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26 May 20237 minute read

ESG Ratchets

A closer look at the Finance and Tax implications
Sustainable Lending

Sustainable lending is currently at the forefront of the international loan markets, with recent developments including the collaboration between the Loan Market Association (Europe), Loan Syndications and Trading Association (United States) and the Asia Pacific Loan Market Association (Asia Pacific) (the Associations) in developing cross-market principles for green and social loans and sustainability-linked loans.

This article focuses on sustainability-linked loans (SLL) which are loans that contain a feature by which pricing adjusts with reference to sustainability performance targets (SPTs) in the Borrower’s business being met.  The Principles note that a key characteristic of an SLL is that an economic outcome is linked to whether an SPT is met, in order to encourage borrowers to improve their sustainability performance. This is typically reflected by way of an ESG margin ratchet which means that the interest rate on the loan will be marginally reduced, once certain, pre-agreed SPTs are met, or failure to meet certain SPTs can mean a marginal increase in the interest rate.  SPTs typically include a host of ESG goals, ranging from reduced carbon emissions in the Borrower’s business to increased female representation on the Board.  

On 4 May 2023 the LMA published model provisions for SLLs which align with the Sustainability-Linked Loan Principles and can be inserted into LMA documentation. The model provisions are a welcome development which will encourage standardisation across loan documentation (assisting in reducing documentation costs), and contains mechanisms for both downwards and upwards margin adjustments depending on number of SPTs being met (or unmet as the case may be) in line with what we have already been seeing in documentation.


Tax Implications

From a corporation tax perspective, and subject to a number of complex tax rules, the Borrower will expect interest payments on a third party loan to be partially / fully tax deductible against its taxable profits.  Any Lender should be similarly aligned with this: if a Borrower is unable to benefit from a corporation tax deduction on interest payments under a Facility, this will impact the Borrower’s credit worthiness and thereby increase the risk of the Borrower defaulting on its interest obligations.  It is therefore an important from both the Lenders’ and Borrowers’ perspectives to ensure that the interest payments under a Facility are tax deductible.

There are a number of UK tax rules which seek to limit tax deductions on interest payments on third party debt which goes beyond the scope of this article (including in particular the corporate interest restriction rules), however a Borrower properly advised would expect to achieve tax deductions on a large percentage, if not all, of its third party debt. 

The concern with ESG margin ratchets in particular is that they could fall foul of a specific UK anti-avoidance rule that if applicable seeks to recharacterise interest payments as dividends from a UK tax perspective.  This is important, because crucially, dividend payments are not tax deductible.  In a doomsday scenario, an ESG margin ratchet caught by these rules could effectively tarnish an entire Facility, and all of the interest payments would be treated as dividends and would not therefore be tax deductible. 

For the reasons set out below, we do not expect most ESG ratchets to fall foul of this anti-avoidance rule, however the ESG ratchets should be considered carefully in Facility Agreements on a case-by-case basis.


The UK anti-avoidance rule

Interest payments are treated as dividends for tax purposes (and not therefore tax deductible) if the interest payments are “special securities”, which for our purposes, includes where the interest payments “depends (to any extent) on the results of (a) the company's business, or (b) any part of the company's business” (s.1015(4) CTA 2010).  The is commonly referred to as a ‘results dependent’ interest rate.   A variable interest rate which links to performance of a Borrower (or a subsidiary, in accordance with HMRC Guidance CTM15520), could therefore fall within the ambit of the legislation.  Although ESG margin ratchets generally have a relatively limited impact on the interest rate under a Facility, the “to an extent” language suggests that there is no de-minimis threshold.

However, there are two arguments why the above anti-avoidance tax risk should not apply to an ESG margin ratchet, and they are as follows:

  1. Not results dependent: the first argument is that an ESG margin ratchet is not linked to performance of the relevant Borrower.  It is instead a sustainability led initiative to provide a financial incentive to the relevant Borrower to satisfy clearly defined SPTs, which are not economic in nature.  HMRC Guidance (ibid) explains that with respect to the ‘results dependent’ legislation above: “the provision is aimed at securities that allow the subscriber to participate in the company profits. The legislation ensures that the company does not get a deduction for interest in computing CT profits if the interest is a distribution of profits.”  The Guidance goes onto say: “‘Results’ has a broader meaning than ‘profits’ and consideration varying with gross receipts or rental receipts would reflect the results of the business.” SPTs applying to ESG margin ratchets generally include an array of targets, including diversity, environmental and social targets.  Although SPTs are something that should be lauded, both Borrower and Lender would not ordinarily view such a ratchet as linked to the profitability or gross receipts of the Borrower (at least not in the ordinary meaning). 
  2. Ratchet loan: as mentioned above, SPTs are generally not economic in nature. Furthermore, even ratchets that have some economic impact, such as increased fuel efficiency, may not lead to increased profitability, as the cost of implementing the technology may be greater than the benefit of the subsequent efficiency (although it would arguably increase the Group’s turnover, at least in the long run).  If, however, HMRC were to argue that on the basis that (some) ESG margin ratchets indirectly lead to increased profitability of the Borrower (e.g. improved fuel efficiency ratchets) the Facility should therefore be caught by the results-dependent legislation, there is a statutory exemption which should apply.  The “results dependent” anti-avoidance rule applies where there is a direct correlation between increased profitability / turnover in the hands of the Borrower and an increase in the interest rate.  If however, the interest rate moves inversely, i.e. the interest rate falls when the borrower’s profitability increases or vice versa – this is known in the Market as ratchet loans, and in such a case the anti-avoidance rule should not apply (see HMRC Guidance (CTM15525) further).  The ESG margin ratchet (the clue being in the name) works in a similar way by reducing the interest rate if the SPTs are met such as increased fuel efficiency or increasing the interest rate if the SPTs are not met. The ESG margin ratchets should therefore fall squarely within the ambit of the exception outlined above.

Accordingly, the above two arguments should apply to most, if not all, types of ESG margin ratchets, such that the results dependent legislation should not apply to disapply interest deductions on payments made under a Facility with an ESG margin ratchet.



Sustainable lending appears to be around to stay which is good news given the encouragement it provides for environmentally and socially sustainable economic activity and growth, and crucially, they should not, in most instances, adversely impact the Borrower from a UK tax perspective.