Many readers may be aware of a recent change in law under which the Government has restricted the ability of UK income tax payers to claim “corresponding adjustments” in respect of debt interest. This may impact on how individual managers of private equity backed portfolio companies holding loan notes are taxed on payments of interest.
Private equity-backed acquisitions will usually involve an acquisition SPV or SPVs financed almost entirely by bank and shareholder debt, including “rollover” loan notes from management. A tax deduction will be sought in respect of the interest cost on shareholder debt, which can be offset against the profits of the target company or group.
However, part of the tax deduction for interest costs on shareholder debt is usually disallowed for tax purposes, under the “transfer pricing” rules. In broad terms, interest can be disallowed on the portion of the shareholder debt that is not considered to be on arm’s length terms (i.e. if the amount lent, or the interest rate, exceeds the terms on which a third party would have lent).
Where interest is treated as non-tax deductible for the payer under the transfer pricing rules, the recipient can make a claim for the interest received to be treated as non-taxable. This is known as a “corresponding adjustment” and is intended to achieve symmetry in the tax position. Previously, it was sometimes (but not always) possible for management teams to obtain tax-free treatment on a proportion of any interest received on their loan notes by claiming “corresponding adjustments” on payments of interest which had been treated as non-tax deductible for the paying company.
However, HMRC perceived the rules to have been exploited as a result of the different tax rates applying to individual managers and portfolio companies. In other words, a disallowed interest payment can result in additional tax cost for the company at the corporation tax rate, but a corresponding adjustment claim by an individual lender can result in a tax saving at the (higher) income tax rate.
The Government has now implemented rules, which took effect from October 25th, which provide that, where a corresponding adjustment is claimed for loan note interest on the basis set out above, the effective tax rate on the interest will be the dividend rate (current top effective rate of 30.56%) rather than the rate for other types of income (current top rate 45%). Although this is clearly less generous than the previous position, under which interest could be received tax free once a corresponding adjustment was claimed, it is still possible for management to claim corresponding adjustments, and achieve tax savings, on some (but not all) of the interest received on their loan notes. Following the change in law, however, the tax rate will only fall from 45% to 30.56% rather than from 45% to 0% as under the previous rules.