New corporate interest restrictions: impact on real estate financing

The Finance Bill published on 20 March 2017 contains detailed legislation for implementing restrictions on the deductibility of corporate debt for UK companies. This will clearly have significant implications in a broad range of circumstances for companies raising finance, limiting deductions to 30% of EBITDA in some cases and, as explained below, potentially encouraging borrowing from third party lenders where currently shareholder debt is favoured.

However, the new rules also need to be understood by banks and other lenders to UK corporates. They may, in some cases, have a significant impact on borrower cash flows and could also lead borrowers to make specific demands to limit the credit protection and security package to be given to their lenders. This is particularly the case in the real estate finance market where loans are often made to single purpose property companies and/or recourse is limited to specific property assets. In this case, interest is likely to focus on the new Public Benefit Infrastructure Exemption.

Background

The new UK rules stem from the OECD’s Base Erosion and Profit Shifting (BEPS) Action Plan. In particular, the OECD reported on the “profit shifting and base erosion” risks associated with intra-group debt and recommended that jurisdictions introduce a “fixed ratio” rule which limits deductions for interest to a fixed percentage (between 10% and 30%) of a company’s earnings before interest, tax, depreciation and amortisation (EBITDA). Following consultation, the UK Government announced that it would implement these recommendations and would, despite widespread concern over the hasty introduction of the new rules, apply the new interest restriction with effect from 01 April 2017 with no general grandfathering for interest on existing debt.

Outline of the new rules

In outline, the Finance Act 2017 will introduce a “fixed ratio rule” set at 30% for UK companies and groups within the charge to UK corporation tax. This will restrict a group’s deductions for interest expense to 30% of its EBITDA. However, this is subject to a number of exceptions, including:

• a £2m de minimis threshold - the new rules do not apply to the first £2m of the group’s interest expense
• a group ratio election - where the worldwide group’s interest ratio exceeds the 30% limit that can be used instead up to a maximum of 100%
• an exception for public benefit infrastructure projects

However, the rules will also include a modified version of the existing worldwide debt cap rules, such that the borrowings of the UK group will only be deductible to the extent that they do not exceed the external borrowings of the worldwide group (or do not exceed the £2m de minimis).

The focus of the OECD’s work was on profit shifting within multinational groups where there is an element of choice as to where interest expenses and interest receipts can be located. It was not intended to affect bona fide third party debt. The group ratio election should, in many cases, ensure that deductions for genuine third party borrowings are not affected, but an international group which already has intra-group debt into the UK in place may find that additional external borrowing into the UK causes interest deductibility restrictions to arise even where these were not previously an issue. Also, the rules are complex and the definition of “related party debt” is wider than simple intra-group lending. In particular, any external loan that is guaranteed by an associated enterprise is treated as “related party debt” and so, in principle, excluded from increasing the group’s interest ratio. Therefore, banks and other lenders may find their borrower clients are keen to ensure that related party guarantees do not restrict the ability of borrower to obtain deductions for the interest payments.

Public benefit infrastructure exemption - potential to extend to most UK commercial real estate

The OECD and the UK Government recognise 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. As a result, the application of the new interest expense restrictions may render such projects not viable, despite the fact that they were not the primary target of the OECD’s BEPS project.

Accordingly, the Government has included a “Public Benefit Infrastructure Exemption” (PBIE) within the new rules. This exemption is targeted at two distinct categories of borrower. Firstly, it will benefit those groups which invest in long-term infrastructure assets which meet a public benefit test and have high leverage as a result. Secondly, the exemption is also aimed at those groups which let buildings as part of a UK property business to unrelated parties – irrespective of whether the building has any “public benefit” in the usual sense. It is this second category which will be of particular relevance and interest to participants in the real estate finance market.

Qualifying Infrastructure Companies

The PBIE will be an elective exemption for “Qualifying Infrastructure Companies” (QICs). QICs are companies which meet all of the following conditions for the accounting period:

• the public infrastructure income test: all, or all but an insignificant proportion, of the company’s income derives from: (a) qualifying infrastructure activities it carries on (see below), (b) shares in a QIC or (c) loan relationships or other financing arrangements to which the only other party is a QIC
• the public infrastructure assets test: all, or all but an insignificant proportion, of the value of the company’s assets derives from (a) tangible assets relating to qualifying infrastructure activities and related service concessions and financial assets, (b) shares in a QIC or (c) loan relationships or other financing arrangements to which the only other party is a QIC
• the company must be within the charge to corporation tax on all its activities, and
• a valid election for the PBIE to apply has been made.

Qualifying infrastructure activities

Qualifying infrastructure activities (QIA) are the provision, upgrade or maintenance of public benefit infrastructure (as to which see below) and the undertaking of public benefit services or integral services using that infrastructure.

In most cases the application of the public infrastructure income test will mean that only borrowers dedicated to carrying out QIA will benefit from the PBIE. However, the fact that the test can also be met where income is generated from shares in a QIC or loan relationships with QICs means that related group companies can together each qualify as a QIC in appropriate circumstances. Many leveraged real estate investment holding arrangements are already structured on a single-property-per-holding-company basis for other tax and commercial reasons and so real estate finance borrowers may, in principle, be in a position to benefit from the PBIE.

