The UK Treasury and HMRC have published a detailed consultation on the legislation which will be introduced next year to restrict interest deductions for UK groups following Action 4 of the OECD BEPS initiative. This Update provides a high level summary of the proposals and identifies some of the key issues to be considered.
With effect from 1 April 2017, UK groups will be restricted to interest deductions of 30% of EBITDA. Where the worldwide group has a higher ratio, groups will be able to elect to use this. There will be a de minimis threshold of £2 million of interest and only net interest expense in excess of this will be restricted. Restricted interest may be carried forward indefinitely, and spare capacity for up to three years.
The Debt Cap rules are being abolished and replaced with a modified rule which will restrict interest deductions where UK interest expense exceeds worldwide interest.
There may be a more generous regime for certain public infrastructure projects, but this appears to have very narrow application. Banks, insurance companies, and certain other particular vehicles may have separate or modified rules applied to them.
Fixed Ratio Rule
The basic rule requires UK groups to calculate their tax-interest which is broadly their interest expense including other finance costs as calculated for corporation tax purposes less interest receipts calculated on the same basis. This is calculated for each entity in the UK group (which will include permanent establishments of overseas group members) and aggregated. The group’s tax-EBITDA is then calculated on a similar basis, aggregating the group members’ profits chargeable to corporation tax and then adding back tax-interest, capital allowances and IP regime deductions. If the resulting tax-interest is higher than 30% of tax-EBITDA, there may be a restriction.
Group Ratio Rule
Groups can elect to use this if it gives a better result. The calculation is based on the accounts profit of the consolidated group, which broadly includes all entities consolidated on a line by line basis in IFRS (or equivalent) consolidated accounts. Groups can elect to include joint ventures in the calculation.
The calculation takes qualifying group-interest over Group-EBITDA. Qualifying group-interest is the net interest expense of the group in the accounts but excludes related party interest, participating loans and some other specific items. Related parties are widely defined to include anyone with 25% common ownership and any persons acting together to exercise control.
Group-EBITDA is total group profits less total net interest, depreciation and amortisation per the group accounts. There is no adjustment for other non taxable amounts such as property revaluations and certain fair value adjustments on derivatives.
If the resulting ratio is higher than 30%, it is then applied to the group’s tax-EBITDA to determine the amount of tax-interest deductible.
In some circumstances, for example if Group-EBITDA is very low, the ratio may be very high. There are suggestions that there should therefore be no carry forward of restricted interest or spare capacity created by the group rule, or alternatively the group ratio should be reduced by a percentage to be determined.
Modified Debt Cap
The debt cap rules are being replaced by a modified debt cap rule which will limit deductible interest to total group-interest, which is a similar definition to that used in the group ratio rule but includes, inter alia, capitalised interest and related party interest.
There are a number of other areas covered in the consultation document. Detailed examples are given covering joint ventures, leases and derivatives. The position is left open on a number of industries and special vehicles including banking and insurance groups, oil and gas companies, REITs, collective investment schemes, non-resident landlords and securitisation companies. There is a proposal to create an additional exclusion for public benefit infrastructure vehicles, but the proposed definitions here are very narrow, and related party interest is again excluded.
The provisions are primarily aimed at multinational groups which have put debt into the UK to finance activities in other jurisdictions. Even where this is third party debt, the rules are intended to apply. Clearly this type of structuring will no longer work where the UK is bearing a disproportionate amount of the group’s overall financing cost.
However the rules have potentially much broader application to any highly geared business, which will typically include the real estate, private equity and infrastructure sectors. In theory the group ratio rule is designed to ensure that wholly UK groups should obtain a deduction for all third party interest. However the group rule is based on accounting profit while the restriction is applied to taxable profits, and the differences can be substantial. Businesses affected should be lobbying for changes here.
The very wide definition of related party interest is also a potential problem, particularly for joint ventures which are funded by shareholder debt. There is a potential restriction of interest on such loans in the JV but the interest will still be taxable in the shareholder’s hands. In future, joint ventures may be structured as LLPs or similar tax transparent vehicles to avoid this problem.
The compliance implications of the new rules should not be underestimated, particularly how they interact with the new proposed rules on corporate losses. Groups will need to ensure that they can undertake the relevant calculations in time to submit accurate corporation tax returns.
Any companies or groups who are UK corporation taxpayers will need to consider the application of these new rules and whether to respond to the consultation. The consultation period closes on 4 August and it is expected that there will be substantial and detailed representations made by affected groups, advisers and trade bodies. It is clear that the Government will be prepared to consider reasonable suggestions for amendments, particularly if evidence is produced that the current proposals would result in unintended consequences. Actual examples of where existing businesses or projects might be adversely affected will be particularly helpful.