Aspects of the taxation of interest look set to change next year following publication of a consultation by HM Revenue & Customs (HMRC).

Funding houses and investee companies putting in place financing arrangements which will still be in place next year need to weigh up the possible impact of the changes, and consider alternatives structures that could be put in place. At this stage it's impossible to predict whether the new provisions will apply to structures already in place (the working assumption is that they will).

Wragge & Co's tax experts look at the most significant of the proposed changes for private equity financing:  

Quoted Eurobonds

Currently, the obligation for a UK company to withhold tax from interest payments does not apply to interest on quoted Eurobonds (interest-bearing securities issued by companies and listed on a recognised stock exchange). Quoted Eurobonds are commonly used by private equity funders structured as limited partnerships, to avoid the process of assessing which of their investors are entitled to have interest paid gross.  

The proposed change is not intended to affect this use of Eurobonds, or using Eurobonds to raise third party finance.

The proposal is to remove the exemption for quoted Eurobonds issued by a company to another company in the same group where there is no substantial or regular trading in the Eurobond. This is because HMRC is concerned that the exemption is being abused, specifically by groups trying to avoid the withholding obligation on intra-group interest by listing intra-group bonds in, for example, the Channel Islands and the Cayman Islands.  

We are yet to see the detailed legislation on what will constitute a "group", but it could impact on funds that have a majority interest in an investee company.  

Funding Bonds (PiK notes)

Where funding bonds are issued to pay interest, the investee company still has to account for withholding tax on that interest (if payable under the usual rules). HMRC is currently obliged to accept further funding bonds as settlement of that withholding tax.  

The proposed change is that the withholding tax would have to be paid to HMRC in cash. This may reduce the benefit of funding bonds, which allow the borrower to meet interest payments if it is low on cash. In particular, the change would affect those arrangements where interest is currently payable by PiK notes to investors other than UK corporatist, or investors benefitting from a zero withholding tax rate on interest pursuant to a tax treaty.

Withholding tax on "yearly interest"

Currently, the obligation to withhold tax on interest only applies to "yearly interest" arising in the UK. No obligation to withhold arises on a debt with a term of less than a year.

The proposed change is to abolish the concept of "yearly" interest so that the deduction of income tax applies in all cases where interest is not otherwise covered by an exemption.

In the case of commercial paper programmes, which rely on paying "short" interest to avoid withholding, issuers will have to consider whether any other exemption from withholding is available to them.  

Timescale

The closing date for comments on the proposed changes is 22 June 2012, with draft legislation to be published in autumn 2012.

We will be monitoring the progress of the consultation closely, and providing additional updates as and when further details are released.