HMRC consultation on tax deductibility of corporate interest expense

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1 Submitted via to: 4 August 2016 RE: HMRC consultation on tax deductibility of corporate interest expense Dear Sirs, BlackRock [1] is pleased to have the opportunity to respond to the Tax Deductibility of Corporate Interest Expense consultation document issued by HM Revenue & Customs (HMRC) and HM Treasury (HMT). BlackRock supports a regulatory and tax regime that increases transparency, protects investors, and facilitates responsible growth of capital markets while preserving consumer choice and assessing benefits versus implementation costs. BlackRock fully supports the aims of the OECD s Base Erosion & Profit Shifting (BEPS) project and we have been actively involved in discussions with OECD members (both directly and in conjunction with other parties) since the initiative was announced in We welcome the opportunity to address, and comment on, the issues raised by this consultation and we will continue to contribute to the thinking of HMRC and HMT on any specific issues that may assist in aligning the UK treatment of corporate interest deductibility with the objectives of the BEPS project. Executive Summary Our comments focus on the investment funds and products which BlackRock manages on behalf of our clients, typically pension funds, insurance companies, retail pensioners and savers. The areas touched on by the consultation that are of most direct relevance to our funds and products are those which could affect the tax treatment of UK securitisation vehicles as well as, more generally, how the proposed rules may impact investment into private assets (private equity, infrastructure and real estate) situated within the UK. Securitisation companies In relation to securitisation companies, we would urge HMT to allow the existing Securitisation Regulations to continue to apply. We note that the UK already has a very robust set of regulations governing the taxation of securitisation companies which restricts their use to only those circumstances where the company meets a tightly defined set of criteria. The nature of these vehicles is such that any element of income which is not classified as tax-interest may prevent their effective operation, should the proposed rules apply. We understand that it is not the intention with regards to such companies to prevent these operating where elements of non-interest income arise. [1] BlackRock is one of the world s leading asset management firms. We manage assets on behalf of institutional and individual clients worldwide, across equity, fixed income, liquidity, real estate, alternatives, and multi-asset strategies. Our client base includes pension plans, endowments, foundations, charities, official institutions, insurers and other financial institutions, as well as individuals around the world.

2 Private asset investment The investments made by funds, such as those managed by BlackRock, into small and medium sized UK companies, UK real estate and UK infrastructure project provides an important source of capital which may otherwise not be available from other sources, such as, for example, bank debt. Shareholder debt commonly forms part of the commercial funding structure when investing into private asset classes of this type in the UK. We would stress the importance, at a policy level, of considering the impact that the proposed rules may have on the attractiveness of the UK as jurisdiction into which private investment might be made. Should the government consider that the impact of the rules may have an undesired adverse impact on the UK in terms of the levels of private investment, it may wish to include certain carve outs or adjustments that allow for the current level of inward investment to be maintained. Such measures may include increasing the de minimis amount of interest that may be deducted before triggering the rules such that a greater proportion of investments, particularly those into small and medium sized companies, are not impacted. Alternatively, an exemption may be considered for widely held investment funds, so as not to disincentivise these from providing capital into the UK. We also note that the proposed exemption in relation to public benefit infrastructure does not extend to shareholder debt. The Government may therefore also wish to consider broadening this exemption, if there is a particular focus on encouraging this type of investment into the UK. We have set out in the appendix to this letter responses to a number if the specific questions posed throughout the consultation document. We would welcome the opportunity to discuss in further detail the points raised in the consultation. Yours faithfully, Roger Exwood Managing Director Product Tax, EMEA roger.exwood@blackrock.com Joanna Cound Managing Director Public Policy, EMEA joanna.cound@blackrock.com 2

