This article was first published on Lexis PSL on December 19th 2016
Remind us, what is the background to the forthcoming rules restricting the deductibility of corporate interest?
The UK government's proposal to restrict the deductibility of corporate interest costs comes from Action 4 of the OECD's Base Erosion and Profit Shifting (BEPS) project, and responds to a perception in some quarters that – notwithstanding the imposition of arm's length transfer pricing, and other anti-avoidance rules – it is still too easy for multinational corporate groups to shift profits to from one jurisdiction to another using intragroup debt.
Unlike many of the other actions proposed by the OECD – which are intended to prevent double non-taxation by ensuring consistent tax treatments across borders – Action 4 results in a one-sided adjustment: the lender is still subject to tax on the full amount of interest, even if the borrower is denied a deduction. Arguably, it is simply a tax raising measure.
The OECD's proposals borrowed heavily from the "interest barrier" (Zinsschranke) introduced as part of the corporate tax reform in Germany in 2008, which limits interest deductions to 30 per cent of taxable EBITDA, leaving at least 70 per cent of EBITDA subject to tax (although other reliefs may be available). This limitation was in part a quid pro quo for a reduction in the headline rate of the German corporate income tax. Similar regimes were subsequently adopted in a number of other European countries.
Although the UK has historically had a generous approach to the deductibility of debt costs, there are already many tax rules in that UK that restrict interest deductibility, including reclassification of deductible interest as a non-deductible distribution, transfer pricing, anti-avoidance rules in the loan relationships rules, and, since 2010, the worldwide debt cap. The proposed interest restriction is yet another measure to add to this pile.
What are the main take-away points from the released draft legislation? Are the rules in line with what we were expecting?
The draft legislation broadly implements the expected policy, consistent with BEPS Action 4, as consulted on by HMRC in late 2015 and announced in the 2016 Budget.
In broad outline, from 1 April 2017, a UK company will only be able to claim a deduction for corporation tax purposes for its annual net interest expense if that net expense does not exceed £2m, or if greater 30 per cent of the group's adjusted earnings before interest, tax, depreciation and amortisation (EBITDA) in the UK. No deduction will be available for interest costs in excess of that amount. Amounts are calculated on a group-wide basis and then allocated to the UK companies in the group, so the £2m de minimis is not available separately to each UK company.
However, a company may be able to claim a deduction for debt costs above that fixed £2m or 30 per cent limit, to the extent that the proportionate interest expense for relevant UK companies in a group (compared to their tax-adjusted EBITDA) is no greater than the equivalent proportion of interest expense to adjusted EBITDA for the worldwide group as a whole.
A company's net interest expense is the difference between (a) the finance payments that it recognises for tax and accounting purposes – loan relationship debits (other than exchange rate losses and impairment losses), debits on derivative contracts relation to interest rates or other debt items, and finance costs relating to finance leases, debt factoring and other arrangements treated as a financing liability for accounting purposes – and (b) the equivalent items recognised by a company as taxable income.
Unlike the worldwide debt cap, where third party interest expense was essentially uncapped, third party debt – such as bank debt – is taken into account on the same basis as any other debt – such as shareholder debt.
There will be special rules for investment in public infrastructure. It had been suggested that there might be special rules for banks or insurance companies, but this now no longer appears to be the case, which will pose significant challenges for businesses in the financial sector.
The draft legislation published on 5 December 2016 includes the "fixed ratio rule" (30 per cent individual entity test) and some core provisions for the "group ratio rule" (ratio of interest expense to EBITDA). The draft also includes rules on carrying forward restricted interest and surplus capacity, rules on companies leaving and joining groups, and commencement, transitional and anti-avoidance rules
What has happened to the existing worldwide debt cap rules? How are they being integrated?
In broad terms, the "group ratio rule" limits a UK company's debt deductions by reference to the UK company's share of the group's overall debt costs, in a similar manner to the worldwide debt cap. As a result, the worldwide debt cap will be abolished, which will be a welcome relief to those forced to wade through the legislation.
Thankfully, the draft interest restriction rules are slightly less impenetrable than the legislation implementing the worldwide debt cap, although taxpayers and advisers will need to get to grips with concepts such as the "tax-EBITDA" and "net tax-interest expense" of a company, and the "interest allowance", "interest capacity", "aggregate tax-EBITDA" and "adjusted net group-interest expense" of a worldwide group, and whether or not to make a "group ratio election".
Only draft legislation for the core provisions have been released - what parts of the draft legislation are still outstanding?
The draft legislation published on 5 December 2016 omits drafting for some areas, with additional drafting to be published in January 2017. The areas to be added include definitions needed for the "group ratio rule"; provisions dealing with interactions between the new interest restriction and other areas of the tax code: for example, the patent box, leasing, REITs, and securitisations; application of the new rules to joint ventures; rules concerning related parties; the proposed public benefit infrastructure exemption; and rules to allocate interest restrictions to accounting period of UK group companies, all of which are expected to be published by the end of January 2017
Do you see any difficulties - practical or otherwise - for groups applying the new rules?
The main issue is that the UK is moving very fast to implement the interest restriction, certainly faster than most other EU or OECD countries, and faster than the BEPS project requires. Based on experience with similar changes that have been rushed in over recent years, the UK will struggle to get the new rules right first time: for example, amendments are already needed to the new anti-hybrid rules introduced in Finance Act 2016. One mercy is that those changes have been proposed before the anti-hybrid rules come into effect. However, the interest restriction rules will be included in Finance Bill 2017, and will doubtless come into effect for accounting periods starting before the legislation is enacted, posing a challenge to taxpayers. Any rectifying amendments will have to have retrospective effect, on legislation that is already retroactive. Not ideal.
How do you think the draft legislation is being received?
Most taxpayers are resigned to the inevitability of the interest restriction being introduced as planned. As I understand it, the experience in Germany is that most companies are not significantly affected by the interest barrier most of the time, although the existing rules in Germany are in some respects less stringent than the proposed rules in the UK (including in particular a simple "per entity" de minimis, unlike the group-wide de minimis proposed in the UK).
Who is likely to be most affected by the new rules?
Many companies and corporate groups in the UK will not be affected, because they have relatively modest interest burdens. Others might be affected from period to period, as their variable profits fluctuate above and below a 3⅓ multiple of their annual interest expense, but they may be able to claim a deduction for excess interest expense carried forward to later periods where there is more capacity, or indeed claim extra deductions for carried forward spare interest capacity.
Heavily geared businesses, for instance ones where there has been a leveraged buyout, or those in capital intensive sectors largely funded by debt, may have problems, and cashflow models and business plans may need to be adjusted. The most prudent investors proceed on the basis that no interest on shareholder debt will be deductible, so any tax deduction is upside.
That said, interest deductions are less valuable in a low tax regime. At the moment, the rate of UK corporation tax is 20 per cent – already low by G20 standards – and will fall to 19 per cent from April 2017, and then to 17 per cent in 2020. Earlier this year, the former Chancellor of the Exchequer indicated an aspiration for the rate to fall as low as 15 per cent in due course.
What could groups do to prepare for the rules coming into force on 1 April 2017?
All potentially affected companies should consider the effect on their cash tax position, and accounting provisions for deferred tax, a matter of urgency.