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Deloitte Alerts - 03/02/2017


Finance Bill 2017: Revised draft legislation on corporate interest restriction

Following the release of a partial initial draft of the legislation on 5 December 2016, a full draft of the corporate interest restriction legislation was released on 26 January 2017.  The revised draft includes legislation on a number of areas which were left outstanding in December, including details of the operation of the group ratio, the exemption for public benefit infrastructure projects, and various other elections, including one to deal with mismatches between tax and accounting measures for the purposes of the group ratio.


Summary

The overall operation of the legislation remains broadly unchanged from the December 2016 draft, with some notable exceptions, such as the inclusion of an ability to increase carried forward capacity by the amount of a group’s aggregate net UK interest income, enabling groups to take advantage in future years (or through reactivation of previous disallowances) of net interest income, the benefit of which would have been lost under the previous draft.

All groups continue to be able to benefit from the 2 million de minimis amount, where this exceeds net interest expense calculated under the fixed or group ratios, although this is only available on a current year basis and is not available to be carried forward. Net interest expense in excess of this will be restricted to 30% of taxable profits before interest and tax depreciation and amortisation (tax-EBITDA), or the group ratio percentage (based on the ratio of accounting net interest expense to accounting EBITDA) of tax-EBITDA, if that is higher and a group elects to use it. Both ratios are limited by a modified debt cap to the group’s aggregate net interest expense of the period, adjusted when applicable to the group ratio to remove related party interest and interest on equity notes and results-dependent securities.

There is no change to the previously announced commencement date of 1 April 2017.

Deloitte comments  

The revised legislation is now largely complete. This is particularly important given that it has been released a little over two months before the date of commencement and, as such, companies have very limited time to get to grips with these rules before they come into force, even more so given the fact that many groups will also need to consider the new loss relief and hybrid rules too.

The revised legislation has been reformatted to create a new Part 10 of TIOPA 2010, with the administration provisions separated into a new Schedule 7A.  Many of the drafting errors identified in the December 2016 version have been corrected in this second release, as have a number of issues of which HMRC have been made aware since the first draft was released.

Many of the previously identified mismatches and distortions appear to have been resolved, including in relation to fair value movements on derivative contracts in most cases, and fixed asset revaluations.  However, some issues remain and it is clear that the compliance burden will be significant; particularly making choices as to whether to make the various available elections.

The area of greatest concern which remains outstanding relates to the impact of these rules on loss-making or struggling UK groups/sub-groups, which will be carrying forward interest expense, restricted by the lack of tax-EBITDA in years where there are performance issues, or in start-up periods. This carried forward interest expense will in some cases be inaccessible in later, profitable periods, particularly for UK-only groups, due to the operation of the modified debt cap, which will restrict capacity to current year net group interest. HMRC is aware of this issue and is considering whether it is possible to resolve it.

This revised draft also contains the long-awaited public infrastructure election rules, which are complicated and in many cases would be of limited benefit. Some groups may be able to take advantage of grandfathering provisions for related party debt, although these are tightly defined and very specific in application.

Although it is clear that every attempt has been made to produce coherent legislation, there is no doubt that these rules are extremely complicated and many groups will have a significant amount of work ahead of them to determine the impact these rules will have on them, and to maintain the necessary calculations on an ongoing basis.

What has changed?

In addition to publishing outstanding areas of legislation, a number of changes have also been made.

Definition of interest capacity

Interest capacity is broadly the amount calculated under either the fixed ratio, or the group ratio if the group so elects, supplemented by carried forward capacity  However, in an amendment to the previously published draft, the current year allowance has been extended to include the group’s net tax-interest income.  This is a positive change, as it effectively provides benefit for periods in which the group has net taxable interest income in the UK, potentially through the reactivation of previous disallowances or by carrying forward the capacity to future years, albeit excess interest capacity can only be carried forward for a maximum of five years.

Tax-EBITDA – tax reliefs

In an extension to the initial draft, the revised legislation has significantly extended the tax reliefs which are excluded from the calculation of tax-EBITDA. The exclusion of research and development and patent box reliefs was expected, but a number of other tax reliefs, including charitable donations, contaminated land relief, pre-trading losses and creative tax reliefs such as film, television and video games reliefs, are also excluded. The impact of this is an increase to tax-EBITDA for companies which are claiming these tax reliefs, thereby ensuring that the benefit of these reliefs is not diluted by reduced interest deductions.

Matched interest

The consequential amendments include a re-write of the “matched interest” provisions, which can exempt certain loan relationship profits of a CFC.  Such profits will be fully exempt where a group has net interest income for a period; where there is net interest expense, the excess of the CFC income over this net interest expense will be exempt. This rule is similar to the existing rule which is based on world-wide debt cap definitions; however, the amount of the exemption may change from under the current rules as the relevant amounts are now defined in line with the interest restriction rules and, as a result, they will pick up (for example) derivative amounts, which would have been excluded under the current rules.