Public benefit infrastructure and property letting businesses

There are broadly two categories of public benefit infrastructure. In addition to assets used to deliver a public benefit and meeting certain other conditions, for the purposes of the new rules UK property will also be an “public infrastructure asset” (and hence rent received from it will also be income from a QIA) where it meets the following criteria:

• the building (or part building) is part of a UK property rental business carried on by the QIC or another member of the borrower’s worldwide group
• it is let or sub-let by a company to unrelated persons on a short term basis (50 years or less)
• it has or has had an expected economic life of at least ten years (later owners may still benefit where the remaining useful life has dropped below ten years, as long as the expected economic life was at some point more than ten years), and
• it meets the group balance sheet test: the building (or part building) must be recognised on the balance sheet of either the QIC itself or another company within its corporate group which is subject to UK corporation tax in respect of all its income.

As a result, a property company solely carrying on a UK property rental activity may satisfy the public infrastructure income test and the public infrastructure assets test, and may be able to rely on the PBIE (where the other QIC conditions are met). In broad terms, a UK property rental business only includes passive property investment - ie “buy and hold” of real estate investments to produce rental income over the longer term. Trading activity would be outside the scope of the exemption - for example development of property for onwards sale or buying and selling property relatively quickly to make a turn. However “develop and let” would generally be inside the scope of the exemption, provided the letting is the long term objective rather than just a short term stop-gap pending sale.

It should be noted that the PBIE is limited to UK property by virtue of the UK property rental business requirement. As such, a group would need to ensure that the relevant company only holds and lets UK property. The holding of foreign property assets within the company (or other material activities in the company besides holding and letting the property) would prevent it qualifying as a QIC and being able to benefit from the PBIE. As a result it is possible that a group would need to reorganise UK and foreign property rental businesses into separate group companies (or separate out wider activities into separate companies) it if wishes to take advantage of the exemption.

The scope of the group balance sheet test means that the company recognising the asset must not have either claimed double taxation relief in the relevant accounting period or made an election to exempt profits and losses of an overseas branch from UK taxation. Again, in practice this is likely to mean that UK property holding and letting should be conducted in a separate company from other activities.

Exemption for qualifying interest of a QIC

Where a company meets the conditions to be a QIC (including making a valid election), 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 either not a related party or otherwise is itself a QIC, and
• the lender only has recourse to the income or assets of QICs (including shares or debt issued by a QIC) - note that recourse could be to the debtor or another QIC.

If a guarantee is given by a related party which is not a QIC, the limited recourse condition may be breached, in which event the PBIE would not apply as the interest will not be qualifying interest (subject to grandfathering for guarantees provided before 01 April 2017). Loans to borrowers seeking to rely on the PBIE can therefore only be supported by guarantees which:

• are provided before 01 April 2017
• are given by an unrelated person, a public body or another QIC, or
• constitute a non-financial guarantee meeting certain criteria, such as performance of a contractual obligation.

Real estate finance lenders are therefore likely to see borrowers seeking to ensure that guarantees fall within these categories, which may limit the overall credit protection lenders can obtain.

The fact that QICs can also derive income from other QICs may also be relevant to real estate finance lenders, as this may assist where lenders are not “lending to the asset” but to a UK finance company, as both the finance company and the property company to which the finance company on-loans borrowed funds may qualify as QICs and benefit from the PBIE. However for this to be the case, the finance company would need to lend only to QICs. In some groups this could encourage the use of two separate group finance companies for QIC and non-QIC financing.

Effect of PBIE on interest restriction

Provided that the PBIE tests are met, a borrower should not suffer any restriction on its interest deductions on loans from third parties. However, as outlined above the activities undertaken by the borrower, the giving of related party guarantees and the elections made by the borrower may all impact on this issue.

It should be noted that the Government has recognised that limited grandfathering is necessary to protect existing UK infrastructure projects (taking into account debt covenants etc). In particular, the Finance Bill includes an exemption for certain interest payable to related parties to the extent the loan was agreed prior to 13 May 2016.

Comment

Lenders should no longer automatically assume that all interest payments on loans to UK companies will be tax deductible for the borrower. As such, it may be necessary for certain lenders to undertake significant tax due diligence before agreeing to lending arrangements (eg when lending backed by assets such as real estate, lenders often seek reassurance from the borrower on the tax position of the companies within the security ringfence). In particular, where, as is common in real estate finance, recourse is limited to the property assets, consideration should be given to the application of the PBIE as a means of ensuring that interest deductions are not restricted and cash flows are not impacted. However, these rules are complex and require on-going compliance and, accordingly, the PBIE will not be a panacea in all cases.

More generally, however, the benefit of the group ratio test may well mean that third party borrowing from unconnected lenders may be more favourable in some cases than shareholder debt, resulting in increased demand for additional third party funding.

It should also be noted that the UK Government is currently consulting on bringing non-UK companies in receipt of UK property income within the scope of UK corporation tax. Provided they do not have a UK permanent establishment, such companies are currently subject to UK income tax on their UK property rental activities, rather than corporation tax. Accordingly, they are currently not affected by the new corporate interest deductibility restriction rules, and do not need to rely on the PBIE. This proposal to bring such companies into the UK corporation tax regime is designed to ensure that both UK and non-UK companies are subject to the same rules, including the restrictions on corporate interest deductions and other restrictions to be introduced in relation to use of corporate losses. One effect would be to bring non-UK companies holding UK property within the scope of these interest deductibility restriction rules, which could in turn lead them to seek to qualify for the PBIE.