UK interest tax relief restrictions to come into force in April 2017 despite calls for delay, government says

Out-Law News | 13 May 2016 | 5:10 pm | 5 min. read

The UK government is pressing ahead with new rules to limit the corporation tax deductions available for interest payments from April 2017, despite calls for the introduction to be delayed, according to a new consultation document published jointly by HM Treasury and HM Revenue and Customs (HMRC).

The document includes a summary of responses to the previous consultation on the rules which acknowledged that most of those who had answered the question on timing had said the rules should not be introduced earlier than 2018, or that the UK should not implement ahead of its international partners. Respondents had suggested that a later implementation date would limit the potential impact of the rules on the UK’s competitiveness and give businesses adequate time to restructure and reorganise before the rules took effect.

However, the government said that its decision to introduce the rules in April "demonstrates the UK’s leadership in implementing the G20 and OECD recommendations".  

Heather Self, a tax expert at Pinsent Masons, the law firm behind Out-law com, said: "It is surely more important for the government to get this right rather than rush to do it first. The changes will be highly complex and are likely to have some unintended consequences; a short delay - perhaps with some targeted anti-avoidance measures in the meantime - even at this late stage, would be a welcome change of heart."

She added: "It is a particular concern for banks and insurance companies, where there remains an intention to introduce further rules applying to their activities from April 2017, even though the Organisation for Economic Co-Operation and Development (OECD)  has not yet completed its work in this area. The phrase 'legislate in haste, repent at leisure' comes to mind."

The proposed restriction on interest relief was one of the recommendations made by the OECD to prevent tax avoidance by multinationals in reports published in October 2015 as part of its base erosion and profit shifting (BEPS) project.

The new fixed ratio rule will mean that tax relief for interest, other financing costs which are economically equivalent to interest and expenses incurred in connection with the raising of finance will be limited to 30% of 'tax-EBITDA'.

Tax-EBITDA will be profits chargeable to corporation tax, excluding interest, tax depreciation such as capital allowances, tax amortisation, relief for losses brought forward or carried back and group relief claimed or surrendered. It is proposed that net chargeable gains should be included within tax-EBITDA, but unused capital losses will not be deducted.

Groups will need to add the tax-EBITDA of each UK resident member company and UK permanent establishment. If the group’s net tax-interest expense exceeds this 30% limit there will be an interest restriction equal to the excess.

Groups will be able to choose how to allocate the interest restriction between the group companies, but the amount of restriction allocated to a company will be limited to its net tax-interest expense.

The restricted interest will be carried forward indefinitely and may be treated as a deductible interest expense in a subsequent period if there is sufficient interest capacity in that period. In addition, if a group has spare capacity for an accounting period it will be able to carry this forward and use it as additional interest capacity in subsequent periods until it expires after 3 years. The proposed rules do not provide for any ability to carry back excess interest or capacity.

The new rules will apply on a group-wide basis. The group will include all companies that are or would be consolidated on a line-by-line basis into the accounts of the ultimate parent company.

There will be a de minimis allowance of £2 million per annum which means that groups with net interest expense below this will be unaffected by the fixed ratio rule. The government says that this will exclude 95% of groups from the new rules.

The government confirmed at Budget 2016 that the new rules will include a group ratio rule based on the net interest to EBITDA ratio for the worldwide group. This is intended to help groups with high external gearing for genuine commercial purposes. The new consultation document explains that the group ratio will be calculated by dividing the net qualifying group interest expense by the group EBITDA. A group choosing to apply the group ratio rule will use the group ratio in place of the 30 fixed ratio rule. The amount available under the group ratio rule will be capped at the amount of net qualifying group-interest expense.

Heather Self said: "The group ratio rule will be welcomed, particularly by groups which are primarily UK-based and funded by external debt.   However, there is further complexity in that the main rule relies on tax EBITDA, while the group ratio is based on book EBIDTA".        

The current 'debt cap' legislation, which restricts corporation tax deductions for interest and other finance expenses claimed by members of a large group by reference to the group's consolidated finance costs, will be repealed, but rules with similar effect will be integrated into the new interest restriction rules. This will mean that a group’s net UK interest deductions cannot exceed the global net third party expense of the group.

The government acknowledges in the consultation document that public benefit infrastructure projects "do not present a BEPS risk provided that all the project revenues are subject to UK taxation, and to the extent that the financing is provided by third parties (with no equity interest), is used only for the project, and does not exceed the operator’s costs of providing or upgrading the infrastructure".

It is proposing a 'public benefit project exclusion' (PBPE), which would enable groups to exclude the eligible tax-interest expense, as well as any tax-interest income and tax-EBITDA connected with suitable projects, from their interest restriction calculation. However, the PBPE would only apply to interest on loans to third parties.

Eloise Walker, another tax expert at Pinsent Masons, said: "The third party debt requirement will come as a real blow to many in the infrastructure sector, who were hoping HMRC would see reason and extend the exclusion to shareholder debt as well as third party funding. This is especially prevalent in existing PPP/PFI structures where local authorities and other government bodies have been keen to ensure that third party developers and construction firms have 'skin in the game' when project companies are set up to build schools and hospitals."

In order to qualify for the PBPE, the project would have to "provide services which it is government policy to provide for the benefit of the public" and a public body would have to contractually oblige the operator to provide those services, or license the operator. In addition the project would have to last at least 10 years or have a shorter rolling term if intended to continue indefinitely. To qualify all the project revenues would have to be subject to UK corporation tax and at least 80% of gross revenue generated from the project assets would be expected to arise from the provision of public benefit services.

The fixed ratio rule would apply to existing as well as new projects and loans. The government said that it does not favour grandfathering of existing loans and would only consider it if "any adverse impacts of the new rules connected to infrastructure finance would be systemic and could not be mitigated in other ways".

"The lack of proper grandfathering seems particularly perverse, given that the OECD left that option open to countries to ease the adverse effects of the new rules on existing structures. Why HMRC is not availing themselves of this get-out, and thus easing the adverse impact on many existing structures, is a mystery - perhaps only explained by their political masters' keenness to be seen to be at the forefront of BEPS implementation and their corresponding ignorance of the consequence," Eloise Walker said.

"Some existing projects will find it difficult to restructure, and the adverse effects of the new rules may cause many to go into default which can trigger a hand-back of the project to the government - and the taxpayer - to pick up the bill. When it blows up in their faces in this way, they will have only themselves to blame," she said.