Whilst this is a positive addition, CFC apportionments generally still are not included in tax-EBITDA and tax-interest.

Outstanding areas for which legislation has now been released

The first draft of the interest restriction rules were incomplete in a number of areas, including:
       Detailed definitions forming part of the group ratio;
       Elections to mitigate tax and accounting mismatches;
       Rules for particular industries, including oil and gas and REITs;
       The Public Infrastructure Exemption;
       Definitions of related parties and acting together, which is relevant for the group ratio; and
       Various administrative provisions such as Revenue and Customs powers and the associated penalty regime.


Group ratio

The revised legislation contains the outstanding definitions which now enable the group ratio to be calculated.  The definitions of “qualifying net group-interest expense” and “group-EBITDA” are broadly in line with expectations.  The rules also include the modified debt cap rule, as it applies to the group ratio.  

Derivative contracts subject to fair value accounting

The impact of significant differences between the tax and accounting treatment of certain items was one of the major areas of concern when these measures were under consultation. These differences could lead to significant volatility for some groups and, potentially, absolute disallowances of significant amounts of third party interest expense.  The response to the consultation, published alongside the first draft of the legislation, stated that the rules would provide for an election to adjust these amounts in the calculation of the group-EBITDA to align accounting profits and group-EBITDA more closely with the UK tax rules.

Although other relevant tax/accounts mismatches have been included within an election (discussed further below), the impact of differences between the accounting and tax treatment of fair value movements on derivatives was considered so significant that the revised rules require a mandatory adjustment for these amounts, rather than an election.

The adjustment effectively deems the “disregard regulations” to have been applied, for the purposes of calculating the group ratio, where the conditions or the regulations would have been satisfied by the group – so basically, where there is a hedging relationship between the derivative contract and an asset, liability, receipt or expense.  The adjustment applies for the purposes of calculating:


       Group-interest – affecting both the group ratio and the modified debt cap for the purposes of the fixed ratio, for example to impose an accruals basis of accounting for interest rate swaps; and
       Group-EBITDA – to effectively impose a realisation basis of accounting for contracts such as commodity hedges.

This is a welcome change, as the potential disallowance of losses on third party derivatives and distortion caused by fair value movements was a very significant potential issue.  However, the adjustment is mandatory and therefore, it could create a significant compliance burden for groups with derivative contracts, including where those contracts are held outside of the UK and including where groups simply hedge FX risk using forward contracts, which is very common.

Whilst this adjustment is a positive change for many groups, a few may find themselves with mismatches where the derivative contract and related hedged item are not held in the same group company, as, in these circumstances, the legislation deems them to be for the purposes of calculating group-interest and group-EBITDA, whereas the conditions in the disregard regulations may not actually be met for the purposes of calculating taxable profits (feeding through to tax-EBITDA and tax-interest). To the extent that the disregard regulations do not apply to a group by virtue of no election having been made, groups can elect to deem that such an election has been made for the purposes of calculating tax-interest and tax-EBITDA under the interest restriction provisions.


Capital expenditure adjustments

In calculating group-EBITDA, adjustments are made to exclude mattes including depreciation, amortisation, impairment losses, fair value movements and disposal gains/losses in respect of ’relevant’ capital assets.  Relevant capital assets include property, plant and equipment, intangible fixed assets, goodwill and share investments.

This clarifies that fair value movements on fixed assets, which could have been distortive for property groups in particular, will be excluded from the group ratio calculations.  The adjustments are mandatory, similar to the derivatives adjustments above, due to the potential distortive impact of fair value movements.


Group ratio blended election

Joint venture companies and consortium companies are often funded by related party debt due to their inability to access debt on terms as favourable as their joint venture members.  The exclusion of related party debt from the group ratio calculation could prevent these companies from being able to benefit from a group ratio election. The group ratio (blended) election provides a possible solution for some joint venture and consortium companies, although it does not go as far as allowing debt raised from third parties by the joint venture partners and on-lent to the joint venture company to be treated as third party debt and, therefore, this measure will not be sufficient to resolve disallowances likely to be suffered by highly leveraged joint ventures..

The election enables joint venture companies to elect to calculate their interest allowance on a blended ratio, comprised of a pro-rata share of each investor’s fixed ratio or group ratio, whichever is higher. The resulting blended ratio would then be applied to the joint venture company’s tax-EBITDA to determine its tax allowance.

