The UK’s Finance Bill 2009 was published earlier this month, and (as trailed in previous consultations and draft legislation) we now know that the rules on so-called “late” payment of interest, and discounts, between connected companies are to be amended with effect for accounting periods beginning on or after 1 April 20091.
At present, a UK debtor company is not able to take a tax deduction for interest paid more than 12 months after the end of the accounting period in which it accrued (“late paid interest”) where the lender and debtor are connected parties and the lender is not subject to UK corporation tax. This is often the case in a private equity structure in relation to shareholder debt advanced from (typically) a Luxembourg holding company to the top UK company in the group.
The new rules give a tax deduction for that late paid interest – subject to the usual transfer pricing restrictions – on a current period accruals basis where the lender is located in a “qualifying territory”. This means a territory which has a double tax agreement with the UK which contains a non-discrimination article. So the typical private equity UK holdco borrower (“Holdco”) will now be accruing UK interest deductions on a current basis on shareholder debt from Luxembourg (a qualifying territory). A similar change has effect in respect of the similar rule in relation to discounted securities issued between connected companies.
This may not necessarily be good news, as in many cases the deferral of the tax deduction for current interest costs into the future has been beneficial, for example where the UK group’s profit forecasts indicate that deductions are unlikely to be useful to the underlying trading group until a future time. Under UK rules, deductions can only be relieved between UK group members on a corresponding accounting period basis. If the newly accruing deductions for Holdco are able to be surrendered down to the profitable trading subsidiary in the current period, then all well and good. However, any such deductions not used or surrendered on a current basis will be trapped within Holdco and unavailable for surrender against future trading profits in subsidiary companies.
Existing planning has typically arranged for the shareholder debt to contain a payment in kind or PIK option. This allows the UK borrower (Holdco) to choose in any period to “pay” the interest which is accruing by issuing further debt. This is economically equivalent to letting the interest roll up, but under UK tax rules counts as “payment” and crystallizes a deduction. Typically this would only be done in a period where a trading subsidiary had unrelieved taxable profits. It allowed the UK Holdco to cherry pick the period in which it triggered deductions.
If the lender company is in a “qualifying territory” like Luxembourg, this planning will no longer work, as described above, since the tax deductions will automatically be available to Holdco on a current basis. If the existing flexibility which a PIK structure provides is required going forward, consideration should be given to restructuring the shareholder loan, and we are happy to advise further if this is relevant to your structure.