its loan agreement), this also does not constitute a guarantee.