UK publishes draft legislation on restrictions for UK interest deductions

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1 12 December 2016 Global Tax Alert UK publishes draft legislation on restrictions for UK interest deductions EY Global Tax Alert Library Access both online and pdf versions of all EY Global Tax Alerts. Copy into your web browser: Executive summary On 5 December 2016, the UK Government published draft legislation to implement Action 4 (limiting base erosion involving interest deductions and other financial payments) of the G20/Organisation for Economic Co-operation and Development s (OECD s) base erosion and profit shifting (BEPS) initiative. The draft legislation follows a consultation document on the detailed policy design issued by HM Revenue & Customs (HMRC) and HM Treasury on 12 May A response to the consultation has also been published. The legislation is intended to apply to interest expenses accruing on or after 1 April However, despite the publication of over 50 pages of draft legislation, there are still several areas where draft clauses remain outstanding. These are expected to be published before the end of January 2017, although the Government has set out its policy intent for these areas within its responses to the May consultation. The provisions of the draft legislation appear to be in line with many of the proposals outlined in the May consultation document, although there are several areas where changes have been introduced as a result of the representations, which are discussed further below.

2 2 Global Tax Alert The rules are complex and will require a number of notifications and elections to be made, some of which are irrevocable. Given the limited time before the rules enter into force, groups should be looking at the provisions in detail and modelling the potential impact in order to assess which options may be most beneficial and what actions might need to be taken in advance of the new rules coming into effect. Detailed discussion Summary of the rules The operation of the draft legislation is broadly in line with the previous proposals set out in the May consultation document. As such, all groups operating in the UK will be required to calculate their net Tax-Interest, which will include expenses otherwise deductible for UK purposes relating to loan relationships, derivative contracts relating to financial assets and financing costs implicit in amounts payable under relevant arrangements (e.g., finance leases, debt factoring or similar transactions). Interest restrictions arise where the aggregated net Tax-Interest of the group exceeds the interest capacity of the group, subject to always being able to offset a de minimis amount of 2 million of interest expense. Where the UK Tax-Interest is greater than 2 million, a group will be required to calculate its Tax-EBITDA (i.e., taxable profit in the UK before interest, capital allowances and deductible amortization on intangible assets) and then apply the fixed ratio rule whereby the deduction of Tax-Interest in the UK group is restricted to 30% of the group s Tax-EBITDA. Alternatively, groups can elect to calculate a group ratio, based on the worldwide group s consolidated accounts, equal to the qualifying net group interest expense divided by the groups accounting EBITDA. Under the group ratio rule, Tax-Interest can be deducted in the UK group up to the group ratio applied to UK Tax-EBITDA even where that is higher than the amount given by the fixed ratio rule. The group ratio percentage to be used is 100% (i.e., interest up to the full amount of Tax-EBITDA is available) where the group is loss making or where the group ratio percentage would otherwise be greater than 100%. The amounts calculated under both the fixed ratio rule and the group ratio rule are subject to an overarching limit in that groups cannot deduct more net Tax-Interest in the UK than their global adjusted net group interest expense. This is termed the modified debt cap rule, which forms an integral part of the new rules. Groups can allocate resulting disallowances and spare capacity to individual companies in the UK group as they see fit provided that no entity is allocated more disallowance than its net-tax-interest expense. Excess Tax-Interest that cannot be deducted, can be carried forward indefinitely and added to the Tax-Interest in future periods. Spare capacity that is unused in a given period can now be carried forward for five years (compared to the three previously proposed). There are no provisions for carry back. The rules also include anti-avoidance provisions which counteract any tax advantage arising where there are arrangements, the main purpose of which is to enable a tax advantage that is derived, in whole or in part, from the interest restriction rules. What are the main changes? There are a number of changes introduced in the draft clauses from the proposals outlined in the May consultation. Key changes include the following: Aligning the start of the modified debt cap with the commencement of the other aspects of the regime previously the modified debt cap only applied for periods of account starting after 1 April Following feedback, periods of account straddling 1 April will now be split, with the existing worldwide debt cap applying up to 1 April and the modified regime applying thereafter. Carry forward of surplus capacity following representations that the previous period was too short, groups will now be able to carry forward surplus capacity for five years rather than three. Exclusion of impairment losses the previous proposal included impairment losses in the calculation of Tax-Interest, whereas these are now excluded. Capping of the group ratio percentage the group ratio percentage will be capped at 100% (which was at the top end of one of the two options proposed in the May consultation to prevent large group ratios from distorting the restrictions). Adjustments to the group interest and group EBITDA calculations one of the biggest issues raised in representations was that due to book/tax differences, the group ratio was overly restrictive and did not achieve its objectives. This is demonstrated by the fact that even wholly domestic groups can suffer an interest restriction under the group ratio rule.