3 Appendix: Responses to specific questions Scope of responses As set out in the cover letter, the below responses relate to the funds and products which BlackRock manages on behalf of its clients. The below does not consider, or make reference to, the implications of any of the points raised to BlackRock s own UK corporation tax affairs. Additionally, where we consider that the questions posed in the consultation document are not of relevance to the funds and products which BlackRock manages or where we otherwise have no specific comments to make, we have omitted those questions from the below list. Therefore we have set out below just those questions to which we are providing a response. Question 4: Do you agree with the proposed treatment of exchange gains and losses? Do you foresee any unintended consequences from this approach? If so, please explain, and suggest an alternative. We have no specific comments in relation to the proposal for exchange gains and losses set out in the consultation, other than to highlight the importance for, at all times, there to be symmetry of treatment with any instruments that are used to hedge exchange gains and losses. This will be of particular importance to investment structures that may utilise a UK company to holds investments in multiple currencies. Question 5: Do you agree with the proposed treatment of impairment losses? Do you foresee any unintended consequences from this approach? If so, please explain, and suggest an alternative. Under the proposed suggestion, the impairment of a loan made by a UK corporate to a third party would act to increasing the net interest expense of the UK group. The potential result, under the fixed ratio rule, may be that some or all of the loss that may be created upon an impairment is disallowed for tax purposes. There is therefore the possibility of such a UK lender gaining no tax relief for the commercial loss suffered in a group that would otherwise have been appropriately capitalised had the loan not needed to be impaired. This gives a seemingly unjust result given that the impairment of a third party loan is not in the control of the lender. To counter this outcome it would be important to also allow any impairment losses on third party loans to have a corresponding increase in the group-interest expense under the group ratio rule, therefore protecting the deduction for genuine commercial loss in these cases. Question 10: Do you agree with the proposed treatment of chargeable gains and allowable capital losses? If not, please suggest an alternative, providing an explanation of why you find it preferable. For a UK group that undertakes an investment business, inclusion of chargeable gains is crucial for the operation of the proposed rules as there may be no other source of EBITDA. Therefore, we are in agreement with the inclusion of chargeable gains in tax-ebitda. If chargeable gains were not to be included this may act as a significant disincentive to invest into the UK for any investment structure that uses third party borrowing to fund UK investment. It may also result in the creation of structures that unnecessarily convert what may otherwise be a chargeable gains into an income amount in order to generate tax-ebitda to allow for a portion of deductible interest. Additionally, given the restricted nature of capital losses, allowing for their inclusion only upon utilisation would seem like a suitable treatment. 3

4 Question 15: Which of these two approaches do you consider to be the most appropriate way to address the risks arising from very high group ratios or negative group-ebitda, and why? How should the percentage cap be set under the second approach? Are there other approaches which would better address this situation? It is relatively common for UK infrastructure projects or similar projects with large elements of underlying real estate to be able to support a high level of external borrowing. Another feature of these projects is that they will often have a construction phase which can last several years and during which little or no revenue is generated. As such it will be important for any final legislation in this area to adequately allow for deduction of external borrowing costs against revenues which arise in later periods. Not allowing for relief based off prior period external borrowing costs would likely act as a significant disincentive to those who may seek to invest into such projects in the UK. Therefore, based on the summaries of the two options presented in the consultation, option two would appear to be the most appropriate as it is the only option that deals with timing differences of a construction phase of a project. Question 20: Do you agree that the proposed definition of related party will be effective in preventing equity investors inflating the group ratio by investing using debt instruments? Please identify situations where this definition would prevent the Group Ratio Rule from taking into account interest payable to lenders that invest for a fixed return and without seeking influence over the borrower? We would like to highlight the importance of the proposal (under para 6.44 of the consultation) to treat collective investment vehicles under common management as not acting together for the purpose of these rules. It may, for instance, be the case that one BlackRock managed fund purchases an interest in third party debt that has been lent to a UK group and a second BlackRock managed fund, holds a significant equity interest in the same group. The funds may have completely distinct groups of underlying investors with the investment decisions made completely independently to one another. The absence of this exemption would introduce significant practical difficulties. Additionally, in cases where independent investment decisions are made for different funds, the arrangements are not intended as a means of circumventing the intention of the proposed rules. Therefore, if there was any concern regarding such an exemption potentially introducing scope for abuse, a purposive test could be included in any qualifying conditions for the exemption, such that only those funds which are truly acting in an independent manner from one another can be included. A separate aspect that may need to be considered is whether there are circumstances where it may be appropriate to add in further carve outs to the definition of related party. These could include scenarios such as where a third party lender is forced to enforce a portion of a loan by taking an equity interest in the borrower, which might be the case when a borrower is experiencing financial difficulties (but is not formally in administration). This may result in a portion of what may be otherwise deductible third party debt becoming disallowed. This would potentially create an additional tax burden in a struggling business where the connection with the lender was not in existence when a loan was originated and where there was no intention of such a connection arising. Therefore, a further carve out for the definition of related parties which are created by enforcement of security on a loan could be considered Question 22: Bearing in mind the Fixed Ratio Rule permitting net interest deductions of up to 30% of tax-ebitda, the Group Ratio Rule, the 2 million de minimis amount, rules permitting the carry forward of restricted interest and excess capacity, and the inclusion in tax-interest of income accounted for as finance income, please describe the key features of situations involving the financing of public benefit infrastructure where a specific exclusion will be necessary to prevent interest restrictions arising in cases where there is no BEPS. 4

