In our May 2016 issue we covered European developments on interest deductibility following the OECD's Base Erosion and Profit Shifting Project (Leveraged Finance tax changes – of limited interest or critical importance?). At that point, the UK Government had just launched its second consultation on the OECD's recommendations. Fast forward a year and the UK's new corporate interest restriction is likely to become law (possibly from 1 April 2017), depending on the outcome of the election in June and a new Finance Bill subsequently being introduced to Parliament.
So what do the new rules look like?
As expected, the legislation closely follows the OECD's recommendations. Its effect is to restrict the amount of profits that can be offset by interest expense for UK corporation tax purposes. Relief for interest will generally be capped at 30% of UK earnings (subject to a higher limit under a group ratio test). To ensure the rules are appropriately targeted, a de minimis threshold and public benefit infrastructure exemption have been introduced. The potential impact of volatility in earnings is also addressed.
In more detail:
When do they apply?
The rules have effect for accounting periods beginning on or after 1 April 2017. Any accounting period straddling this date will be split in two, with only the period commencing 1 April subject to the new rules.
There is no general grandfathering; existing financing arrangements in place on 1 April 2017 will therefore be caught by the new rules.
Who do they apply to?
The rules operate by reference to a 'worldwide group', which takes its accounting meaning (ie an ultimate parent and its consolidated subsidiaries). However, it's the group's UK corporation tax-paying members (UK-resident companies, or those with UK permanent establishments) that will suffer the interest restriction.
What do they apply to? The rules apply to interest expense. However, this is wider than just interest, encompassing other financing costs such as amounts arising from loan relationships, derivatives, finance leases, debt factoring, finance concession arrangements, and guarantee fees.
What is the de minimis threshold?
Each group will have an annual de minimis allowance of £2 million. Accordingly, groups whose net interest expense does not exceed this threshold will not be subject to the corporate interest restriction. The UK Government expects the de minimis threshold to remove 95% of groups from the new rules. However, in the context of the leveraged finance market, even assuming interest rates at the lower end of the spectrum at around 4% p.a., that puts groups with debt packages which have more than approximately £50million outstanding above the de minimis threshold potentially subject to the restriction.
How will the restriction operate?
Where a group's net UK interest expense exceeds the de minimis threshold, its UK tax deductions will be restricted via the default fixed ratio method, or the elective group ratio method, as follows:
Fixed ratio method
Under this method, a group's deductions for net UK interest expense are limited to the net UK interest income of the group for the period plus the lower of (a) 30% of the group's UK "tax- EBITDA" (broadly equivalent to UK taxable profits), and (b) the net interest expense of the worldwide group (ie the modified debt cap).
The term "tax-EBITDA" is defined in the legislation by reference to tax concepts rather than accounting concepts. It means broadly profits chargeable to UK corporation tax excluding interest, capital allowances, amortisation and certain tax reliefs.
Group ratio method
Recognising that some groups are highly leveraged with third party debt for non-tax reasons, this alternative method is intended to prevent excessive restrictions on interest deductibility.
Under the group ratio method, deductions for net UK interest expense are limited to the net interest income of the group for the period plus the lower of (a) a percentage (up to 100%) of the group's UK tax EBITDA (as explained above) based on the group's net interest expense to EBITDA ratio (here taking an accounting meaning and broadly determined by reference to the financial statements for the group), and (b) the qualifying net interest expense of the worldwide group (broadly the same modified debt cap as for the fixed ratio method, but with further adjustments).
How is earnings volatility addressed?
The Government recognises that timing differences may arise between interest expense being incurred and earnings being generated. Provision has therefore been made to limit the impact of any such volatility:
Disallowed interest expense can be carried forward indefinitely, and 'reactivated' in future periods where there is spare capacity.
Where a group's interest allowance (ie the amount of interest expense it may deduct in a particular period) exceeds its actual interest expense, the excess capacity can be carried forward for up to five years for use in subsequent periods.
What is the Public Benefit Infrastructure Exemption (PBIE)?
The PBIE provides a limited exemption in relation to third party debt for UK infrastructure companies, and for UK property companies holding only UK real estate let for 50 years or less. It applies on a company-by-company basis (rather than to individual projects), and is claimed via an election. Limited grandfathering is available for certain related party debt entered into before 13 May 2016.
What are the reporting requirements?
A UK reporting company, appointed by the worldwide group, is responsible for submitting an interest restriction return to HM Revenue & Customs. Even groups not subject to the restriction must submit a return, albeit in abbreviated form.
The return sets out certain prescribed information for each UK company, together with details of the restricted interest for this period (and earlier periods, where carried forward) and how this has been allocated between the UK companies. The amount, and allocation, of any carried-forward excess capacity is also detailed.
Given the haste with which the corporate interest restriction has been introduced, and the complexity of the legislation, it's likely that the new rules will take some time to settle. In the meantime, businesses will be left grappling with the new regime while counting the cost, both in terms of restricted deductibility and increased compliance. If you would like to discuss the impact of these rules in more detail, please do contact us.