In October 2015, the UK government launched a consultation on the introduction of new rules to counteract BEPS (Base Erosion and Profit Shifting) arising from the use of interest payments. The outcome of the consultation was published as part of the Budget in March 2016, at which time the government confirmed that it would be proceeding with the introduction of a structural restriction on interest deductibility.
The new restriction is intended to operate alongside the various transactional-based restrictions already present in the UK tax code (such as the transfer pricing, distributions and unallowable purpose rules), and will apply with effect from April 1, 2017. The new restriction will apply both to external and intra-group debt, so it will not be precluded from applying solely by virtue of the fact that the interest in question accrues on debt advanced by a third party lender.
The UK government is currently consulting on the detailed design of the new restriction, and intends to publish legislation later this year for inclusion in Finance Bill 2017.
The Proposed Restriction
The proposed restriction has the following key features, and will apply on an accounting period-by-accounting period basis:
- A fixed ratio rule (the FRR), limiting UK tax deductions for net interest to a maximum of 30 percent of a group’s tax-adjusted UK EBITDA;
- An optional group ratio rule (the GRR), which a group can apply in place of the FRR and which allows tax relief for interest to be calculated by reference to the group’s net interest to EBITDA ratio;
- A de minimis rule, whereby the new restriction will not apply to groups whose net UK interest expense does not exceed £2 million in any given accounting period;
- The ability to carry forward spare borrowing capacity from one accounting period to the next (for up to 3 years), and the ability to carry forward restricted interest indefinitely;
- A modified worldwide debt cap rule, which will apply in addition to the FRR and/or GRR, and which is intended to ensure that groups with low levels of external debt cannot leverage up their UK operations to the FRR limit; and
- Targeted anti-avoidance rules aimed at preventing the circumvention of the new restriction.
For groups that are not automatically taken out of the rules by the proposed £2 million de minimis rule, there is likely to be a significant administrative burden involved with familiarizing themselves with the new rule and in identifying the relevant tax-adjusted amounts that have to be taken into account in applying the new rule.
Moreover, there is currently no proposal for existing debts generally to be grandfathered. While the government has indicated a willingness to grandfather some unused interest expenses carried forward from periods before the new rule comes into effect on April 1, 2017, the related principal amount outstanding on existing loans will not be grandfathered.
This means that existing financing arrangements in place as at April 1, 2017, will generally be within the scope of the new rule.
Group concept. The FRR will be applied on a group-wide basis (rather than on a company-by-company basis).
For the purposes of the FRR, the definition of a “group” will be based on accounting concepts: in essence, a group will comprise the “ultimate parent” (generally the top level holding company in a corporate structure), together with all companies that would be consolidated on a line-by-line basis into the consolidated accounts of the ultimate parent.
Definition of interest. The concept of ‘interest’ is extended by the FRR to comprise all payments that are economically equivalent to interest, as well as expenses incurred in connection with the raising of finance. This means that payments in kind (sometimes referred to as “funding bonds”, or “PIK”) will have to be taken into account when applying the FRR, as will related payments such as guarantee fees.
However, in applying the FRR it is only the net interest expense position that matters. Financing income amounts (such as interest received) are netted off against financing expense amounts in order to reach a net position: it is only the net position that is in principle subject to the FRR restriction on deductibility. This is likely to be of particular importance to multinational groups with centralized treasury functions, as an FRR that operated by reference to the gross rather than net interest position clearly would have presented serious issues for intra-group treasury activities.
Interaction with other parts of the UK tax code. The FRR is intended to apply after almost all other parts of the UK tax code have been considered. This includes the UK’s transfer pricing rules, purpose rules and anti-hybrid rules in particular. This means, for example, that groups still may suffer an FRR-based restriction on interest deductibility, even though HMRC is in agreement that the interest in question has a legitimate commercial purpose, does not give rise to a hybrid mismatch outcome and (based on an Advance Thin Capitalisation Agreement) is arm’s length for UK transfer pricing purposes.
In addition, although it had been hoped that the new FRR would result in the repeal of the worldwide debt cap, the UK government has indicated that a modified debt cap rule will continue to apply alongside the new FRR.
The modified debt cap rule is intended to prevent groups that would not otherwise have high levels of external debt from leveraging up their UK operations to the FRR limit. In essence, the rule will “cap” the amount of UK net interest for which a group can obtain tax relief by reference to the net external interest expense of the group.
Carry-forward rules. The government is proposing that interest restricted under the FRR should be eligible for carry-forward to future accounting periods indefinitely. This should mean that if there is sufficient capacity in those future periods, the carried-forward amount should become deductible (and should therefore be eligible for tax relief).
The government is also proposing that unused borrowing capacity (calculated by applying the borrowing limit under the FRR) from one accounting period be eligible for carry-forward for up to three future accounting periods.
These aspects of the rules will be helpful to groups, as they should go some way to mitigating the impact of the new rules on earnings volatility across multiple accounting periods.
However, disappointingly there are no proposals to allow the carry-back to previous accounting periods of interest deductions that are restricted under the new rules, or of unused borrowing capacity (calculated by applying the borrowing limit under the FRR). Moreover, the ability to carry-forward excess interest deductions may ultimately not be of any value in view of separate changes on the carrying-forward of losses (the CFL Rules), which were announced at the Budget in March 2016 and which are expected to come into force on April 1, 2017 too.
The CFL Rules will limit the amount of profit that can be sheltered using carried-forward losses, such that only 50 percent of profits in excess of £5 million can be sheltered. At present, the government intends that:
- Carried-forward losses from before April 1, 2017, will not be subject to the FRR, but will be affected by the new CFL Rules;
- Interest that arises on or after April 1, 2017, and that is affected by the FRR will not be subject to the CFL Rules; and
- Losses arising after the application of the FRR will be subject to the CFL Rules.
Illustration of Effect of the FRR
The following table illustrates the basic effect of the 30 percent FRR rule as proposed by the UK government
Click here to view the image.
Under the GRR, groups can elect to apply a group ratio instead of the fixed ratio that applies under the FRR. The GRR is entirely optional and is expected by the UK government to benefit only a small proportion of groups.
The GRR is aimed at groups that are highly leveraged for commercial reasons, and allows them to obtain tax relief for net interest deductions up to a limit in line with the group’s overall position. The government is continuing to consult on whether the GRR should itself be subject to a percentage limitation (more than 30 percent, but less than 100 percent) in order to counter potential abuse.
Generally however, the GRR is a welcome feature of the new rules that should go some way to mitigating their impact on groups whose funding structures do not present BEPS risks.
Summary and Next Steps
The FRR generally will have no grandfathering, and will apply from April 1, 2017. The rule could result in significant restrictions on interest deductibility for certain groups, such as private equity owned portfolio companies where leverage ratios typically run in the 4 to 7 times EBITDA region (and possibly even higher in the early stages of an acquisition).
All groups should therefore be considering the ramifications of these forthcoming changes and the possible need to refinance their existing funding arrangements.