Tax deductibility of corporate interest expense

Following confirmation at the Autumn Statement 2016 that the UK would implement the Organisation for Economic Co-operation and Development's (OECD’s) recommendations on interest restrictions with effect from April 2017, the Government has now released a consultation response document and draft legislation providing further detail of its proposals. The Government has rejected calls for significant changes to the rules and to any delay in their implementation. As such, the proposed structure of the rules remains fundamentally unaltered, though the response document does set out a number of detailed changes to the way the rules will work.

The new regime will incorporate the existing debt cap regime, which will be repealed, meaning that groups will need to apply both the new 30% of Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) restriction (the fixed ratio rule) and a restriction based on the external borrowing levels of the worldwide group. However, the UK will introduce a group override (the group ratio rule) allowing additional interest deductions where the UK group’s fixed ratio (whilst exceeding 30% of EBITDA) does not exceed the worldwide group’s fixed ratio, as well as a £2m threshold below which the new rules will not apply (it is claimed that this will exclude 95% of groups from the rules).

Background

The OECD’s final report on Action 4 recommended that jurisdictions should introduce a rule which limits deductions for interest to a fixed percentage of a company’s earnings before interest, tax, depreciation and amortisation (EBITDA). The recommended ratio would be between 10% and 30%, depending on a range of factors that jurisdictions may take into account.
The report recognised that the fixed ratio rule might be ameliorated by supplemental provisions, including:

• override by a group ratio rule, where the wider group’s actual ratio of external borrowings to earnings is higher than that allowed in a particular jurisdiction
• a de minimis provision to carve out smaller companies and groups
• an exclusion for interest paid to third party lenders on loans for public benefit projects, and
• carry forward of disallowed amounts of interest.

In addition, the report allows jurisdictions to supplement the fixed ratio rule with other provisions to prevent BEPS through interest deductions.

In May 2016, the Government released a consultation on the detailed design and introduction of the new regime to restrict deductions of interest by companies designed to implement the recommendations for addressing base erosion and profit shifting (BEPS) activities under Action 4 of the OECD’s BEPS Action Plan. The UK has been keen to be seen as one of the early adopters of the OECD’s BEPS recommendations in a number of areas, and restricting interest deductions is proving no exception. In particular, as the UK’s corporate tax rate falls (currently 20%, 19% next year and 17% from 2020), the UK Government wishes to ensure that the low tax rates are combined with a broad tax base and, in particular, little avoidance activity. However, equally the UK Government does intend to implement each of the exclusions from the restriction contemplated by the OECD recommendations.

UK proposals

In outline, the UK Government will introduce a “fixed ratio rule” set at 30% of EBITDA, subject to a £2m de minimis threshold. In addition, the UK proposes to adopt the OECD’s relaxation where the worldwide group’s interest ratio exceeds the 30% limit and also provide an exception for public benefit infrastructure projects. However, the UK also intends to retain the fundamental premise of the existing worldwide debt cap rules - that the borrowings of the UK group should not exceed the external borrowings of the worldwide group - albeit by integrating it within the new rules. Despite widespread concern over the unnecessarily hasty introduction of the new rules, the Government will implement the new interest restriction with effect from 01 April 2017 and there will be no general grandfathering for interest on existing debt.

Fixed ratio rule

The key aspect of the interest restriction is the fixed ratio rule which will limit corporate deductions for “tax-interest” to 30% of “tax-EBITDA”. The rules will operate on a group basis (rather than on a company by company basis). As such, both the tax-interest and tax-EBITDA will be calculated on a group basis. The group will include all members that are within the charge to UK corporation tax.

Despite respondents suggesting otherwise, the Government will define “interest” (referred to as “tax-interest”) widely to cover any interest type return (including through derivatives) as well as expenses incurred in raising finance.

The rules will be applied on a net basis so that the tax-interest will be the consolidated finance expense amounts less the financing income amounts of the UK members of the group. EBITDA (referred to as “tax-EBITDA”) will be based on the aggregated EBITDA across the UK group requiring the group to sum the EBITDA of each UK member and UK PE in the group. EBITDA will be measured by reference to amounts taxable and deductible for UK corporation tax purposes, subject to a lower floor of zero.

If the UK group’s net interest expense exceeds its interest capacity (based on the 30% EBITDA calculation), then there will be an interest restriction equal to the excess. The group will then be able to decide how to allocate that excess between the group members with net interest expense.

If interest deductions are restricted by the rules, then the member suffering the restriction will be entitled to carry forward that restricted interest indefinitely. It will be deductible in subsequent periods as if it were an amount of interest of that period. In addition, where a group has spare capacity in one year, it may allocate that capacity at its discretion to group companies to be carried forward for up to five years (extended from three years in the earlier consultation), subject to not breaching the 30% limit for an individual company. However, the Government does not propose to include rules allowing for carry back of spare capacity.