5 Question 23: Are there any situations involving the financing of public benefit infrastructure where interest restrictions could arise in the absence of BEPS despite a PBPE with the above conditions? If so, please provide details and suggest how the proposals could be changed to prevent undue restrictions occurring. Question 24: Are there any situations where interest restrictions would arise connected with public benefit infrastructure despite the provisions outlined in this document, and where those restrictions could have wider economic consequences? If so, please provide details, including an explanation of why the consequences could not be avoided, such as by restructuring existing financing arrangements. Please suggest how the rules could be adapted to avoid those consequences while still providing an effective counteraction to BEPS involving interest. We agree with the thrust of Question 22, namely that there will most often not be a material restriction of external debt deduction. However, each project varies and the infrastructure investing sector is still evolving. Therefore, it is not possible to conclude whether there are any circumstances in which interest deductions would not be restricted. This is particularly true of joint venture deals. The preservation of deductions for external debt does not, however, mean that the infrastructure investing sector will not be disrupted by the measures as proposed. Shareholder debt is a common feature of many of the commercial structures used to fund UK infrastructure projects and the application of the rules and the corresponding restrictions placed on such structures could potential have a significant adverse effect on the appetite for non-uk investors to provide capital for such projects. We appreciate the effort made in the consultation document to develop principles as to whether a project qualifies as public interest. BlackRock has a significant presence in the Renewable Power (solar and wind) market and would appreciate still further guidance as to whether such projects are intended to be capable of meeting the Public Benefit test. We believe that reliable, environmentally friendly, generating capacity is something that it is government policy to provide for the benefit of the public. It seems open to doubt whether the tests set out in the consultation at 7.7 (read together with 9.37 to 9.40) are met in the case of UK power generation. We would welcome a statement of policy intent on this point. Question 26: As securitisation structures and transactions are often complex, there may be exceptions to the analysis set out above. Please would you set out any examples of securitisation structures or transactions within the securitisation regime where a net interest expense position might arise so that the application of the interest restriction rules could lead to an unintended restriction on the securitisation company? The analysis given in the consultation relies on the entirety of the income received into the securitisation vehicle being classified as tax-interest. Although this may quite often be the case, there may also be occasions where a securitisation structure receives other income streams associated with the securitised assets that may fall to be items that would be tax-ebitda. Examples of this would include royalty streams or rental income over real estate (to the extent this did not otherwise fall to be tax-interest as payments under a lease 1 ). Even relatively small amounts of these types of income would lead to the securitisation structure being in a net interest expense position. It should also be noted that regulatory requirements placed on securitisation structures mean that it is often the case that the manager or originator of the assets must maintain at least a 5% interest in the notes which are issued by a securitisation structure (the Risk Retention amount). Depending on the exact nature of the securitisation structure in question, the Risk Retention may be held by an entity that is directly or indirectly the shareholder of the note issuing company. Therefore, the application of the group ratio rule would not fully compensate for any income that is not tax-interest that arises into the securitisation structure as at least 5% of the notes may not qualify as group interest expense. 1 Please see the response to question 43 5