3 Global Tax Alert 3 As a result of representations, the rules will now include adjustments to the group interest and group EBITDA amounts to align these more closely with the UK tax rules. This includes optional adjustments by way of election for capitalized interest and recognition of amounts arising from changes in accounting policies, exclusion of fair value movements on capital assets, recognition of the cost of employee share options on exercise and adjustments to the calculation of gains on asset disposal in line with the tax basis. While it will now be possible to recognize pension costs on a paid basis rather than an accruals basis when calculating the group EBITDA, pension costs will still need to be taken into account despite several representations being made on this. In addition, groups will be given an optional election to exclude the fair value movements arising on derivatives when calculating interest and EBITDA for both the fixed ratio and group ratio rules, which will work on a similar basis to the existing Disregard Regulations. These were welcome developments but it is still likely that some groups will suffer interest restrictions as a result of book/tax differences. Exclusion of some related party debt when calculating the group ratio although the Government does not propose to change its intention to exclude interest on related party loans from the group ratio calculation, it does intend to introduce a targeted exclusion from the general treatment of related party debt where at least 50% of a class of issued debt is not held by related parties. In these scenarios the related party debt can be included for the purposes of calculating the group ratio rule. The rules will also include limited exclusions where a person becomes connected as a result of a liquidation or restructuring. Public Benefit Infrastructure Exemption the consultation response announces a widening of this exemption as it was felt that the previous proposals were too narrow. The wider exemption will apply on a companyby-company basis under which Qualifying Companies (i.e., those which only generate operating income from qualifying activities and have no financial income other than from other qualifying companies, along with meeting certain other criteria) will be fully excluded from their group s interest restriction calculations, with the exception of any non-qualifying interest expenses. Non-qualifying interest expense is broadly interest paid to related parties or lenders which do not only have recourse to the income or assets of the Qualifying Company, or where guarantees have been provided by a non-qualifying Company. The exemption will target companies that generate operating income from the provision, upgrade or maintenance of public benefit infrastructure and the undertaking of public benefit services or integral services using that infrastructure. Public benefit services will be defined more broadly than was previously expected and will include services that are procured by a public body (or its wholly owned subsidiary), provided in consequence of specific arrangements made by Parliament, or services performed in the interest of national security. In addition, the provision of rental property to unrelated parties is also expected to come within the exemption. Within the announcements is confirmation that the exemption can be expected to apply to activities including water, gas and electricity transmission, interconnectors, distribution and supply, thermal (coal and gas), renewable and nuclear energy generation, port and airport operators, and the rail network. In each case the activity will need to be governed by specific legislation or be regulated by bodies established by statute. In certain cases, the draft legislation is also to permit the deductibility of interest payable to related parties to be grandfathered to the extent the loan was agreed prior to the publication of the May consultation document. This will only apply where 80% of the Qualifying Company s expected income has been materially fixed for 10 years or more by long-term contracts with, or procured by, public bodies or their wholly owned subsidiaries. All the other conditions for the Public Benefit Infrastructure Exemption must still be met. Effect of the patent box deduction will be ignored representations highlighted that including the patent box deduction in the calculation of UK Tax-EBITDA would reduce the benefit of the patent box regime and it is therefore proposed to exclude this from the calculation. This will also bring the Tax-EBITDA more in line with the accounting EBITDA. In addition to these areas, the proposals set out in the May consultation document focused on the key concepts without including some of the more administrative matters. The draft legislation provides further details of how groups will need to report interest restrictions and allocations of disallowable amounts.

