Out-Law Legal Update 6 min. read

Implications of interest restriction for real estate


LEGAL UPDATE: From 1 April 2017, companies are likely to be subject to a restriction on the tax deductions available for interest payments. The latest version of the legislation was in the Finance Bill, but was removed after the general election announcement. 

New interest restriction

A new 'fixed ratio' rule is likely to apply from 1 April 2017 to limit the tax relief available for companies in respect of interest payments. Tax relief for interest is limited to the lower of:

  • 30% of profits chargeable to corporation tax, excluding interest, capital allowances, tax amortisation and relief for losses; and
  • the adjusted net group-interest expense of the group for the period.

There is a de minimis allowance for groups of £2 million a year. An alternative group ratio rule based on the net interest to EBITDA ratio for the worldwide group is intended to help groups with high external gearing for genuine commercial purposes.

The rules are a response to the recommendations made by the Organisation for Economic Cooperation and Development (OECD) in connection with its base erosion and profit shifting (BEPS) project, designed to reduce tax avoidance by multinationals.

When the rules were originally announced the British Property Federation (BPF) and other industry bodies pointed out that the BEPS risk in relation to third party debt secured on UK real estate is low and did not justify the blanket application of the regime to property transactions.

The government responded by widening a 'public infrastructure exemption'  so that it will take certain real estate investments as well as some infrastructure projects, out of the interest deduction restriction.

Investors who might be affected by the corporate interest restriction (CIR) are likely to try to meet the conditions of the public infrastructure exemption (PIE) which would exempt interest on third party debt from the CIR regime.

This update looks at the current position on the public infrastructure exemption (PIE) as it applies to real estate. It is based on the Finance Bill legislation published on 20 March and the draft HMRC guidance issued on 31 March 2017 – both of which could change.

PIE for property rental activities

The core conditions for the PIE to apply in relation to property rental activities are:

  • the company carries on a qualifying infrastructure activity, which means it must provide a ‘public infrastructure asset’, and is allowed also to carry on any other activity which is ancillary to or facilitates the provision of that asset;
  • a let building is treated as a ‘public infrastructure asset’ if it is used by the company for a UK property business for tax purposes, and is let for an effective term of 50 years or less to parties which are not ‘related’;
  • all, or all but an insignificant proportion, of the relevant company’s income and assets must derive from the let property or ancillary activities relating to it;
  • the property must be recognised as an asset on the company’s or relevant group balance sheet;
  • the lender’s recourse in relation to the loan must only be to the income, assets or shares of the company (or another company qualifying under the PIE);
  • the company is ‘fully taxed’ in the UK , meaning that every activity carried on by the company is within the charge to corporation tax, and it has not made any claim for double taxation relief; and
  • an election must be made before the start of the relevant accounting period (except for elections for any period beginning before 1 March 2018 where it is possible to make the election retrospectively). An election can be made on a group basis.

The effect of the exemption applying is, broadly, that there will be no restriction under the corporate interest restriction rules on interest paid to non-related parties. The CIR rules remain applicable to interest paid to related parties.

Recent developments

In the draft of the legislation included in the Finance Bill when it was first published in March 2017, the ‘comparative debt’ condition was dropped. This would have required the gearing of the relevant company to be not less than ‘comparable’ group companies carrying on similar activities. This would have created uncertainty and would have restricted the application of the PIE in some groups, so this is a positive development.

The PIE election can now be made on a group basis which effectively allows the insignificant income and assets test to be satisfied on a group basis.

New provisions clarify the position in relation to joint ventures where one of the joint venture parties would not satisfy the PIE test but another party would.

Some other concerns with the previous version of the legislation have been addressed, including clarifying that sub-letting of property can be a qualifying activity, and assisting the potential application of the PIE at early stages of the project where income and asset values may be minimal.

Guarantees provided before 1 April 2017, or provided by related parties and which are non-financial (eg guarantees of performance of services), will now be disregarded.

Implications

The announcement of the general election has disrupted the passage of the legislation through Parliament.  Although the provisions were in the Finance Bill published in March 2017, like many other provisions, they were removed from the bill which because law before Parliament was dissolved in the pre-election run-up. It is expected that the provisions will be reintroduced in a post-election Finance Bill, but they will not become law until the autumn.  The interest deduction restriction provisions may change when they are re-introduced in a Finance Bill, as the government responds to comments on the previous drafting. They could also change as the Bill passes through the Parliamentary process. However, it is unlikely that there will be further major changes to the legislation before it is enacted so businesses now have a reasonably clear picture.

Most real estate investors are likely to fall within the PIE, so the main focus will be on ensuring that the conditions are met on a continuing basis, including that relevant activities are not tainted by non-qualifying activities and income. Investors will need to carry out detailed analysis on joint venture and partnering structures.

The PIE applies to companies carrying on a property rental business. If the particular circumstances of a project results in it being treated as a trading activity, interest deducted on the basis of the company carrying on a property rental business could be adjusted. Given the unclear line between investment and trading treatment in some circumstances, businesses should ensure that projects are reviewed from this perspective.

Where a group election for the PIE is made for property rental activities, group activities will need to be regularly monitored to ensure that no group company ceases to meet the conditions for the election as failure by one group company will lead to the group election being invalidated for all companies within it.

Joint ventures remain a difficult area. The broad principle of the changes made is to allow a shareholder qualifying for the PIE to obtain a proportionate exemption under the PIE where the other shareholders do not qualify. This is a welcome development though it is not yet clear whether it will deliver the ‘right’ result on all fact patterns. Joint ventures will be an area where for the moment the CIR rules will need to be worked though on a case-by-case basis. Joint venture agreements may need to contain provisions dealing with the status of shareholders for the purpose of the PIE.

Many real estate investments are held through non-UK resident structures which are not subject to corporation tax. Although the CIR rules will not currently apply to these non-residents, the consultation on non-resident companies issued on 20 March 2017 indicates that the Government clearly intends to bring non-trading activity within the scope of corporation tax so it could be expected that the CIR rules will apply to non-residents in future periods. For the current period, a non-resident will not be carrying a on a qualifying activity for PIE purposes in relation to group elections.

The draft guidance helpfully states that the anti-avoidance rules would not apply to a commercial restructuring designed to allow a group to benefit from the PIE rules. Such a restructuring could involve moving subsidiaries that cannot meet the PIE conditions to a separate part of the group structure, creating a sub-group of companies that can qualify.

John Christian is a real estate tax expert at Pinsent Masons, the law firm behind Out-law.com.

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