Tax Services 13 May 2016 Tax deductibility of corporate interest expense Further consultation Consultation on detailed policy design and implementation On 12 May 2016, HM Treasury and HMRC released a further consultation on the tax deductibility of corporate interest expense. This new consultation seeks input on the detailed design of the new rules for the purposes of drafting legislation to be included in Finance Bill 2017. Responses are sought by 4 August 2016. In publishing this consultation on the detailed design, the Government has confirmed that, from 1 April 2017, it will cap the amount of UK tax relief for interest to 30% of taxable earnings before interest, depreciation and amortisation (EBITDA) calculated across the UK group. Alternatively, groups may elect for the interest restriction to be based on the net interest to EBITDA ratio for the worldwide group. To ensure the rules are targeted where the greatest risk lies, the rules will include a de minimis allowance of 2 million net UK interest expense per annum and provisions for public benefit infrastructure. Disallowed interest can be carried forward indefinitely, while excess interest capacity can be carried for a maximum of three years. There is no provision for carry back. The Government has maintained its view that grandfathering is only needed in exceptional circumstances. Although the rules are aimed primarily at preventing base erosion and profit shifting by multinational groups, there is no general exclusion for domestic groups. This means that they may still be affected, especially given the effect of a number of computational provisions is not straightforward. In general, however, the group ratio rule should mitigate the effects of the interest restriction for domestic groups. The consultation considers the interaction with other specific regimes (such as the oil and gas ring-fence rules, the research and development (R&D) legislation and the position for Real Estate Investment Trusts (REITs), while noting that the Government will continue to work with interested parties to develop appropriate rules for groups in the banking and insurance sectors (two options are proposed in the consultation and an OECD discussion draft is due on 18 July). The new rules will apply to the concept of Tax-Interest, which is defined in the consultation and includes all amounts of interest, other financing costs economically equivalent to interest, and expenses incurred in connection with the raising of finance. The interest restriction rules generally apply after all other rules which determine the taxable profit or loss of a company for a period, but before most rules governing loss relief.
How the rules are expected to work All groups will be able to deduct up to 2 million net UK Tax- Interest expense There is a cap on deductible net Tax-Interest expense of 30% of UK Tax-EBITDA A group can elect to receive a higher deduction than that given by the fixed ratio rule by applying worldwide group ratio of interest to EBITDA to UK Tax-EBITDA In addition, the net Tax-Interest amounts cannot exceed the global net Adjusted Group-Interest expense Indefinite carry forward of disallowed interest and three year carry forward of excess capacity. All groups operating in the UK will be required to calculate their UK net Tax-Interest amount as defined. Where this is 2 million or less, the group can deduct all Tax-Interest and the rules apply no further. For other groups, they will be required to calculate their Tax-EBITDA as defined. They must 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. 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 and no more spare capacity than it would have as a standalone company. Alternatively, groups can calculate a group ratio, based on the worldwide group s consolidated accounts, equal to the group s net Qualifying Group- Interest expense divided by its Group-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 global groups net Qualifying Group-Interest expense does not include interest paid to related parties. Related parties are broadly defined as when one party has effective control over the other, or a 25% or greater investment in the other or a third person has a 25% or greater investment in both. Furthermore, associated enterprises for the purposes of the OECD model tax convention are also treated as related parties. The investments of two or more persons acting together should be aggregated when applying the 25% test. Where the worldwide group is in a loss position, then the interest limit under the group ratio will be the amount of net Qualifying Group-Interest expense. In such a circumstance, or where group profits are low such that the group ratio is very high, the Tax deductibility of corporate interest expense 2