6 As noted in the consultation, the Taxation of Securitisation Companies Regulations 2006 (the Securitisation Regulations ) already provides for a specific regime for the taxation of UK securitisation companies that meet certain requirements. In particular, the Securitisation Regulations only apply in the cases of UK companies that are party to a capital markets arrangement 2. This requirement, along with other qualifying tests set out in the Securitisation Regulations, means that there is little (if any) scope for these rules to apply in cases for which they were not originally intended. In other words, the structures that are able to qualify under the Securitisation Regulations should not present a material risk of BEPS. In recognition of the conduit nature of securitisation vehicles and the targeted scope of the Securitisation Regulations, it would seem reasonable to have UK securitisation companies remain solely taxable under the Securitisation Regulations. Therefore, being specifically carved out of the proposed interest deductibility rules. This would ensure the continued effective operation of UK securitisation structures and would avoid any of the complications presented by elements for non tax-interest income arising into such structures. Question 29: As a result of the proposed exclusion from the group of subsidiaries held at fair value, views are invited as to whether a specific rule is required to prevent collective investment vehicles from being the ultimate parent company of a group. It is relatively common for funds that invest into private assets (for example, private equity or real estate funds), to have a number of intermediate holding companies between the fund vehicle and the target asset. Even where the target asset is held at fair value in the accounts of the fund, the holding companies that sit between the fund and the target may be fully consolidated. Therefore these companies may form a group for the purposes of the proposed rules. It is also often the case that where external debt is used, that the loans are taken into the intermediate holding companies rather than into the target investment directly. Taking external debt at this level allows for these loans to be secured over the shares of the target company as well as to offer structural subordination for lenders by allowing for lending into intermediate companies at different levels above the target investment. It should be noted that these type of funds are often constituted as a limited partnership. Therefore, in these cases, the requirement for a group to sit beneath a corporate entity would mean that the fund vehicle would not be able to form the ultimate parent of a group. However, any funds that are set up of corporate entities or in cases where the various holding structures otherwise sit beneath a single corporate holding vehicle, absent any rules to the contrary, all intermediate holding entities would be treated as a single group. Should any UK companies form part of the intermediate holding structure then these may be able to access the rules on the basis of the facts and circumstances of the group of holding entities as a whole. It is not clear whether this would offer any scope for unintended outcomes in the rules. However, if, as a policy matter, it was desirable for a collective investment scheme not to be able to form a group, then specific rules may be needed to be deal with situations such as that presented by intermediate holding structures. Application of the rules to Non Resident Landlords Although not posed as a numbered question, we note that the consultation does enquire with regards to the any considerations in respect of the taxation of Non-Resident Landlords We note that Non-Resident Landlords (within the meaning of the NRLS) are able to deduct interest when filing returns to HMRC, but do so within the scheme of Income Tax, not Corporation Tax. Income Tax payers are subject to different rules from companies subject to UK Corporation Tax and this needs separate consideration: 2 As defined in the Insolvency Act

7 i. Income tax payers are not eligible for group relief and therefore this would create an unfair disadvantage as restricted interest in one group company could not be surrendered and used by another group company. ii. If intergroup transfers/surrenders take place these need to be accounted at fair market value thus potentially triggering tax charges which would have been otherwise done on a tax neutral basis where the group is subject to UK Corporation Tax. iii. How would these rules work alongside the loan relationship rules and the fact that NRLs are out of scope e.g excludes from the relevant group interest amount any debt which is released or restructured as part of a corporate rescue, would the same be done on a tax neutral basis for NRLs? Question 40: Do you agree with the proposed treatment of derivative contracts for calculating tax-interest? Do you foresee any unintended with this approach? If so, please explain, and suggest an alternative. Question 41: Do you agree with the proposed treatment of derivative contracts for calculating tax-ebitda? Do you foresee any unintended consequences from this approach? If so, please explain, and suggest an alternative. Question 42: Do you agree with the proposed treatment of fair value movements on hedging relationships? Would this cause particular difficulties for groups, that would warrant particular rules to replace the fair value movements on hedging relationships with amounts recognised on an appropriate accruals basis (for example, in line with regulations 7, 8 and 9 of the Disregard Regulations S.I / 3256) We have no specific comments in relation to questions 40, 41 and 42 other than to highlight, as with Question 4, that it will be vital that any hedging relationship, however it has been established, should lead to a symmetrical outcome. i.e. if the income/asset being hedges formed part of the EBITDA, then any derivate movement should also form part of the EBITDA with the same applying for any amounts which constitute tax-interest. Question 43: Does this approach adequately address the position for both the lessor and lessee across the range of different leasing arrangements? If not, how could the rules be adapted to better address these situations? One fundamental point which does not seem to be fully addressed in the consultation is the intended treatment of property rental income. The section dealing with lease arrangements does describe the receipt of rent. However, this infers that this is in relation to a leased asset rather than real estate. Taking into account the predictable and periodic nature of rental income, it would make sense that it would be included as tax interest in the same way that payments made under leases would be included. This follows the same logic set out in section 9.21 to 9.27 of the consultation. Given the significant size of the UK real estate investment market, we would urge HMT to confirm their policy intentions in relation to rental income as soon as possible. 7