Robert Maas, Tax consultant at CBW, and Thomas Adcock, Head of Tax at CBW, explain why UK property groups need to be aware of the corporate interest restriction as well as potentially avenue of relief in the form of the public interest exemption.
This restriction was introduced in response to the OECD’s BEPS (Base Erosion and Profit Shifting) project. It is intended to ensure that the UK does not bear an undue proportion of the overall financing costs of international groups of companies.
Unfortunately, in the context of property investment, where borrowings are normally raised for a specific property or project and often secured on the project, it can work unfairly because it ignores that relationship between the borrowing and the asset.
The restriction denies a deduction for part of the interest and other financing costs incurred by a company within the scope of corporation tax. That part is based on the interest payments and profits of the entire international group. A company can be within the scope of corporation either because it is a UK company or it is a non-UK company that owns UK property.
Broadly speaking, there is no restriction if the interest (and other financing costs) incurred by all of those group companies within the charge to corporation tax is less than £2 million. Where it exceeds this figure, an interest restriction must be calculated and allocated between those entities within the charge to corporation tax. This can be calculated by reference only to UK profits. This is normally likely to be very unattractive in a property investment context. Alternatively, it can be calculated by reference to the group’s worldwide profits, and will, broadly speaking, be the proportion of group net interest that the profits of the companies within the scope of corporation tax bears to total group profits.
The calculation is complex; HMRC guidance alone extends to more than 500 pages long! What follows is a brief overview of the mechanics behind the calculation. We strongly suggest that if your UK group of companies net interest expense is around £2 million that you seek advice from your tax advisors.
The first step is to investigate whether you are within the rules at all. This requires you to establish the worldwide group and to calculate the UK group’s net tax interest expense. Establishing the entities that fall within the worldwide group is not that straightforward but it does not include companies that are simply associated with each other – they must be part of a group. The UK group’s net tax interest expense is the aggregate net tax interest expense (or income) of the UK group. This is calculated as follows:
|Company A||Company B||Company C||Aggregate|
The second step is to calculate the “interest capacity” of the worldwide group for the accounting period, i.e. the group’s financial year (or that of the parent company if all of the group companies do not have a common accounting date). The interest capacity is the group’s “interest allowance” for the accounting period plus any part of the interest allowance for the five previous years that was not utilised in the year.
The “interest allowance” is the sum of the “basic interest allowance” of the group for the accounting period plus the amount of any aggregate net tax-interest income of the group.
If the interest allowance calculation produces a figure of less than £2 million, the interest allowance is £2 million.
The group can calculate its basic interest allowance under either the fixed ratio or group ratio method. If it wishes to adopt the group ratio method, it needs to elect to do so in its Interest Restriction Return (see below under Returns). The election needs to be made separately for each accounting period.
Under the fixed ratio method, the basic interest allowance is the lower of:
- 30% of the aggregate “tax – EBITDA” of the group for the period, or
- the fixed ratio debt cap of the group for the period – which is the adjusted net group-interest expense of the group (plus any excess debt cap of the group generated in the immediately preceding accounting period).
For the purpose of (2) the net group-interest expense for an accounting period is the sum of the relevant expense amounts (i.e. interest and other financing costs) that are recognised in the financial accounts of the group as profit or loss, less interest receivable (and certain other items that are treated for corporation tax in the same way as interest receivable).
In both calculations, the aggregate tax – EBITDA of the group is the total of the tax – EBITDA for the period for every company that was a member of the group at any time in the period. If this is a negative figure, the aggregate tax – EBITDA is nil. The tax – EBITDA of a company is its adjusted corporation tax earnings for the accounting period less the excluded amounts (or the adjusted loss for the period). Accordingly, only a company within the charge to corporation tax can have a tax – EBITDA. Broadly speaking, the excluded amounts are interest and other financing costs, losses, deficits on loan relationships or management expenses brought forward from an earlier period, film and similar tax reliefs, group relief and R & D expenditure.
If the election to adopt the group ratio method is used, the group ratio percentage is the proportion that the qualifying net group-interest expense of the group for the period bears to the group-EBITDA of the group for that period. The group-EBITDA is the sum of the group’s profit (or loss) before tax, the net group-interest expense of the group and the group’s depreciation and amortisation adjustment. These amounts are all taken from the group’s consolidated accounts, which are required to be prepared either under International Accounting Standards (IAS), UK Generally Accepted Accounting Principles (UK GAAP) or the GAAP of either Canada, China, India, Japan, South Korea or the USA.