Government considers that additional measures might be required to prevent excessive interest relief. At first sight the group ratio rule should exclude wholly domestic groups from having an interest restriction under these rules. However, because of the way the rules are calculated, in particular that the group ratio is calculated based on adjusted accounting figures but applied to taxable figures of the UK group and that interest paid to related parties is excluded from the group ratio, the group ratio rule might not prevent a restriction from occurring. In addition, under an overarching limit based on the existing worldwide debt cap, groups cannot deduct more net Tax-Interest in the UK than their global net Adjusted Group-Interest expense, although the 2 million allowance still applies. This is termed the modified debt cap rule. This differs from the existing worldwide debt cap (which is being repealed) as that restricts UK deductions with respect to gross group interest expense. Whilst interest paid to related parties is excluded in calculating the group ratio rule, it is included in the modified debt cap rule. This additional restriction is not part of the OECD proposals, but its purpose (similar to that of the existing worldwide debt cap) is to prevent groups that have little net external debt in the worldwide group gearing up the UK to the fixed ratio rule limit. 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 be carried forward for three years. There are no provisions for carry back. There will be detailed anti-avoidance rules covering areas such as the buying of excess interest or spare capacity, schemes to exploit the definition of group or related party and schemes to manipulate the level of interest or profits so that more interest becomes deductible. Definitions Group: The same definition of group is used for all aspects of the rules. The group will comprise the ultimate parent and entities that are consolidated on a line by line basis in the parent s consolidated accounts (excluding, for example, associates and joint ventures). Similar to the current worldwide debt cap rules, the ultimate parent must be a company or similar entity and not generally a partnership, including limited liability partnerships, for example. Tax Interest: The net interest amount subject to restriction includes amounts economically equivalent to interest. This encompasses loan relationship debits and credits (including from related transactions), debt-related derivative contract debits and credits and interest implicit in certain leases. Foreign exchange differences on the principal of loans are generally excluded. Tax-EBITDA: This means taxable profits before certain amounts such as for capital allowances, taxdeductible amortisation, Tax-Interest (as defined above), relief for losses carried forward or back and group relief between companies in the same group as defined. It also excludes exempt branch profits and dividends, and CFC inclusions, but includes net chargeable gains, but not unused capital losses, and consortium relief. Total group-interest: This is the amount which is added back in calculating the worldwide group s EBITDA which is different to the amount of Qualifying Group-Interest which is the figure brought into the numerator in the group ratio. It is defined in a similar way to the current worldwide debt cap rules. The starting point is the amounts recognised in the consolidated profit and loss and so would exclude amounts in other comprehensive income or which are recognised directly in equity. Adjusted Group-Interest: This is the figure brought into the modified debt cap and is largely the Total Group-Interest but with some adjustments to align with the UK tax rules e.g., including capitalised interest. Qualifying Group-Interest: This is the figure brought into the group ratio rule and is the Adjusted Group- Interest but with some amounts of interest excluded. Related party interest, financing costs on profit participating loans, perpetual debt, compound instruments and hybrid debt are all excluded Group-EBITDA: The consultation document specifically draws out the point that the Group EBITDA will be defined and may differ from that shown in the accounts. This will add further to the complexity in applying the group ratio rule. For example a profit or loss on disposal of a subsidiary will need to be adjusted where the disposal includes tangible or intangible assets. Tax deductibility of corporate interest expense 3
Commencement date The rules will apply from 1 April 2017. Where the actual period of account for the group straddles 1 April 2017, the proposed rules will apply on the basis that the group prepares accounts for two notional periods of account, one ending on 31 March 2017 and another commencing on 1 April 2017. For the purposes of the fixed ratio rule, it is expected that in most cases, time apportionment will be appropriate. For the group ratio rule, a just and reasonable method must be used and the consultation document suggests that in many cases the group ratio for the notional period of accounts commencing on 1 April 2017 will be the same as that for the actual period of account. The current worldwide debt cap regime will apply to the actual period of account which straddles 1 April 2017. Where a group is subject to a net restriction under the current worldwide debt cap regime for the actual period that straddles 1 April 2017, it will not be permitted to carry forward any spare capacity for the notional period of account commencing on 1 April 2017. The new modified debt cap will not apply until actual periods of account for the group commencing on or after 1 April 2017. The Government is proposing that grandfathering of existing debts will be permitted only in exceptional circumstances which is likely to only include debt in some existing UK infrastructure projects. Interaction