UK Government Confirms Introduction of New Cap on Interest Deductibility
The UK Government has recently confirmed that it will be introducing a new cap on interest deductibility. Under the new rule, the ability of groups to obtain tax relief for interest will be limited by reference to a ratio of their net interest expense to earnings before interest, taxes, depreciation and amortisation (EBITDA). The new rule is expected to apply with effect from 1 April 2017, leaving private equity funds very little time in which to consider its impact and to refinance their existing arrangements.
In October 2015, the UK Government launched a consultation on the introduction of new rules to counteract base erosion and profit shifting (BEPS) arising from the use of interest payments. The outcome of the consultation was published as part of the Budget in March 2016, at which time the government confirmed that it would be proceeding with the introduction of a structural restriction on interest deductibility.
The new restriction is intended to operate alongside the various transactional-based restrictions already present in the UK tax code (such as the transfer pricing, distributions and unallowable purpose rules), and will apply with effect from 1 April 2017. The new restriction will in principle apply to both external and intra-group debt, so will not be precluded from applying solely by virtue of the fact that the interest in question accrues on debt advanced by a third party lender.
The UK Government is currently consulting on the detailed design of the new restriction, and intends to publish legislation later this year for inclusion in the Finance Bill 2017.
The Proposed Restriction
The proposed restriction has the following key features, and will apply on an accounting period-by-accounting period basis:
A fixed ratio rule (FRR), limiting UK tax deductions for net interest to a maximum of 30 per cent of a group’s tax-adjusted UK EBITDA.
An optional group ratio rule (GRR), which a group can apply in place of the FRR and which allows tax relief for interest to be calculated by reference to the group’s net interest to EBITDA ratio.
A £2 million threshold, whereby the new restriction will not apply to groups whose net UK interest expense does not exceed £2 million in any given accounting period.
The ability to carry forward spare borrowing capacity from one accounting period to the next (for up to three years), and the ability to carry forward restricted interest indefinitely.
A modified worldwide debt cap rule, which will apply in addition to the FRR and/or GRR, and which is intended to ensure that groups with low levels of external debt cannot leverage up their UK operations to the FRR limit.
Targeted anti-avoidance rules aimed at preventing the circumvention of the new restriction.
For groups that are not automatically taken out of the rule by the proposed £2 million threshold, there is likely to be a significant administrative burden involved with familiarising themselves with the new rule, and in identifying the relevant tax-adjusted amounts that have to be taken into account in applying it.
Critically, there is also currently no proposal for existing debts generally to be grandfathered. Whilst the government has indicated a willingness to grandfather unused interest expense carried forward from periods before the new rule comes into effect on 1 April 2017, the related principal amount outstanding on existing loans will not be grandfathered. This means that existing financing arrangements in place with portfolio companies as at 1 April 2017 will generally be within the scope of the new rule, at least in relation to interest accrued on or after that date.
Additionally, the interaction of the new rule with the UK’s existing ‘late paid interest’ rules could be particularly draconian. The late paid interest rules are still generally applicable to many private equity groups, and result in tax relief for interest accruals being deferred until the interest is paid in cash or in kind. Under the current proposals, if interest is accrued prior to 1 April 2017 but not recognised for tax purposes until then (or a subsequent date) by virtue of the late paid interest rules, the new cap on interest deductibility will apply. This could therefore result in the interest in question being non-deductible for tax purposes, even where (both economically and commercially) the interest is in reality pre-1 April 2017 interest.
The FRR will be applied on a group-wide basis, rather than on a company-by-company basis. For the purposes of the FRR, the definition of a “group” will be based on accounting concepts. In essence, a group will comprise the “ultimate parent” (generally the top level holding company in a corporate structure), together with all companies that would be consolidated on a line-by-line basis into the consolidated accounts of the ultimate parent.
For these purposes, collective investment schemes and limited partnerships are excluded from the definition of ultimate parent entities. In addition, the new rules are also likely to provide that subsidiary undertakings that are recognised at fair value in the accounts of a collective investment scheme (as opposed to being consolidated on a line-by-line basis) will form their own separate group.
The effect of either of these two provisions of the FRR should be that a portfolio investment owned by a private equity fund should not be treated as grouped with any other unrelated portfolio companies owned by the same fund. However, each “sub group” owned by the private equity fund will still need to consider the application of the FRR to its particular situation.
Definition of “Interest”
The concept of “interest” is extended by the FRR to comprise all payments that are economically equivalent to interest, as well as expenses incurred in connection with the raising of finance. This means that payments in kind (‘PIK’, sometimes also referred to as funding bonds) will have to be taken into account when applying the FRR, as will related payments such as guarantee fees.