It will be seen that if the fixed ratio method is used, the calculation can be made using only the accounts that are needed for UK corporation tax purposes (unless the non-UK companies have net interest received). However, this limits the interest deduction (over all of the companies within the scope of corporation tax) to 30% of EBITDA, whereas in many property investment companies, the interest approaches 100% of EBITDA.
However, to make the group ratio election, consolidated accounts of the entire group are required. If these are not prepared in accordance with IAS or one of the acceptable national GAAPs listed above, they need to be prepared afresh in accordance with one of the qualifying methods.
The interest restriction is of course the amount by which the interest paid exceeds the interest capacity of the group.
The interest capacity is allocated among those members of the group that are within the scope of corporation tax. Provided that the group submits an Interest Restriction Return, this can be done in any way the group wishes. If no return is submitted, it is allocated in the proportion that the interest paid by each company bears to the total of such interest paid by all of the companies that are within the scope of corporation tax.
Special rules apply to joint venture companies and companies which are members of a partnership. The rules are modified in relation to banks and insurance companies, investment managers, certain shipping companies, public infrastructure companies and REITs.
Public Infrastructure Companies
Thankfully there is some help in the form of the public infrastructure exemption for UK property businesses.
When this was initially introduced, many if not most property business would not be able to meet the conditions as they would fail to meet the ‘public benefit test’ set down in the legislation which limits the exemption to companies providing oil and gas plants, schools and hospitals (for example). However, in order for companies not to be deterred from carrying on such businesses, parliament accorded UK property businesses special treatment and benefit from the CIR legislation via an alternative set of qualifying conditions which does not require the company to meet the public benefit test. Broadly the CIR public infrastructure exemption works by allowing all of the interest payable on loans to third parties – but no relief at all for connected party financing.
As you would expect, there are a number of conditions that need to be met in order for the company to meet the CIR public infrastructure exemption:
- The company meets the public infrastructure income test for the accounting period;
- The company meets the public infrastructure asset test for the accounting period;
- The company is fully taxed in the UK in the accounting period; and
- The company has made the relevant election within the time limit for doing so before the end of the accounting period
- The loans under which the interest is payable will limit the companies recourse to recover the assets of the company;
- Every source of the income the companies have at any time in the accounting periods are within the charge to corporation tax;
- The companies have not made an election to exempt part of its profits or losses from foreign permanent establishments;
- The companies have not made a claim for double tax relief;
- The companies carry on a UK property business and significantly all of its income derive from that business and significantly all of its other assets relate to that business; and
- The buildings being let out in the course of its UK property business are:
- Let on short leases or sub-leases (i.e. leases or sub-leases of less than 50 years) to parties that are not related to the company;
- Have an expected economic life of at least 10 years;
- Are recognised on the balance sheet of the company which is taxable in the UK.
The rules are complicated and care needs to be taken in not only reviewing existing debt structures but also in arranging new ones as whilst the law allows for the exemption to apply where debt is structured through intermediary holding companies, where the subsidiary qualifies as a qualifying infrastructure company, issues arise where eth debt is secured or guaranteed by a company that would not qualify for the exemption.
However, this is a welcome and valuable relief, without which may make a significant number of UK property groups unviable.
Where a company’s interest deduction is restricted, a special tax return, an Interest Restriction Return, must be filed in addition to the corporation tax return.
A group of companies can appoint a Reporting Company. However, if it does so, the Reporting Company needs to file an Interest Restriction Return each year, irrespective of whether or not the restriction in fact applies in a year. The Reporting Company needs to be one within the scope of corporation tax. The reporting company must submit an Interest Restriction Return to HMRC within the corporation tax time limit for the accounting period. This must contain any elections. This must show the name and tax references of all of the group companies within the scope of corporation tax. It must also show the calculation of the interest restriction and its apportionment amongst the UK companies that are within the scope of corporation tax. The group can decide how it wishes to allocate the restriction. However, if a company does not assent to the appointment of the reporting company, that company’s pro-rata share must be allocated to it. This is the proportionate that its interest expense bears to the total interest of all the UK taxable companies. It appears that this return has to be filed even where there is no interest restriction.
If you have any questions or concerns regarding the corporate interest restriction and changes from 1 April 2020, please get in touch with our tax team who will be able to assist you further.