In my blog discussing the information provided in the UK’s Business tax road map on interest deductibility I highlighted a number of areas of uncertainty. In May 2016 the Government issued a further consultation document, “Tax deductibility of corporate interest expense: consultation on detailed policy design and implementation” providing more information on the new rules. From 1 April 2017 the UK will be introducing a fixed ratio rule limiting a group’s UK tax deductions for net interest expense to 30% of its UK EBITDA. The group ratio rule will be available to groups which have high levels of external debt for commercial reasons.
7 new things we now know about the proposed rules
1. New concept of “Tax interest”
A new concept of tax interest includes interest on debt, derivative contract debits and credits, interest under finance leases and notably, refinancing break costs. It is the net tax interest of the group which needs to be considered for the 30% test.
Of particular importance to the project finance sector is that finance income generated on service concession financial assets is defined as tax interest.
2. New concept of group wide “Tax EBITDA”
We now know that the 30% test will be applied to tax EBITDA which will be calculated on a group wide basis. This is essentially the taxable profits of the UK group but with tax interest, tax depreciation (including capital allowances), tax amortisation, all company level loss relief and any amount surrendered or claimed via group relief from fellow group companies added back.
3. The public benefit project exclusion (PBPE)
Third party interest in some public benefit projects will not be subject to the new interest deductibility rules. The main conditions for the exclusion borrow heavily from the wording used in the accounting standards for public to private service concessions. For example, the project must involve the provision or upgrade, maintenance and operation of project assets and must have at least a 10 year term.
The definition of a procuring public body is more widely drawn than some commentators had expected and includes local authorities, designated educational establishments, health service bodies and Government departments, giving comfort to sectors such as student accommodation, street lighting and waste where some projects may now benefit from the PBPE. Doubt remains for other deals such as those in renewables, rolling stock and regulated utilities.
If a project meets the conditions it can exclude third party interest expense, the interest income and the EBITDA of the project from the group’s calculation of the fixed ratio rule restriction. As this impacts the whole group, consideration needs to be given as to whether applying the PBPE will provide the best possible outcome.
4. Definition of group
It is at group level that the fixed and group ratios will be calculated as well as some of the concessions provided, such as the £2m de minimis threshold.
The UK is following the Organisation for economic co-operation and development’s (OECD) suggestion of basing the definition of group on the International Financial Reporting Standards (IFRS) consolidation rules. Project finance companies typically have limited recourse finance and some would have preferred that any interest restriction could be calculated on a stand-alone basis without reference to the position of other group companies as the group aspect adds an extra layer of complication. However, the Government has reaffirmed that the calculation is to be made by reference to the group’s tax EBITDA.
5. Adjustments for interest and earnings volatility
To address interest volatility, where interest is disallowed it becomes known as restricted interest but this can be carried forward indefinitely. The restricted interest will not be considered a carried forward loss and therefore will not be subject to the new loss restriction rules discussed below. Carry backs of restricted interest will not be allowed.
Earnings volatility is to be smoothed by the ability to carry forward spare capacity calculated as the interest limit for the year less the actual net interest expense. The Government is proposing that this capacity can be carried forward (again no carry back will be allowed) but with a three year expiry.
6. Interaction with other rules
One of the uncertainties around the new rules was the interaction with existing and other proposed legislation and greater clarity has now been provided.
For example, in the March 2016 Budget the Government announced its intention of reforming the UK’s tax loss rules which included a restriction on the utilisation of brought forward losses, such that only 50% of taxable profits can be offset. We now know that the utilisation of brought forward tax losses is to be considered after the deduction of interest including the utilisation of any brought forward restricted interest. This interaction of the two new sets of rules is likely to bring forward the payment of tax for some types of deals in the project finance sector and could result in unused losses at the end of projects (although this risk is mitigated by the new ability to surrender carried forward losses via group relief).
In addition, the amounts to be included in the calculation of tax interest will be after any adjustment required under other targeted legislation such as the UK’s transfer pricing rules.
The Government previously indicated that it would only allow grandfathering in “exceptional circumstances” and this is still the Government’s stance.
There has been some welcome news while some areas of uncertainty remain. Particularly welcome will be the news that service concession accounting finance income is included in tax interest and the fact that the PBPE is more widely drawn than many anticipated, although some project finance deals will still be unsure whether they can take advantage of the exclusion.
On the downside it will not be possible for many project finance companies to calculate their interest restriction without reference to the group wide tax EBITDA which may create uncertainty.
We await the draft legislation after the consultation period closes on 4 August – there is still time to make representations to Government to shape the direction of the proposals.
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 don’t hesitate to get in touch.