However, in applying the FRR it is only the net interest expense position that matters, as financing income amounts (such as interest received) are netted off of financing expense amounts in order to reach a net position. It is the net position that is, in principle, subject to the FRR restriction on deductibility.
This is likely to be relevant to private equity funding structures involving multi-tiered acquisition vehicles used in debt push-downs. Typically, such structures will have been established to achieve structural subordination for different categories of lenders; as the debt is pushed down to portfolio companies by way of back-to-back lending, it should be the case that the FRR applies only in relation to the net interest position of the ultimate portfolio company borrower.
Interaction with Other Parts of The UK Tax Code
The FRR is intended to apply after almost all other parts of the UK tax code have been considered. This includes the UK transfer pricing rules, which means that private equity groups may still suffer a restriction on interest deductibility even if they have agreed with HMRC that the interest in question is arm’s length under an Advance Thin Capitalisation Agreement.
In addition, the UK Government has indicated that a modified debt cap rule will apply alongside the new FRR. This rule is intended to prevent groups that would not otherwise have high levels of external debt from leveraging up their UK operations to the FRR limit. In essence, the rule will “cap” the amount of UK net interest that a group can obtain tax relief for by reference to the net external interest expense of the group.
The modified debt cap rule will need to be considered in addition to the FRR itself, which in turn will need to be considered after the application of the more transactional-based restrictions in the UK tax code, such as the transfer pricing rules.
The government is proposing that interest that is restricted under the FRR should be eligible for carry-forward to future accounting periods indefinitely. This should mean that if there is sufficient capacity in those future periods, the carried-forward amount should become deductible, and should therefore be eligible for tax relief.
The government is also proposing that unused borrowing capacity (calculated by applying the borrowing limit under the FRR) from one accounting period be eligible for carry-forward for up to three future accounting periods.
These aspects of the rules will be helpful to private equity groups, as they should go some way to mitigating the impact of the new rules on earnings volatility across multiple accounting periods of portfolio companies.
There are, however, no proposals to allow the carry-back of interest that is restricted or of unused borrowing capacity, which is disappointing. In addition, the ability to carry-forward excess interest deductions may ultimately not be of any value in view of the forthcoming wider changes on the carrying-forward of losses (the CFL Rules), which were announced in the Budget in March 2016 and which are also expected to come into force on 1 April 2017.
The CFL Rules will limit the amount of profit that can be sheltered using carried-forward losses, such that only 50 per cent of profits in excess of £5 million can be sheltered. At present, the government intends that
Carried-forward losses from before 1 April 2017 will not be subject to the FRR, but will be affected by the new CFL Rules.
Interest that arises on or after 1 April 2017 and which is affected by the FRR will not be subject to the CFL Rules.
Losses arising after the application of the FRR will be subject to the CFL Rules.
Illustration of The Effect of The FRR
The following table illustrates the basic effect of the 30 per cent FRR rule as proposed by the UK Government
Taxable EBITDA (£m)
Net interest expense (£m)
Net allowable interest (£m)
Interest restricted (£m)
Under the GRR, groups can elect to apply a group ratio instead of the fixed ratio that applies under the FRR. The GRR is entirely optional, and the UK Government expects it to benefit only a small proportion of groups.
The GRR is aimed at groups that are highly leveraged for commercial reasons, and allows them to obtain tax relief for net interest deductions up to a limit in line with the group’s overall position. As such, the GRR is a welcome feature of the new rules that should go some way to mitigating their impact on groups whose funding structures do not present BEPS risks.
As first blush, the GRR may seem to be the obvious solution for private equity groups. This is because, as noted above, the private equity fund itself should not be grouped with individual portfolio companies. It might therefore be thought that debt advanced by the fund would count as ‘external’ for the purposes of applying the GRR, thereby allowing a higher degree of leverage than the FRR permits. However, the consultation paper indicates that debt advanced by a private equity fund will be ignored when assessing the amount of external debt under the GRR. This means that debt advanced by the private equity fund itself cannot be used to achieve a higher level of leverage than the FRR permits.
The FRR will generally have no grandfathering, and will apply from 1 April 2017. The rule could result in significant restrictions on interest deductibility for private equity-owned portfolio companies, where leverage ratios typically run in the x4 to x7 EBITDA region, and possibly even higher in the early stages of an acquisition.
All private equity groups should urgently be considering the ramifications of these forthcoming changes and the possible need to refinance their existing funding arrangements.