The rules will include a de minimis limit of £2m, meaning that any group with up to £2m of net interest expense will not suffer any interest restriction. However, even if a group has less than £2m net interest in a year, that interest may still absorb any carried forward interest capacity where it exceeds the group’s fixed ratio in that year.

The current worldwide debt cap regime

The consultation response document confirms that, despite calls for the worldwide debt cap to be entirely scrapped, the Government will incorporate parts of the existing regime in the new rules. In particular, the principle that the UK group’s net UK financing costs must not exceed the global financing expenses of the worldwide group will be re-enacted. This will prevent groups with little external debt from gearing up to the fixed ratio rule limit within the UK. As such, the borrowings of the UK group will need to pass two tests to be deductible, both the fixed ratio rule and the modified debt cap rule.

The existing worldwide debt cap rules will be repealed and the modified and re-enacted debt cap rule will be fully integrated into the new regime such that the de minimis of £2m will apply to it. In addition, any restriction of interest under this modified debt cap rule will be treated in the same way as a restriction under the fixed ratio rule and be available for carry forward to future periods. Contrary to earlier indications, these changes will also now be introduced with effect from 01 April 2017 (rather than only for actual periods of account commencing on or after 01 April 2017).

Group ratio rule

Recognising that some groups may have high external gearing for genuine commercial purposes, the Government will include a group ratio rule based on the net interest to EBITDA ratio for the worldwide group. This is intended to allow businesses operating in the UK to continue to obtain deductions for interest expenses in line with the worldwide group’s financial position.

The group ratio will be calculated based on the proportion of the “net qualifying group-interest expense” to the “group-EBITDA”. The figures will be calculated using the accounting figures for the worldwide group (albeit subject to an election to adjust the figures to better align group accounting profits with the calculation of taxable profits in the UK).

The original consultation document went to some length to discuss the issues around identifying the amount of group-interest, group-EBITDA and the use of accounts drawn up in accordance with various accounting standards. It is important to note that various adjustments are required to be made, particularly to exclude related party interest and interest relating to certain equity like and hybrid instruments. In addition, the consultation response confirms that the rules will provide for certain further adjustments (some optional) to better align the calculation of group-interest and group-EBITDA with the UK tax rules.

On the issue of who is a “related party”, the original consultation proposed that the Government would adopt the OECD recommendations in full, leading to a broad definition covering persons with effective control, or under common effective control, where the relevant level of investment is 25%+ or where entities are associated for the purposes of Article 9 of the Model Tax Convention. In addition, attribution rules will apply where parties are “acting together” in respect of relevant equity entitlements or voting rights. Again, the Government has rejected calls to water down these provisions. However, a targeted exclusion will be included for situations where at least 50% of a class of issued debt is not held by related parties.

Where the group-EBITDA is small (perhaps due to trading difficulties), the group ratio may be very large. In such cases, the allowed level of UK interest may also be very large, albeit subject to an overall cap equal to the total group’s net interest expense under the modified debt cap rule. If the group EBITDA is zero or less, then the interest cap will simply be the group’s net qualifying group-interest expense. However, the Government is concerned that the group ratio rule may in some cases result in excessive UK interest capacity relative to the actual UK activity of the group, leading to the possibility of excessive interest capacity carry forward or recovery of large amounts of previously restricted interest. To deal with this concern, the Government has decided to limit the operation of the group ratio rule to 100% of tax-EBITDA.

Public benefit infrastructure

The Government recognises that public benefit services are often provided using infrastructure which is funded using private finance. In such cases, the operator (which may consist of one or more special purpose companies) typically undertakes a long-term project to provide or upgrade, maintain and operate the infrastructure. Often the project is structured so that income and operating expenditure have little volatility, and in consequence it may be both highly geared and generate only a small profit margin over the cost of finance. Because of this, it is possible that the new interest expense restrictions would render such projects not viable, despite the fact that they do not typically present a BEPS risk. Accordingly, the Government proposed the introduction of a “Public Benefit Infrastructure Exemption” from the rules, which is intended to be limited to those groups which invest in long-term infrastructure assets and have high leverage as a result.

Nonetheless, responses to the May 2016 consultation argued that this proposed Public Benefit Infrastructure Exemption was too narrow in some respects and, as a result, the Government has widened its scope in a number of ways. However, fundamentally, the Public Benefit Infrastructure Exemption will not exempt interest except on loans that are used in their entirety to fund taxable public benefit infrastructure and which arise from a commercial decision by the owners of the infrastructure to obtain debt finance.