4 4 Global Tax Alert In particular, groups will need to appoint a reporting company and notify HMRC within six months of the end of the relevant period of account. The reporting company will need to file an interest restriction return within 12 months of the end of the accounting period, which will need to include prescribed information for each company that is covered by the return, a statement of calculations as well as details of how the interest restrictions have been allocated among the group. Even if a group is not subject to interest restrictions, an abbreviated return will need to be filed. What is outstanding? While a large proportion of the legislation has been published as part of the draft Finance Bill clauses, there remain outstanding areas which are not expected to be released until January These areas include: The definitions needed for the group ratio rule, particularly relating to group EBITDA. The ability to exclude the fair value movements on derivatives, capitalized interest and the impact from changes in accounting policy are also outstanding. Details about how the regime will apply to associates and joint ventures, although the consultation responses confirm that an election will be available for joint ventures to use a blended group ratio based on the weighted average of its corporate investors. Investors in partnerships that are fully consolidated into the investors accounts will also be able to elect to treat the partnership as if it was accounted for under equity accounting for the purposes of calculating the group ratio. The Public Benefit Infrastructure Exemption. Rules in relation to specific industries and investment regimes, such as the oil and gas industry, Real Estate Investment Trusts, the securitization industry, registered societies and groups invested in by insurance groups. Details are also still awaited in relation to the treatment of interest distributions from investment funds and registered societies. Rules to deal with the interaction with other tax regimes, including the patent box, the Northern Ireland rate of corporation tax and Gift Aid. Rules dealing with changes of accounting policy will also be included, along with administrative rules dealing with the enquiry, penalties and information powers. Rules dealing with leasing, which are not expected to change from the previous proposals, despite representations made about their impact. However, the Government has noted that this area will be kept under review as part of engagement on the treatment of lease payments more generally in advance of the introduction of IFRS 16. Interactions with specific industries Banking and insurance: Banking and insurance groups will be subject to the Fixed Ratio Rule in the same way as other industry groups, instead of having a modified application of the rule. The Government has also stated that it will monitor whether there is a need to amend the rules to deal with possible risks arising from mixed groups that combine nonfinancial services businesses with a regulated bank or insurer. Securitization: Specific provision will be made so that all amounts that fall within the permanent securitization regime are included in Tax-Interest. Furthermore, while results-dependent loans are usually to be excluded from the definition of interest for the purposes of calculating the group ratio rule, this will not be the case for instruments issued by a securitization company within the permanent securitization regime. Specific investment regimes: Interest distributions made by authorized investment funds, investment trust companies and property approved investment funds are not to be treated as Tax-Interest. The Government does not intend to exclude Real Estate Investment Trusts, although changes will be made so that these will not be forced to pay excessive Property Income Dividends. Oil and gas: Activities within the oil and gas ring-fence will be excluded entirely from the interest restriction rules, although activities outside the ring-fence will be subject to the rules in the normal way. What should groups be doing? The new rules are complex and may require a number of notifications and elections to be made, some of which are irrevocable once made. Consequently groups will need to carefully model the potential impact in order to assess which elections may be most beneficial and what actions to take. This may also flag areas where it may be strategic to consider refinancing or restructuring in advance of the rules applying. Although there are still some areas where the detailed legislation is not yet known, given the limited time before the rules become operational, groups will need to start reviewing and assessing the potential impact now.

5 Global Tax Alert 5 In addition, the operation of the rules is likely to require detailed calculations and obtaining the information may not always be straight forward. The definition of group will be driven by the International Accounting Standards definition, which may not be the same as that used when preparing the group s financial statements. Furthermore, although there are provisions to allow the use of financial statements prepared under certain other generally accepted accounting practices for the purposes of the group ratio rule (including UK and US GAAP), it may be necessary to prepare additional financial statements, particularly where there is a deemed group that is different to the actual group. Groups will also need to assess the impact of planned mergers, acquisitions and disposals to understand how this may change their position. Alongside this, groups might want to consider making further representations on the proposed rules, as changes can be expected between now and the final legislation. Impact Given the significant impact the rules are likely to have on financing structures, and on pricing and investment decisions, groups would be well advised to consider the impact of the rules as soon as possible. The start date of 1 April 2017 means that the new rules will come into effect in a matter of months and, although the proposals are still in draft (and some aspects have not yet been published), by the time the Finance Bill is published groups will have very little time to react and take appropriate steps and so action now is encouraged. For additional information with respect to this Alert, please contact the following: Ernst & Young LLP (United Kingdom), London Claire Hooper chooper@uk.ey.com Richard Milnes rmilnes@uk.ey.com Jo Myers jmyers@uk.ey.com Craig Hillier chillier@uk.ey.com Ernst & Young LLP (United Kingdom), Manchester Graham Wright gwright1@uk.ey.com Ernst & Young LLP, UK Tax Desk Leader, New York James A. Taylor james.taylor1@ey.com

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