Interest allowance (alternative calculation) election

This election enables groups to, broadly, align the calculation of their group-interest and group-EBITDA with the UK tax rules in respect of five areas which could cause significant distortion in the calculation of the group ratio.  The affected areas are:
       Capitalised interest in stock (to include P&L movements within group-interest);
       Profits and losses on disposal of capital assets (to align these with capital gains/allowable losses for tax purposes);
       Employers’ pension contributions (to include contributions when paid);
       Employee share acquisitions (to include awards for which tax deductions are taken); and
       Changes in accounting policy (to reflect e.g. the future spreading of adjustments under the Change of Accounting Practice Regulations).

If the group chooses to make the election, it is required to adjust all five of these areas.  Once made, an election is irrevocable.

Public Infrastructure

Following significant consultation with interested parties, the public infrastructure election will not be irrevocable. Instead, an election may be revoked, after it has been in force for five years. Similarly, once revoked, another election cannot be made for at least five years.

The rules are complicated and “qualifying companies” will need to work through them to determine whether the election will be beneficial, particularly given the length of the ‘lock-in’ period. The rules include provisions to prevent companies falling out of the rules where temporary circumstances cause them to fail to qualify for no more than five days throughout an accounting period.

The public infrastructure election operates to exempt interest expense for the purposes of these rules; however, this generally only applies to third party debt. The rules also contain limited grandfathering provisions for pre-13 May 2016 loan relationships including those held by related parties; in practice, these are likely to have limited application due to the prescriptive conditions (in particular, at least 80% of a company’s qualifying infrastructure receipts need to be highly predictable for a period of at least 10 years from 12 May 2016, by reference to a contract entered into with or procured by a prescribed public body).

The election must be made prior to the start of the accounting period for which it will have effect, albeit this deadline is relaxed for periods commencing on or before 31 December 2017, where companies may make an election on or before that date, giving affected companies time to consider their options in their first period of application.  

In order to qualify for this election, in addition to meeting the public infrastructure assets and public benefit test, a company must be fully taxed in the UK.  The implications of this are that a company which has elected into the public infrastructure regime cannot make a claim for double tax relief or make an election to exempt a foreign branch during the time the election is in effect.  Although this is in line with the provisions in the fixed ratio and group ratio which reduce EBITDA for income upon which foreign tax has been paid and which has therefore benefitted from double tax relief, and may be limited in the number of companies it affects, it is a restriction which companies will need to take into consideration in the election decision.

The election will only apply to companies in a group which meet the qualifying conditions.  To the extent that a group comprises of qualifying and non-qualifying companies the non-qualifying companies will still be subject to the interest restriction provisions.  In this case the tax-EBITDA and tax-interest amounts of the qualifying companies are excluded entirely from the calculation of the fixed ratio and generally the 2m de minimis amount is not available.

Related parties

Parties are considered to be related to one another in one of three circumstances:
       Where they are consolidated for accounting purposes;
       Where one participates in the management, control or capital of the other (or where the same person participates in the management, control, or capital of both); or
       Where one party has a 25% investment in the other, or a third person has a 25% investment in both relevant parties.

The provisions defining related parties, which are relevant to the group ratio, are likely to cause uncertainty for many groups as some are subjective and may be difficult to interpret.  In particular, the 25% investment definition contains a number of ‘acting together’ provisions which are potentially very broad, including: a test along the lines of the concept of ‘broader collaboration’ between investors, included in the consultation document; and lenders holding debt and equity in the same proportions.

Perhaps the area of greatest concern is the deeming of certain loan relationships to be related party where a third party loan is guaranteed by a related party. This provision appears likely to impact a significant number of groups whose third party debt is guaranteed by a group member company, although we assume that this is not the intention and we will raise the issue with HMRC.

The treatment of debt as third party where related parties hold less than 50% of a single debt issuance has been included in the rules.

Anti-avoidance

The main anti-avoidance provisions remain unchanged; however, additional provisions have been added in an attempt to clarify that transactions will not be caught to the extent that they arise wholly from ‘commercial restructuring arrangements’.  The definition of such arrangements is exhaustive and restrictive and whilst the clarification that arrangements which bring new loan relationship receivables into the UK will not be caught by the anti-avoidance is welcome, clearer guidance is needed to enable groups to determine whether transactions having similar effect will likewise be outside the scope of this widely-drafted rule.

Compliance and administration

The compliance and administration requirements of these rules are onerous.  The rules apply to companies of any size and will therefore introduce some level of complexity for all corporation tax payers.

Whilst the rules do allow an election to file an abbreviated return, this is not open to groups which want to carry forward excess capacity. This appears excessively punitive.


Elections

The legislation allows taxpayers to make a number of elections in applying these rules, including:
       A group ratio election – to use the group ratio instead of the fixed ratio;
       A group ratio blended election;
       An interest allowance (alternative calculation) election;
       An interest allowance (non-consolidated investment) election;
       An interest allowance (consolidated partnerships) election; and
       A public infrastructure election.

With the exception of the public infrastructure election, these elections can all be made (and revoked, if applicable) in the interest restriction return.



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