Background: revised ICAEW guidance issued in 2017 cast doubt on common intra-group financing structures
The Institute of Chartered Accountants in England and Wales (ICAEW) periodically publishes guidance (Guidance) on the determination of distributable profits.
The Guidance sits at the intersection of company law and accountancy – company law determines whether or not a transaction is a distribution but the determination of what profits are distributable to shareholders is made in accordance with relevant accounting standards, hence the need for accounting guidance on the issue.
The Guidance also sets out the ICAEW’s view on circumstances which could constitute a distribution (a matter of law rather than accounting), and it is this aspect of the Guidance which ruffled a few feathers when a revised version was issued in 2017, because of its potential impact on common intra-group financing structures.
The problems raised by the 2017 Guidance
The 2017 Guidance stated, for the first time, that:
- an upstream or cross-stream guarantee would be a distribution where no market fee is paid to the surety for the grant of that guarantee;
- the grant of an interest-free on-demand loan by a subsidiary to a parent or other sister company could constitute a distribution, because of the interest foregone on the loan by the subsidiary.
Neither statement was consistent with prevailing market views. If they were correct, transactions previously considered lawful would potentially be off limits to companies without distributable profits, and directors and lenders alike could be affected by the potential invalidity of existing arrangements.
Because of the uncertainty introduced by the 2017 Guidance, the Law Society has produced two new notes addressing the issues raised. The Law Society notes, broadly speaking, return us to the pre-2017 status quo.
The Law Society’s reassertion of the status quo
Upstream and cross-stream guarantees
Prior to the 2017 Guidance, it had generally been believed that the giving of a guarantee would only be a distribution if provision needed to be immediately made for it in the company’s accounts under relevant accounting principles – which would not usually be the case where there was no reasonable prospect of the guarantee being called upon.
The Law Society concludes that a guarantee given by an English company to a creditor of its parent or a fellow subsidiary in relation to a normal financing transaction cannot constitute a distribution regardless of whether a fee is paid. The reference to a normal financing transaction is one in which the directors of the relevant subsidiary decide in good faith and on reasonable grounds that the guarantee is unlikely to be called, having considered the financial position of the principal obligor.
The giving of an upstream (in favour of a parent company) or cross-stream (in favour of a sister company) guarantee may amount to a distribution but only if:
- the intention is that guarantee will be called (or is objectively likely to be called); and
- the subsidiary does not receive appropriate value for assuming that contingent liability.
These judgments need to be made at the point at which the guarantee is entered into, based on information available (or which ought to be available) to the board at the relevant time. If it is not a distribution when entered into based on the application of the above principles then subsequent events will not affect the analysis.
So, we really are back to where we were before the 2017 Guidance, but, with a couple of very useful reminders on best practice in establishing the legality of intra-group guarantees and loans.
Best practice in documenting intra-group guarantees
In order to fall within the parameters of the guidance, subsidiary boards granting a guarantee should record clear evidence of the directors’ assessment of:
- the corporate benefit accruing to the subsidiary through the grant of the guarantee;
- the likelihood of the guarantee being called upon.
Establishing corporate benefit
In giving a guarantee, the directors of the subsidiary must act in the interests of that company. If they do not, they are potentially personally liable to the company for its losses. Similarly, a guarantee may be set aside and benefits conferred under it may be recovered by the guarantor if the beneficiary of the guarantee has actual or constructive notice of the facts giving rise to the breach.
Accordingly, establishing corporate benefit is necessary for both the protection of the directors and the lender (it is for this reason that commercial lenders invariably require sight of authorising board minutes where corporate benefit is established).
As the Law Society makes clear, there is no legal requirement to charge a fee for the grant of a guarantee and the subsidiary board can take into account wider benefits accruing as a result (for example, being part of a financially stable group of companies with continuing access to management, services, expertise and more favourable access to finance).
Assessing the likelihood of the guarantee being called upon
Boards of guarantor companies will need to ensure that, at the time the guarantee is entered into, they have properly considered how likely it is that the guarantee will be called. If they properly establish that it is unlikely then the guarantee will not comprise any element of a distribution.
If they establish that it is likely or inevitable but they receive full value for assuming that risk then it is not a distribution. That value is likely to be in the form of the wider non-cash benefits outlined above. The law affords directors “a margin of appreciation” – if the benefit is of some value to the subsidiary the Law Society considers that it will be “less likely” that a court would find the intention was to make a distribution, even if full value was not given.
On-demand intra-group loans
The Law Society’s analysis of on-demand intra-group loans is very similar, and again reasserts the position taken by practitioners prior to the 2017 Guidance. A “normal intra-group on-demand loan” – a loan immediately repayable on demand which the board of the lender considers, in good faith and on reasonable grounds (having assessed the borrower’s financial position) is likely to be repaid by the borrower on demand – is not a distribution, whether interest-bearing or not.
The fact that a subsidiary does not charge interest (or charges interest at less than the market rate) on an on-demand loan does not result in a disposition of the subsidiary’s assets – interest foregone cannot therefore, as a matter of law, be a distribution.
An on-demand loan may constitute a distribution, but only if:
- viewed objectively the borrower will not be able to repay the loan on demand; and
- the lender does not receive appropriate value for the risk.
Again, a margin of appreciation to the assessment of value applies. Obviously enough, if there is no intention that the borrower should ever be required to repay the loan, the loan will likely constitute a distribution.
These assessments need to be made at the point at which the on-demand loan is entered into, based on information available (or which ought to be available) to the board at the relevant time. If it is not a distribution when entered into based on the application of the above principles, then subsequent events (such as a default in repayment) will not affect the analysis.
In granting the loan, the directors need to ensure it is in the interests of the subsidiary to grant an interest-free loan – the same wider non-cash benefits outlined above of continued existence within the wider group can legitimately be taken into account.
Osborne Clarke comment
Whilst it is fair to say that market practice on intra-group financing did not move on the back of the ICAEW’s 2017 Guidance (as many expected the legal analysis on these points to be challenged), the Law Society’s notes have gone a long way in re-establishing prevailing market views on the validity of these common intra-group financing transactions, and are extremely welcome.
Whilst clearly not binding law, we consider that the views expressed by the Law Society are correct in principle and that it is unlikely that the courts will ultimately stray far from them.