On 26th January 2017 the Government released a new batch of draft legislation for the BEPS regime and further amendments were announced in the Budget of 8 March 2017.
The new rules will limit interest deductions to 30% of the aggregate tax-EBITDA of the UK companies within a worldwide group or, where it is greater than 30%, the worldwide group’s ratio percentage of the aggregate tax-EBITDA. The group ratio percentage is derived from the net group-interest expense of the group to its consolidated accounting profits. Each group will be able to deduct £2m (the de minimis) of its interest expense. A Public Infrastructure Exemption (PIE) for relevant companies will be introduced whereby interest on third party debt and some pre-May 2016 connected party debt is ignored for the purposes of the restriction.
The PIE and the group ratio calculation rules have been drafted into legislation and there was positive news too on the refinancing of grandfathered debt.
A significant change is that flexibility has been introduced into the PIE election, and it is no longer irrevocable. The election will apply indefinitely unless revoked but the option to revoke is now available after the election has been in force for at least five years. Once revoked, a new election can only be made after a further five years.
To claim the PIE you need a qualifying infrastructure company with qualifying infrastructure.
Qualifying infrastructure companies
We now know that there will be five main conditions to meet the definition of a qualifying infrastructure company. Two are that the company is subject to UK corporation tax, and that you must elect into the regime. The other three are:
I. The income test – whether income is derived from qualifying activities.
II. The asset test – whether the company recognises the qualifying asset in some form on its balance sheet.
III. The comparative debt test – whether the level of debt in the project company is not dissimilar to that used for other infrastructure projects in the same group.
Income test: All but an insignificant amount of revenue must be derived from qualifying activities. “Insignificant” is not defined so companies e.g. in the waste sector, which use third party income to offer their public benefit services at a better price might not be eligible, although previously the Government indicated in its December 2016 response to the consultation that they would be.
Comparative debt test: As anyone who has been through a transfer pricing benchmarking process will attest, finding a directly comparable project or company for tax purposes is difficult and expensive. In the March Budget 2017, the Government indicated that the wording of this test will be relaxed to exclude non-UK and non-PIE companies.
Two types of asset are eligible for the PIE: tangible UK infrastructure assets procured by a public body or used in the course of a regulated activity, and buildings of a UK property business let on a short term basis (50 years or less) to unrelated parties. The infrastructure must be recognised in the financial statements of a fully taxable UK resident entity and have a useful economic life of at least 10 years.
A PIE election means that connected party debt entered into on or before 12 May 2016 will also be excluded from the group’s interest deductibility calculations as long as the majority (80%+) of future revenues from the infrastructure for the next 10 years is highly predictable under the agreement with the relevant public body. This suggests that interest on existing connected party debt for projects with less than 10 years to run will not be eligible.
Refinanced grandfathered debt will no longer fall out of the regime, although if the debt amount is increased or the term extended, the interest on the portion of the “new” debt created will not benefit from the exemption.
Considerations for electing into PIE
Electing into the PIE may not provide the best outcome for the group as a whole. It will not be beneficial where the inclusion of the project company’s numbers actually improves the overall group interest deductibility position by contributing net finance income (which is likely in projects where financial asset accounting applies). Where the overall group interest is already fully deductible under the fixed or group ratios, or indeed falls below the £2m de minimis, it will also not be beneficial. As the election can only be revoked after a minimum of five years, groups will need to consider the impact of the rules across that five year period rather than in one year in isolation.
While the PIE is in play, the relevant group will no longer have access to the £2m de minimis although the draft legislation includes a provision that the group should be left in a no better/no worse position than under the de minimis.
Definitions for the group ratio rule have now been fully drafted. As anticipated, a worldwide group will consist of all consolidated subsidiaries and the parent entity, with the UK group consisting of those members of the worldwide group that are subject to UK corporation tax. The consolidation must be under IFRS principles or an alternative framework specified in the draft legislation such as UK GAAP, US GAAP or Canada (PE) GAAP.
As joint ventures between unrelated parties will not be consolidated in either parent group, they will form their own group for the purposes of the rules. SPVs and holding companies that are accounted for at fair value in the parent accounts will also form groups of their own. There are opportunities and pitfalls to consider when applying the new interest deductibility rules for these small groups.
In the January 2017 draft legislation, any guarantee provided by a related party to a third party lender would automatically have made that debt connected for the purposes of these rules. The March Budget 2017 updated this so that the rules will not apply to certain performance guarantees, nor to all guarantees granted before 31 March 2017, nor will it apply to intra-group guarantees in the context of the group ratio rule.
The PIE is just one of a number of elections that can be made under the new legislation. Elections available to investors include the group ratio election and the blended group ratio election (to include their share of joint ventures when calculating the group ratio). Careful thought and analysis should be given to the numerous options available to ensure that groups reach the optimum position.
Countdown to 1 April
The new rules come into force from 1 April 2017. We have come a long way in the short, but very eventful, space of time since the Government indicated in October 2015 that the UK would be in the vanguard of introducing legislation in line with the OECD’s report on interest deductibility in relation to countering BEPS. The framework of the UK rules is closely aligned to that suggested by the OECD though the Government has taken on board some of industry’s comments on its proposals along the way. We await the final legislation.
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 including whether you will be able to make use of the PIE and any potential grandfathering, please do get in touch.