with other tax rules The consultation document includes detail on how the proposals interact with other tax reliefs. For example adjustments are required in the calculation of Tax-EBITDA to take account of the enhanced deduction for R&D and the R&D expenditure credits. Similarly adjustments will be made so that relief is not obtained at the full corporation tax rate for interest on debt used to finance profits that are taxed at a lower rate under the patent box. Specific industries Banking and insurance: These financial services are not included in the new rules for the moment. The Government is considering various options, including whether to apply the rules only to nonbanking and insurance companies within financial services groups, or to introduce a targeted antiavoidance rule. These considerations with be informed by the OECD s own document on banking and insurance, due on 18 July 2016. Specific investment regimes: Interest distributions made by authorised investment funds, investment trust companies and property approved investment funds are not treated as Tax-Interest. Therefore, the Government expects that these vehicles are unlikely to be affected by the rules, although they are not formally excluded and interest paid on ordinary debt could be restricted. The Government is not proposing to exclude REITs, although it has asked how the rules might be adapted to cater for them. Ring fence: Activities within the oil and gas ring fence are not intended to be adversely affected and the Government is considering options for the oil and gas industry. Public benefit infrastructure: The consultation sets out the Government s proposal for an exclusion for projects where a public body (as defined) has contracted with the private sector for services that it is Government policy to provide to the public. The project must involve the provision/upgrade, maintenance, and operation of infrastructure and have an expected duration of at least ten years. The absence of one element of a fully serviced infrastructure project would appear to be outside of the exclusion. All revenues must be subject to UK corporation tax and 80% of them must come from the provision of public services. None of the funds for which the interest costs would be excluded are to be used other than for project assets. It s not clear therefore how additional debt taken on over life of a project, to pay swap break costs on the refinancing of a project for example, might be treated. The definition of a public body includes the typical Government bodies and departments that might be expected. It also includes anybody that acts under the remit of a statutory instrument with the primary objective or providing goods or services for public, community or social benefit, which has been funded for that purpose and the extension may therefore extend to some projects carried out in regulated sectors such as water, gas and transport. If these conditions are met, eligible third-party loans used to fund project assets can be excluded from the interest restriction rules. Associated tax-ebitda should also be excluded from the calculation. Tax deductibility of corporate interest expense 4
EY Assurance Tax Transactions Advisory How we can help Given the significant impact the proposals are likely to have on financing structures, and on pricing and investment decisions, groups are encouraged to continue to engage with HM Treasury and HMRC on this matter. The start date of 1 April 2017 gives groups little time to restructure their operations, especially as there will be very limited, if any, grandfathering provisions. The impact of the parallel work at EU level (as part of the EU anti-tax avoidance directive) will also need to be taken into account. We can help groups make representations to HM Treasury/HMRC as well as assess the impact of the proposed rules on their current structure and consider restructuring and refinancing options. Further information For further information, please contact one of the following or your usual EY contact: Claire Hooper chooper@uk.ey.com 020 7951 2486 Graham Wright gwright1@uk.ey.com 0161 333 2879 Jo Myers jmyers@uk.ey.com 020 7951 1127 Richard Milnes rmilnes@uk.ey.com 020 7951 7750 About EY EY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities. EY refers to the global organization and may refer to one or more of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit ey.com. Ernst & Young LLP The UK firm Ernst & Young LLP is a limited liability partnership registered in England and Wales with registered number OC300001 and is a member firm of Ernst & Young Global Limited. Ernst & Young LLP, 1 More London Place, London, SE1 2AF. 2016 Ernst & Young LLP. Published in the UK. All Rights Reserved. ED None In line with EY s commitment to minimise its impact on the environment, this document has been printed on paper with a high recycled content. Information in this publication is intended to provide only a general outline of the subjects covered. It should neither be regarded as comprehensive nor sufficient for making decisions, nor should it be used in place of professional advice. Ernst & Young LLP accepts no responsibility for any loss arising from any action taken or not taken by anyone using this material. ey.com/uk Tax deductibility of corporate interest expense 5