On 5th December 2016, the Government released its response to the May 2016 consultation document and published some of the draft legislation relating to the BEPS interest deductibility proposals.
Although a delay in the regime start date had been requested, it was confirmed that the legislation will come into effect from 1 April 2017 but there was some good news for investors in the information released.
Glad tidings we bring
We now know that the legislation for the new rules will include a widening in scope of a number of previously announced concessions and a relaxation of the Government’s previous stance in respect of grandfathering. There will be a further batch of legislation released in January 2017.
The Government is proposing to allow grandfathering for some existing public benefit infrastructure deals in respect of related party debt. This will apply for any companies that elect into the new Public Benefit Infrastructure Exemption (PBIE). Provided the related party debt was in place by 12th May 2016 and certain conditions are met, the interest payments will not be caught by the new interest restriction rules. Given the pre 12 May 2016 rule, groups acquiring existing project companies will need to think carefully before refinancing related party debt held in the project company. For investors in project companies where the related party debt has been, or will be, agreed after 12 May 2016, the most welcome news is that the PBIE has now been extended.
Public Benefit Infrastructure Exemption (PBIE)
Following representations on the narrowness in scope of the previously announced exemption, the PBIE will now also include companies with projects in renewable energy generation, the rail network, ports and airports as well as water, gas and electricity transmission infrastructure. The definition of public benefit services has been extended to include the provision of rental property to unrelated parties, though no detail has yet been given.
It was also good news for project companies in the waste sector as latest guidance suggests that they may be able to elect into the PBIE. Where ancillary services (such as energy from waste sales to third parties) enable public benefit infrastructure to be provided on an economically viable basis, this should not prevent a company qualifying.
How the Exemption Will Work
The PBIE is now on a company by company basis, as opposed to project by project. Groups electing a project company into the PBIE will disregard the third party debt and tax-EBITDA of that company in the group interest restriction calculation. However, interest on related party debt will still need to be included. Companies have to elect into the regime and there may be some situations where not doing so will be more beneficial for the group as a whole. Once made the election is irrevocable but it is unclear whether project companies will have only one opportunity to make the election or if there will be an option to make the election at any time during the life of the project. Draft legislation on the PBIE is due in January 2017.
The Government has also extended the ability to carry forward spare capacity from three to five years in light of submissions made to the consultation. This means that where the maximum deduction of interest is not made in one year, the unused capacity can assist in the setting off of interest in subsequent periods when there may be reduced capacity in period due to falling tax-EBITDA or more interest to be deducted.
There was also good news for joint ventures. An election will now be available to use a “blended group ratio” based on the weighted average group ratios of their corporate investors. More details due in January.
There are still some areas of uncertainty, particularly around the group ratio rule, and the administrative burden will be onerous for many groups.
Group Ratio Rule
The full draft legislation for these rules will not be available until January 2017, so there is still uncertainty surrounding how they will apply. We do now know that the group ratio will be capped at 100% of tax-EBITDA. Where the group ratio method provides a better result than the 30% fixed ratio, the UK group can use the group ratio instead. The group ratio percentage of the aggregate tax-EBITDA of the group is compared with the qualifying net group-interest expense of the group and the lower amount is taken. The group ratio is calculated as the qualifying net group-interest expense divided by the accounts-EBITDA of the group. Interest payable to related parties such as shareholders will not be included in these calculations. It is probable that the various EBITDAs will change every year and only be known with hindsight, so groups will need to consider how to approach this uncertainty from a financial modelling perspective.
The compliance burden in relation to the new interest deductibility rules is likely to be significant. A group company will need to be nominated to act as the “reporting company”. This company will be responsible for submitting the new interest restriction return which will include details of all relevant group companies and the calculations for the period. The return will nominate which UK companies with net tax-interest expense will suffer any disallowance for the period. The possible impact on the interest deductibility calculations when assessing the sale of a group company or the purchase of a target will need to be considered.
Modified debt cap
The Government is repealing the worldwide debt cap regime and introducing a modified debt cap as part of the new interest deductibility rules. As yet there is no equivalent of the Gateway test for the modified debt cap rules, so the regime will potentially be more administratively burdensome than the old worldwide debt cap.
New Year Resolutions
Many of the changes announced will be welcomed by the infrastructure sector as a number of the concerns raised during the consultation process have been recognised. However, there is much for groups to consider between now and 1 April 2017.
Groups will need to digest the draft legislation to assess their position, hampered by the fact that it is incomplete in key areas around the group ratio rule and the PBIE. They will also need to start putting processes in place for the onerous reporting requirements and will need to identify the UK and worldwide groups that will be subject to the rules. Whether to elect into the PBIE will also need to be considered, particularly as it will not always give the best outcome for the group and the election is irrevocable.
While the developments that we have seen should provide lenders with more comfort, we might also expect to see new clauses inserted in loan agreements requiring that no group interest disallowance will be apportioned to the borrower project company unless it is unavoidable.
More information on some of the principles of the new rules including the concepts of tax-EBITDA, tax-interest and the fixed ratio rule can be found in my previous blog released post the May 2016 consultation and earlier blog following the March 2016 release of the UK’s Business Tax Roadmap.
We await the next batch of draft legislation in late January 2017.
If you have any questions regarding the above or would like to speak to someone at Operis about how the new rules may affect you, please do get in touch.