More specifically, the Government will introduce an elective exemption for Qualifying Companies on the following basis:

• Qualifying Companies are those which do not generate operating income other than from qualifying activities or hold non-qualifying assets (unrelated to public benefit infrastructure).
• Qualifying Companies must be within the charge to corporation tax on all their activities and must make an irrevocable election into the regime.
• Qualifying Activities are the provision, upgrade or maintenance of public benefit infrastructure and the undertaking of public benefit services or integral services using that infrastructure.
• Public benefit infrastructure encompasses objects that are used to deliver a public benefit service and that have an expected economic life exceeding ten years.

Where the conditions are met and the company has elected into the regime, interest expense will be excluded from the group’s interest restriction calculation if it is qualifying interest. Qualifying interest will need to meet a number of conditions including:

• the lender is not a related party
• lenders only have recourse to the income or assets of Qualifying Companies, and
• the loans are not guaranteed (unless by other Qualifying Companies or public bodies).

In addition, the Government has recognised that limited grandfathering may be necessary to protect existing UK infrastructure projects (taking into account debt covenants etc). In particular, the Government has agreed that the deductibility of interest payable to related parties can be grandfathered to the extent the loan was agreed prior to the publication on 12 May 2016 of detailed proposals for the interest restriction rules. Grandfathering will be limited to cases where 80% of the Qualifying Company’s expected income has been materially fixed for ten years or more by long-term contracts with, or procured by, public bodies or their wholly owned subsidiaries. The only relaxation of the Public Benefit Infrastructure Exemption conditions is that the interest may be payable to related parties. All the other conditions must still be met, including electing for the Public Benefit Infrastructure Exemption to apply.

Other issues

The Government has also responded on a number of other detailed areas:

• Interaction of the new rules with specific regimes, including securitisation companies and collective investment schemes (including AIFs, ITCs, REITs and PAIFs), where in general the Government has rejected calls to exclude such entities from the rules.
• Application to non-resident companies. The Government announced in the Autumn Statement that it will consider bringing all non-resident companies receiving taxable income from the UK into the corporation tax regime and will look at the options for implementing the limitation of interest deductions when it consults on this measure in Budget 2017.
• Application of the rules to banks and insurers, and groups which contain banking and insurance activities (which awaits the outcome of further OECD work). The issue here is that banks and insurers are often in a net interest income position, and so the basic OECD Action 4 proposal does not address BEPS issues in these sectors through use of excessive interest charges. Nevertheless, the Government has rejected calls to exclude banks and insurers from the rules and intends to apply the Fixed Ratio Rule to banking and insurance groups in the same way as other groups. However, the Government will monitor whether there is a need to amend the rules to deal with possible risks arising from “mixed” groups.

Anti-avoidance

The interest restriction rules will themselves, of course, be a form of anti-avoidance legislation. Nevertheless, the draft legislation includes further widely drafted anti-avoidance rules to prevent groups entering into arrangements to “undermine the effect of the rules”, such as schemes to manipulate the amounts of tax-interest expense taken into account.

Commencement

Although the consultation response document acknowledges the widespread concern expressed over the introduction of the rules from 2017 and the sentiment that, especially in the wake of the Brexit vote, the Government should delay their introduction, the Government has rejected these calls. In essence, the Government takes the view that this is an important change to protect the UK tax base from erosion, it has now been consulted on widely and, in any event, the Government is simply levelling the playing field with many competitor jurisdictions, such as Germany.

The Government plans that the new rules will come into force from 01 April 2017, with rules needed to deal with the position of groups having accounting periods straddling this date. In relation to the modified debt cap, it would apply to periods of accounting commencing on or after 01 April 2017, with the existing rules applying until that date.

Excess interest expenses for pre-2017 periods may be carried forward into the post-2017 period and will not be subject to the new interest restriction regime (but may be limited by other Government proposals to limit carry forward of trading losses that will also come into effect on 01 April 2017).

Comment

The draft legislation released so far, which runs to 54 pages, encompasses the core rules for the interest restriction, including the fixed ratio rule and the modified debt cap. It also includes the framework for the group ratio rule and the mechanism for allocating any restriction to individual companies and accounting periods. Commencement, transitional and anti-avoidance rules are also included.

The Government has indicated that it will publish the remaining provisions by the end of January 2017 in an updated version of the draft legislation. These will include the definitions needed for the group ratio rule, including how it will apply to joint ventures, rules concerning related parties and the Public Benefit Infrastructure Exemption and how the rules will apply to particular issues and industries such as REITs and securitisation companies.

The existing draft legislation is open for comments until 01 February 2017 and any comments should be sent to interest-restriction.mailbox@hmrc.gsi.gov.uk

Update

The Government has now released further draft legislation, see "Deductibility of corporate interest expense: further draft legislation".

For more information on the public benefit infrastructure exemption and, in particular, its application to UK property businesses, see "New corporate interest restrictions: impact on real estate financing".