Corporate interest deductibility - an update
We last reported on the impact of the rules introducing a new cap on the deductibility of interest for UK corporation taxpayers in our December newsletter. Since then, further detailed legislation, particularly in relation to the group ratio rule and the Public Benefit Infrastructure Exemption, has been published and the rules as a whole further tweaked in relation to specific concerns.
Legislation is already (provisionally) in effect although, in light of the General Election next month, the draft legislation was dropped from the Finance Bill which has subsequently become Finance Act 2017. While we cannot be sure that this legislation will be reintroduced in its current form, and with the same effective date of 1 April 2017, we believe this to be the most likely outcome and are therefore working on this assumption until we know more.
These provisions mark a fundamental change to the way in which groups may claim deductions for interest and other financing costs in the UK. Prior to 1 April this year, interest on third party debt was generally deductible in full, interest on shareholder debt was generally deductible to an arm's length amount and there was no fixed financial ratio. This can no longer be assumed, save in groups where net interest expenses fall within the de minimis.
Key featuresTiming – the legislation applies in respect of all periods and parts of periods falling after 1 April 2017 and there are no general grandfathering or other transitional provisions. Basic framework – interest expenses of a group which would otherwise be deductible for UK corporation tax purposes in an accounting period will be restricted (i.e. cease to be deductible) to the extent that the net UK interest expenses of the group in that period exceed:
De minimis – there will be no restriction for groups where the net UK interest expense is less than £2 million per annum. Modified Debt Cap – a modified debt cap will apply to stop groups which do not have significant amounts of external debt using internal gearing into the UK to take advantage of the deductions permitted under the Fixed Ratio Rule. Carry Forward Costs – where interest costs are restricted in an accounting period, it will generally be possible to carry those forward indefinitely and treat them as accruing in subsequent periods, subject to the application of the interest cap in those periods. Carry Forward Capacity – where a group has unutilised capacity (e.g. where its net UK interest expenses are less than 30 per cent of UK tax EBITDA), that capacity can be carried forward for up to five years and added to (and thereby increase) the interest capacity of the group in subsequent periods. |
Group Ratio Rule
Although the headline cap is set (arbitrarily) at 30 per cent of the group's UK tax EBITDA, the Group Ratio Rule exists as a mitigant that will be extremely important for more highly leveraged groups where net UK interest expenses exceed that cap. In this scenario, the Group Ratio Rule is intended to prevent excessive interest deductibility restrictions for groups that are highly leveraged with third party debt for non-tax reasons.
The Group Ratio Rule is based on a calculation of the worldwide group's net interest expense over EBITDA.
What is the group?
It is worth noting here that the members of a worldwide group are determined using accounting concepts and the group is therefore not something which is readily susceptible to manipulation to improve the deductibility rate.
The group, however, does not include subsidiaries which are accounted for at fair value. This is particularly important for investment companies and funds because it should mean that their portfolio companies are not consolidated into one group for the purposes of applying the new corporate interest restriction.
Unexpected disallowances
The ability to elect to use the Group Ratio Rule will not necessarily even enable the deduction of all third party interest, as might be expected. Unexpected disallowances can arise, mainly because a number of items are not included in the worldwide net interest expense of the group which might normally have been expected to count as commercial borrowings.
Chief among these is an exclusion for interest on related party debt, which has the effect of reducing the ratio of group net interest expense to group-EBITDA thereby increasing the amount of interest that cannot be deducted. While the principle is understandable, the breadth of the definition of "related party" is such that some more tenuously linked debt might fall out of the Group Ratio Rule calculations:
- A related party is not the same as a group company, but extends to any party that is under 25% common ownership with the group or "acting together" with other investors who together own more than 25%. This means that interest paid on shareholder debt will generally be excluded.
- Helpfully, however, where unrelated parties hold at least 50% of a class of debt issued by a company, debt of the same class held by a related party is not related party debt.
- Guarantees by related parties can convert third party borrowings into excluded related party debt. However, in the context of the Group Ratio Rule, this rule does not now apply to related party guarantees provided before 1 April 2017, guarantees provided by a member of the group (again meaning the accounting group) or non-financial guarantees provided in respect of obligations to provide goods or services.
Interest which would not be deductible in the UK on ordinary principles (e.g. profit participating debt or results-dependent securities) will also be excluded from the calculation.
Group Ratio Elections
The Group Ratio Rule uses accounting measures of interest expenses and EBITDA. These may differ (sometimes dramatically) from the tax figures. In relation to the old worldwide debt cap, these differences led to a number of statutory instruments to correct the perceived anomalies. We would be surprised if we did not see the same this time. However, some of the anomalies have been addressed by allowing groups to elect for certain figures in the accounts to be deemed to be drawn up using UK tax rules rather than accounting rules. These elections relate to revaluations of derivatives, capital assets and pension obligations.
