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April 25, 2017


In what is one of the most fundamental changes to U.K. tax law of the last decade, a new regime is to be implemented with effect from 1 April 2017 that restricts the tax deductions that are available for interest expense based on a percentage of the U.K. group’s EBITDA. While the formal enactment of the new law has been postponed until after the General Election, this delay is not expected to lead to any deferment of the effective date of 1 April. Prima facie the rules implement the base erosion and profit shifting (BEPS) Action 4 recommendations but the broad ambit of the U.K. rules means that all groups with aggregate net U.K. interest expense in excess of £2 million will need to carefully evaluate the impact of the new regime. The rules apply equally to groups wholly financed by third-party debt and those that have never engaged in base erosion or profit shifting.


Although the final draft law was only included in the Finance Bill published on 20 March, the new rules apply as of 1 April 2017. Businesses with an accounting period that straddles that date will be required to apportion their results and interest expenditure into two notional accounting periods normally by pro-rating the figures for their full year on a time basis. The existing restrictions known as the worldwide debt cap (WWDC) will be withdrawn at the same time and replaced by a modified debt cap within the wider corporate interest restriction code.

Definition of group

The rules operate by reference to a “group”, whether for the purpose of determining the interest capacity of the U.K. group or computing the group ratio (see below). Broadly speaking, “group” takes its definition from International Accounting Standards (IAS) and comprises the ultimate parent and all of its consolidated subsidiaries. For most groups, this should correlate to the entities that are included in the group financial statements, but caution is needed as the definition is complex and those with uncommon ownership structures would be wise to read the rules carefully.

All members of the group are within the scope of the rules, but it is those that are either U.K. tax residents or that are trading in the U.K. through a permanent establishment that are potentially subject to restrictions.

What is interest?

For the purposes of this regime, “interest” comprises those amounts of costs and income that are relieved / taxed under the loan relationship or derivative codes, as well as amounts relating to finance leases and debt factoring. Impairment losses and foreign exchange gains are excluded. The definition is therefore broad and would include, for example, costs of raising loan financing.

Basic approach

A group is subject to interest restrictions in a period of account if the aggregate net tax interest expense of the group exceeds the “interest allowance” of the group for the period. That excess is treated as non-deductible for the accounting period although it may be possible to utilise this in future periods (see below).

The default approach to determining the interest allowance is to apply the fixed ratio method, which is 30 percent of the aggregate of the tax-EBITDA amounts of all of the U.K. group members. Tax-EBITDA is determined by taking a company’s profits chargeable to corporation tax before any loss relief and adding back (or deducting as the case may be) amounts relating to interest, capital allowances, intangibles and certain specified tax reliefs, the most common of which is research and development tax credits.

Interest capacity is then restricted to the lower of the amount determined under the fixed ratio method and the amount permissible under the modified debt cap rules.

Modified debt cap

The maximum amount permissible under the debt cap rules is an amount equal to the adjusted net group-interest expense for the period. This is determined by reference to the worldwide group and in simple terms is the net interest charge per the group financial statements adjusted for capitalised interest, loan waivers and dividends in respect of preference shares accounted for as liabilities.

It is expected that the new approach to the application of the debt cap will cause problems for some groups that currently do not have a problem under WWDC.

Group ratio method

As an alternative to the basic approach, groups may choose to apply the group ratio method on an elective basis. Ostensibly this alternative exists to ensure that groups that operate in more highly geared sectors or groups that have an entirely U.K. footprint can still obtain a tax deduction for their external financing costs. The rules are far from foolproof, however, and the need to accommodate the group ratio method is at the heart of the more complex features of the new code.

