From April 2017, the UK government is to cap the amount of corporation tax relief for interest to 30% of taxable earnings in the UK or the net interest to earnings ratio for the worldwide group. This is subject to a threshold limit and specific exemptions for public benefit infrastructure. This is bad news for both lenders and borrowers. Particularly for those operating in highly leveraged industries such as the private equity and real estate markets. Further work remains to be done on the application of these rules to groups in the banking and insurance sectors.
In terms of good news, the HMRC Double Taxation Treaty Passport Scheme is also to be reviewed this year and its extension to sovereign wealth funds, pension funds and partnerships considered.
With effect from Royal Assent to the Finance Bill 2016, the UK government is to legislate to clarify that "residual payments" made by securitisation companies will not be treated as annual payments and so can be paid without UK withholding tax. This is a welcome clarification.
Most OECD countries allow interest expense to be deducted in calculating taxable profit or a company's "tax base". This gives rise to tax planning opportunities (the UK's rules on interest deductibility are generally considered particularly generous). Common forms of planning involve groups placing high levels of debt in high tax jurisdictions. The use of such planning is perceived to have aided multinational corporations to pay little or no tax in many of the markets in which they operate and to give such corporations an unfair advantage over domestic groups. This perception led the OECD to recommend in October 2015 (as Action 4 of its Base Erosion and Profit Shifting (BEPS) project), restrictions be introduced on the availability of corporate interest deductions. This was followed by a HMRC consultation and the announcements made as part of today's budget.
The UK government (consistently with the OECD recommendations) are to introduce both a Fixed Ratio Rule and Group Ratio Rule, with the repeal of the UK worldwide debt cap. The Fixed Ratio Rule will limit corporation tax deductions for net interest expense to 30% of a group's EBITDA and is very much, a blunt tool. The Group Ratio Rule will limit corporation tax deductions based on the net interest to EBITDA ratio for the worldwide group, and is intended as a relaxation of the Fixed Ratio Rule. However, the Group Ratio Rule effectively requires each and every entity within the group to have a ratio equal to the group ratio. This is commercially unrealistic and to the extent it is not achieved, there will be double taxation and denials of relief for real interest costs.
The new rules will be subject to a de minimis group threshold of £2 million net of UK interest expense. Restrictions are also to be introduced to ensure that the new rules do not impede the provision of private finance for certain public infrastructure in the UK. The application of these new rules to the insurance and banking sectors remains subject to further consultation.
These new rules will be relevant to both borrowers and lenders. The disallowance of interest deductions will increase the cost of borrowing and therefore affect the ability of entities to service debt. This will be relevant to the terms on which lenders are willing to advance debt.
The government is to publish draft legislation for inclusion in Finance Bill 2017. The new rules will come into effect from 1 April 2017. Grandfathering is not expected to be available, this will apply to existing and new loans. It is important to remind lenders to take these changes into account in cash flow modelling when making loans in the year ahead.
Securitisation companies and residual payments
Residual payments are made by securitisation companies as these special purpose vehicles typically contain more financial assets than are likely to be required to repay the investors, meet transaction costs and retain a profit. Or putting it another way, they are over-collateralised. This excess protects against possible poor performance of the assets and enables the vehicle to obtain an attractive credit rating. There has been uncertainty as to whether these residual payments should be classified as "annual payments", and therefore whether they should be subject to withholding tax. With effect on and after the date of Royal Assent to Finance Bill 2016, this uncertainty is to be eliminated by removing the obligation to withhold income tax in respect of such payments. This is a welcome clarification.
HMRC double tax treaty passport scheme
This scheme was introduced in 2010 to reduce the administrative burden for foreign companies lending to UK companies by making it easier for them to access the UK's network of tax treaties. HMRC is to review the application of the scheme and release a consultation document to determine whether it remains fit for purpose and whether it should be extended to other types of foreign lender, including sovereign wealth funds, pension funds and partnerships. This could be good news for lenders wishing to break into the UK debt market and therefore for borrowers too.