Public Benefit Infrastructure Exemption
The public benefit infrastructure exemption (PBIE) recognises that the nature of infrastructure projects can support the higher gearing which is common in the industry and will be important both in the context of projects and real estate. The exemption applies on a company-by-company basis rather than to individual projects, so that funding raised at a group level in respect of multiple projects may be appropriately covered, and enables eligible companies to elect for third party interest to be deductible in full.
Eligibility for the PBIE
A company is eligible for the PBIE (a QIC) if:
- it is fully taxed in the UK;
- all, or all but an insignificant proportion, of its income and assets must be referable to activities in relation to public infrastructure assets (qualifying infrastructure activities); and
- it has elected to apply the exemption.
Activities qualifying for the exemption include the provision (and ancillary activities such as upgrade or maintenance) of assets forming part of the infrastructure of the UK, e.g. utilities, telecommunications, transport, health and education, which meet a public benefit test. The asset meets the public benefit test if it is procured by a relevant public body or used in the course of a regulated activity (i.e. regulated by an infrastructure authority).
Qualifying activities also include the provision of rental properties as part of a UK property business to unrelated parties on a short-term basis (i.e. 50 years or less).
Consequences of electing
Assuming all criteria are met, qualifying companies are effectively allowed deductions for all their interest paid to unrelated parties but no deductions are allowed for interest on related party debt. This gives certainty in respect of third party interest, but affects the group calculations in the particular way specified by statute which may not necessarily always be the best course of action either for the company or the group (whose interests might conflict) for the following reasons:
a) QICs may not benefit from any part of a group's annual £2 million de minimis;
b) interest on the shareholder debt of the QIC will be non-deductible (save on certain pre-13 May 2016 loans) even if it would otherwise have fallen within 30 per cent of the group's EBITDA or the group ratio; and
c) the remainder of the UK group is deprived of the QIC's EBITDA for the purposes of Fixed Ratio and Group Ratio calculations, which may disproportionately restrict interest deductions across the group as a whole.
As an election (or its revocation) is for a period of at least five years, groups will need to give serious thought to the long term impacts of an election, including the impact of any changes of ownership.
A very limited grandfathering will be available for certain long-term fixed income infrastructure projects where the loan was entered into before 12 May 2016. The prescriptive conditions require that for the interest on such loans to be deductible, inter alia, at least 80 per cent of a company's qualifying infrastructure receipts need to be highly predictable for a period of at least 10 years from 12 May 2016, by reference to a contract entered into with or procured by a prescribed public body. This will assist in some cases but there will be many more projects which have modelled cash flows based on unrestricted interest deductions and which may struggle to remain viable on the basis of the new rules.
Service concession arrangements
It is worth noting that, where a service concession agreement is accounted for as a financial asset, amounts included as financing income implicit in the receivables under the agreement will be included within the calculation of tax interest (even though it is not necessarily taxed as interest). That can result in projects involving service concession arrangements effectively having the benefit of a complete exemption from the rules. While the deductions would likely be deferred to later periods, the net cash tax payable each year will probably not be materially changed by these rules in this scenario (since unused interest expenses can be carried forward under these rules).
However, it is only those projects which have an effective Government guarantee of payment and do not take, e.g. demand risk, that will benefit from this treatment.
Allocation of disallowed interest
The (draft) legislation also includes details of how returns and restrictions will be applied in practice. In brief:
- each group will have a reporting company, either appointed by the group or, in the absence of any such appointment, by HMRC;
- the reporting company will have to file an interest restriction return to HMRC within, broadly, 12 months of the end of the relevant accounting period; and
- the return will contain details of, among other things, the group's net UK interest expense, its interest capacity and the allocation of any interest which is restricted under these rules between the UK members of the group.
Groups have the capacity to allocate restricted interest costs between the UK members of the group as they see fit, but if a UK member does not agree with the allocation in the return, it can elect to be a non-consenting company, in which case its interest costs will be restricted by an amount equal to its pro rata share of the restricted interest costs of the group, calculated by reference to the proportion that its net interest expenses bear to total net interest expenses of all UK members of the group with a net interest expense.
This default pro rata allocation of restricted interest costs may well not be the optimum solution either commercially or from a tax point of view so it will be important to address this allocation process when entering into any loans (whether intra-group or third party) or during any company sale or acquisition.
Lenders will be keen to ensure that the borrowers to which they have lent suffer as small a restriction as possible on their interest payments, particularly in relation to third party debt costs. Some form of protective wording is therefore increasingly going to be seen although there is then a discussion to be had, both in respect of competing existing third party lenders' interests and in ensuring that future borrowing ability is not compromised by earlier negotiated positions.
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