The Most Competitive Corporate Tax System in the G20…?
"[t]he most competitive corporate tax system in the G20" were the words with which HM Revenue and Customs and HM Treasury launched last October's consultation on the tax deductibility of corporate interest expense. According to the consultation paper, and in line with OECD concerns, current provisions for deducting corporate interest expenses open the possibility for multinational companies to achieve base erosion and profit shifting – in other words, tax avoidance strategies that exploit gaps and mismatches in tax rules to artificially shift profits to low or no tax locations. The government launched the consultation in order to consider the OECD's recommendations for addressing the issue. The findings have now been distilled and have resulted in new rules to apply from 1 April 2017 onwards.
There are, of course, legitimate situations in which interest expense can and should be deducted from tax. However, the consultation paper (and the OCED concerns on which it is based) focuses on three basic scenarios in which base erosion and profit shifting can be achieved through payment of interest (or payments economically equivalent to interest):
- multinational groups electing to place higher amounts of third party debt in countries with high tax rates;
- multinational groups increasing the group's third party interest expense through the use of intra-group loans to generate interest deductions; and
- multinational groups funding the generation of tax exempt income through third-party or intra-group financing.
Principally, the tool envisaged by the OECD to combat each of the above concerns is to limit net deductions for interest made by a company to a set percentage of that company's earnings before interest, taxes, depreciation and amortisation (EBITDA) – the so-called "fixed ratio rule."
The UK, in line with the recommended approach, will enact a fixed ratio rule, and limit corporate tax deductions for net interest expense to 30% of a group's EBITDA. However, the proposal will also add further elements intended to ensure that the UK tax system remains competitive and that the restrictions imposed by the fixed ratio rule are proportional. The most relevant is that the fixed ratio rule will only apply once a threshold amount of £2 million of net UK interest expense has been reached. A detailed consultation is now underway to finesse the rules further.
As many groups borrowing funds in the so-called "mid-market" will incur interest expense of £2 million or more per annum, the rules will become relevant quite quickly to private equity sponsors, trade buyers, corporate borrowers and large-scale debt-funded real estate investments alike.
The principal impact of the rules will be that corporate groups will be heavily incentivised to incur most if not all of their interest expense at the entity that generates the majority of the group's EBITDA. For most leveraged or corporate real estate acquisitions that rely on debt being incurred through a special purpose vehicle which is then deployed to acquire the EBITDA-generating asset in question, this will not be a practical solution and could lead to a shift in the structuring of such acquisitions if the new rules prove to be burdensome and/or impact the economic viability of such transactions.
Fieldfisher are actively monitoring the situation and, as with the initial consultation (where we responded to advise against introducing a general interest restriction as "too disruptive to legitimate business"), will participate in the ongoing consultation process.
If you believe that you or your organisation may be affected by the rules set out above, please do not hesitate to contact members of the Fieldfisher finance or tax teams who will be able to address any concerns.