A full description of the operation of the group ratio method is beyond the scope of this update but the key features are as follows:

  • The interest allowance is computed by multiplying the group ratio percentage (as opposed to 30 percent) by the aggregate tax-EBITDA of the U.K. group.
  • he group ratio percentage is computed as the qualifying net group-interest expense divided by the group-EBITDA for the period.
  • It should be noted that qualifying net group-interest is computed in the same manner as the adjusted net group-interest expense (see above) but excludes amounts payable to related parties and amounts payable on certain results-dependent securities / equity notes.
  • Group-EBITDA is the profit before tax in the group financial statements with amounts added back or subtracted in respect of net interest, capital expenditure (e.g., depreciation, revaluations, disposals), and fair value movements on certain derivative contracts, the movements of which would generally be ignored for U.K. tax purposes.
  • On an elective basis, further adjustments can be made concerning capital gains, capitalised interest, pension contributions and share option costs — items that cause significant book / tax differences at an EBITDA level.

In the case of groups that are joint ventures, there is the possibility of making a group ratio (blended) election. This should be particularly useful in scenarios in highly geared sectors where the funding has been obtained at the investor level and pushed down. By making an election, the joint venture group’s percentage can be determined by reference to that of its investors.

When the group ratio percentage is either a negative amount (i.e., when the global group is loss making) or higher than 100 percent, it is deemed to be 100 percent such that the allowance is equal to the aggregate tax-EBITDA of the U.K. group.

Again, this is subject to any further restrictions imposed by the debt cap. In this case, the debt cap is determined by reference to net qualifying group-interest expense.

Reactivation of disallowed interest and carry-forward of excess capacity

When a company has disallowed interest in a period, this may be carried forward indefinitely and deducted in a period where there is excess capacity. This may provide some respite for loss-making groups in respect of the new rules restricting relief for carried forward tax losses, which also apply as of 1 April 2017.

The unused capacity of a particular period can be carried forward for five years. Again, the drafting of the rules is not completely straightforward but essentially operates to give relief on a first in, first out basis.

Public Benefit Infrastructure Exemption (PBIE)

The PBIE was introduced in recognition of the particular debt funding requirements of the infrastructure and real estate industries. It should be noted that in a divergence from the Organisation for Economic Co-operation and Development (OECD) recommendations, the PBIE will apply on a company by company basis rather than a project basis.

The conditions that must be met to permit a company to elect for PBIE and the consequences are complex. The key points are as follows:

  • To qualify, income must be derived from infrastructure assets that satisfy a public benefit test. This includes assets used for transportation, utilities, waste processing, oil pipelines, prisons, health, education and telecommunications.
  • The exemption is extended to include buildings that are leased to unrelated parties.
  • An election must be made to apply the PBIE prior to the start of the relevant period, and once made, it is irrevocable for five years. A special transitional provision is in place for the first period of account to give groups time to consider this election.
  • Where PBIE applies, a company’s tax-EBITDA third-party interest costs, interest payable to other qualifying infrastructure companies, and interest on certain grandfathered loans entered into before 13 May 2016 will all be excluded from the interest restriction calculations.

It is unclear if the election will always be available, even in seemingly standard cases. Due to restrictions on parental guarantees and constraints around the assets (including shareholdings in subsidiaries) that a qualifying company can own, it is likely that many groups will have to reorganise both their group structure and their borrowing arrangements.

The exemption may not even be beneficial to some groups. For example, it may be that gearing in an infrastructure entity would otherwise be improving a group’s modified debt cap position. Care is therefore needed prior to making an election that will have a long-term effect.

Compliance requirements

The administrative provisions run to approximately 45 pages and it is expected that the new regime will impose a considerable additional compliance burden on all but the smallest groups.

The key tenet is that groups will appoint a reporting company, which will be responsible for filing an annual interest restriction return that will be due 12 months from the end of the period of account to which it relates. This return will need to include details of any of the myriad available elections that the group wishes to make, computations of the various amounts required to determine any disallowance and a statement of allocated interest restrictions.


The new rules are likely to have a significant impact on many U.K. corporate tax payers. The resultant disallowance of financing costs could lead to an increase in the effective tax rate and higher cash tax payments.

Many groups are conducting modelling exercises to assess the impact and avoid unexpected surprises at year end. Proactive action may also identify opportunities to mitigate the extent of any adverse outcome through refinancing intragroup lending structures.

A full assessment of the impact of the rules is essential. A failure to factor them into forecasting could lead to flawed decision-making in determining how future investments are structured and financed, whether from acquisition activity or organic growth.