The article was first published on Lexis PSL on February 14th 2017
Several areas of drafting for the new corporate interest restriction were outstanding - what provisions have now been released?
The first draft of the legislation for the corporate interest restriction was published on 5 December 2016, but the 54 pages omitted some important areas, including definitions needed for the "group ratio rule"; provisions dealing with interactions between the new interest restriction and other areas of the tax code, such as 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 periods of UK group companies.
A revised draft was published on 26 January, intended to fill most of these gaps, and lengthening the draft to a hefty 133 pages.
The legislation will be included in Finance Bill 2017 and is now intended to form a new Part 10 of the Taxation (International and Other Provisions) Act 2010 (TIOPA), coming into force from 1 April 2017.
Despite the length of the draft legislation, clarifications and modifications are still expected in some areas. A few gaps will be filled by further amendments or secondary legislation, including treatment of authorised investment funds (AIFs) – that is, authorised unit trusts and open ended investment companies (AUTs and OEICS) – and investment trusts (ITs), and some aspects of companies within the securitisation regime.
What are the most interesting points arising out of the new drafting? Are the new provisions broadly in line with what we were expecting?
The new provisions are broadly in line with expectations, but with 133 pages of fine-grained new legislation to pore over, and new and unfamiliar definitions and concepts, the devil will be in the detail. No doubt interesting and unexpected features will continue to emerge from further in depth study of the draft legislation, and attempts to apply the rules to factual scenarios.
For example, at the end of the draft legislation is a schedule setting out detailed provisions for the submission of "interest restriction returns", including a further replication of the usual HMRC powers to demand information from taxpayers and third parties.
One interesting rule is in clause 452, which treats a debtor and creditor as "related parties" for the purposes of the rules, if another company, which is related to the debtor, provides a guarantee. Why this should be the case is not made clear.
Another feature worthy of note is that double tax relief on interest income creates "notional untaxed income" which is left out of the calculation of the tax-interest income amount, reducing capacity to claim tax deductions on related interest expense.
We now have the key definitions that feed into the 'group ratio' method for restricting interest - how will the group ratio be calculated?
The concept is simple, but the implementation is fiendishly complex.
In broad terms, the group ratio rule depends on comparing the interest expense of UK companies in a group (as a fraction of their adjusted EBITDA) to the interest expense of the worldwide group as a whole (as a fraction of its total adjusted EBITDA) and disallowing UK interest expense to the extent that it exceeds the level of the worldwide group. To put it another way, the interest allowance of the UK group is a fraction of the worldwide interest expense set by the UK earnings divided by the worldwide earnings
In practice, applying this rule depends on calculating the "aggregate tax-EBITDA" of the group" (that is, the UK taxable profits of the group) and the "group ratio percentage" (based on the "qualifying net group-interest expense" of the group – which itself depends on the "adjusted net group-interest expense", based on the "net group-interest expense" taken from the group's accounts but subject to various adjustment – and the "group-EBITDA" – the consolidated profit before tax of the group also taken from its accounts, with interest and depreciation added back).
Suffice to say that the draft legislation is fiendishly complex, and one can spend many happy hours chasing similar but slightly different definitions up and down the draft legislation trying to pin down exactly what they mean.
An optional 'alternative calculation' election has also now been included for groups who want to apply the group ratio method. Further elections have also been introduced concerning joint ventures and partnerships - do you see these being taken up by groups? What is the rationale for having these?
Taxpayers have a menu of six optional elections, two of which are irrevocable. Such elections are welcome, but they do add considerably to complexity. Taxpayers may find it difficult to determine whether they should elect or not, particularly where an election cannot be revoked.
The "interest allowance (alternative calculation) election" – one of the two irrevocable elections – will allow a group to divert from its accounting treatment, and adopt the UK tax treatment instead in relation to items such as capitalised interest, gains or losses on the disposal of capital assets, pension contributions, employee shares, and changes in accounting policy. Some taxpayers may welcome the ability to follow the tax treatment of such items in working out whether they have sufficient taxable profits to obtain a tax deduction for debt costs (rather than comparing tax apples to accounting oranges).
Other elections will, for example, allow groups to include a proportion of income and expenses from non-consolidated investments, such as joint ventures, or, conversely, to exclude income and expenses from consolidated partnerships. Either may be beneficial, depending on the nature of the tax profile of the investment.
We now have the drafting for the public benefit infrastructure exemption and provisions dealing with particular industry areas, such as oil and gas, leasing, insurance and REITs - what are the key points to note here?
The "public benefit infrastructure exemption" is largely as expected.
In broad terms, a qualifying infrastructure company can elect for its interest payments to fall to outside the interest restriction, if the loans are limited in recourse to the assets of or shares in an infrastructure company, and either the creditor is an unrelated third party or the loan was in existence before 13 May 2016.
To qualify, a company will need to be fully taxed in the UK, and have all (or almost all, save for an insignificant proportion) of its income from and assets in qualifying infrastructure activities. Qualifying activities include the usual public sector activities – such as utilities, transport, health, and education – provided they are procured by a public body or regulated by a public infrastructure body.
An interesting extension is that a company investing in UK real estate will also qualify as an infrastructure company if its properties are let on a short term basis (leases for 50 years or less) to unrelated third parties. This may allow many property investment companies to escape from the interest restriction rules.
It was originally proposed that an election for the public benefit infrastructure exemption would be irrevocable, but the new draft legislation will allow the election to be revoked after five years, but then a new election cannot be made for another five years.
Have any substantive changes been made to the provisions that were published in December 2016?
There revised draft legislation is largely the same as the previous draft, with few changes worth noting.
There is a new exception which disapplies the targeted anti-avoidance rule in relation to arrangements that can reasonably be regarded as arising wholly from "commercial restructuring arrangements", defined as including the bringing of loan relationships into the UK corporation tax net (for example, where the receivable was previously held outside the UK) or where a restructuring secures and exemption from interest restriction in a way that is " wholly consistent" with the draft legislation, and only involves "ordinary commercial steps in accordance with generally prevailing commercial practice". What this might mean is left as an exercise for the reader!
It is still intended for the new corporate interest restriction provisions to enter into force on 1 April 2017 - how do you see the introduction of these rules working in practice, and what will be the biggest challenges?
The new rules are very long and very complex, and potentially far reaching in their consequences. Most corporation tax payers will escape based on the £2m de minimis, but those who don't will have a headache, with a lot of work to do in relatively little time, particularly if they also need to take into account the recent introduction of anti-hybrid rules, and the proposed changes to loss relief rules which allow relief in wider circumstances but can restrict the amount available. Many pieces are moving at the same time.
Taxpayers and their advisers will need to work through the rules and assess how to calculate the necessary adjusted figures from accounting and tax numbers, and then which elections should be made, and finally back to completing tax returns, paying tax, and reporting the resulting position in the accounts. All potentially affected companies should consider the effect on their cash tax liabilities, and their accounting provisions for deferred tax, a matter of urgency.
It is not hyperbole to suggest that some highly-geared businesses, most of whose income is required to service third party debt, may become insolvent if debt deductions are denied, leaving them liable to pay corporation tax where there is little or no net income after their debt is serviced. Borrowers will be looking carefully at their financial models, and lenders may want to reconsider their financial covenants and security.
Although the interest restriction responds to the OECD's BEPS project, there must be a suspicion that some OECD countries, such as the US, may never implement them. An interest restriction is included in the EU's Anti-Tax Avoidance Directive, but most EU member states will not introduce equivalent rules until January 2019. Admittedly, some EU jurisdictions have had similar rules for several years, but on the whole, those rules have much more generous per-entity de minimis levels. The UK's £2m group de minimis leaves many groups potentially facing a restriction, and the wide-ranging rules may adversely affect the attractiveness of the UK internationally. The UK has had a good story to tell in recent year, as a jurisdiction which is open for business – a decreasing rate of corporation tax, dividend exemption, substantial shareholding exemption, lack of dividend withholding tax, wide treaty network, reformed CFC regime, and so on. The precipitate introduction of the interest restriction will not make the UK any more attractive to investors.
The final message is that the UK is still charging ahead with implementing the interest restriction from April 2017. There is as yet no sign that the government will respond to the pleas from taxpayers and advisers for more time to digest the changes.