In this second article in a series on recent tax developments and the challenges they present to companies in the UK we consider two new sets of complex rules that were introduced in response to recommendations made by the OECD as part of its “BEPS Project”: the new regime on interest deductibility that will take effect from 1 April 2017 and the hybrid mismatch rules that took effect on 1 January 2017. Between them they comprise over 200 pages of dense new legislation and many more of guidance, so a lot of midnight oil will be burnt by tax directors trying to determine how they apply to different group structures.
Interest deductibility rules
The interest deductibility rules aim to remove the benefits of putting disproportionate leverage into the UK. Various developed economies, such as Germany, Italy, Japan and Australia, have had similar rules for some time, but the UK rules will not be quite the same, which may create compliance headaches for groups operating across those different jurisdictions.
The rules will work by limiting the amount of interest that can be deducted for tax purposes by the UK entities in a group as a proportion of their aggregate EBITDA. This is subject to a group de minimis threshold of £2m of net interest expense per annum – the limit only applies to amounts above the threshold. A key point to note is that the new rules are not confined to related party debt; they could also apply to third party debt if the group’s UK interest burden is disproportionately high. So, these rules will go further than targeting tax avoidance and could affect arrangements which are not aimed at tax planning but simply reflect high leverage (or low profit).
The default rule will be the fixed ratio rule under which the tax deductible amount of interest is limited to 30% of a group’s UK EBITDA (unfortunately, it is not as simple as taking these numbers from the financial statements: each is calculated under specific tax rules). This is broadly equivalent to an interest cover ratio (i.e. an interest cover ratio below 3?:1 means part of the interest expense will be disallowed as a deduction for tax purposes), but for these purposes interest and EBITDA are calculated using specific tax principles.
In an attempt to mitigate the position for industries or groups that are simply highly geared in the UK (and often for good commercial reasons or misfortune), a UK subgroup that would be restricted by the 30% test may elect to apply the group ratio rule, which uses a ratio of interest to EBITDA based on the position of the worldwide group instead of the fixed 30% limit. In either case, there is an absolute limit on deductibility of the total external interest expense of the worldwide group, referred to the “modified debt cap”.
Where deductions are restricted, they can be carried forward to future years, provided that the ratio in those future years or the modified debt cap limit is not exceeded. If there is spare capacity (i.e. the full amount under the cap has not been used), it will be possible to carry this forward for up to 5 years. This is intended to mitigate the inherent uncertainty and volatility that arises as a result of the of rules that are calculated by reference to earnings each year. There are concerns that the way that these rules interact with the modified debt cap potentially undermines their effectiveness, especially for UK-only groups.
There is an exemption for companies that engage in qualifying infrastructure projects and for certain real estate businesses, but the rules will otherwise apply across all sectors; hopes that the government would provide a carve out for banking and insurance groups were not realised.
Hybrid mismatch rules
The hybrid mismatch rules broadly target cross-border arrangements that seek to exploit difference in the tax treatment of an entity or instrument under the laws of two or more tax jurisdictions. They focus in particular on two forms of tax arbitrage: payments that are deductible for the payer but not taxable in the hands of the payee, and payments that generate deductions in more than one jurisdiction.
The rules will mainly be applicable in related party situations, or where the tax advantage is in some way “structured”, such as being priced into the arrangement. They apply where the arrangements include a “hybrid instrument” or a “hybrid entity”. Essentially, a hybrid instrument is one that is characterised differently in the respective jurisdictions of the payer and payee: for example, an instrument that is treated as deductible debt for the payer but is equity for the recipient. A hybrid entity is one that is treated as a company in one jurisdiction but is transparent in another: this situation arises often in US-headed groups, as the US “check the box” rules allow groups to elect to treat subsidiaries as if they were transparent branches of their parent company for US tax purposes. A number of groups have financed their investments through so-called “tower structures” that involve chains of US and non-US companies that rely on this arbitrage. Any such structuring would need to be considered closely and is likely to be vulnerable to challenge under the new rules.
In general, the rules are very broad and can potentially apply in a wide range of situations where you might not expect. One particularly complex area of the new rules relates to “imported mismatches”. These are situations where the mismatch does not involve the UK directly, but where a UK taxpayer is party to wider arrangements where there is a mismatch in another jurisdiction. For example, if a UK borrower is funded by a simple loan from a Luxembourg holding company that, in turn, issues hybrid debt instruments to its non-EU parent, the rules could prevent a deduction in the UK borrower.
Both the interest deductibility rules and the hybrid mismatch rules will require an analysis of the position of non-UK members of a multinational group. Treasury and structuring decisions made outside the UK and with no direct relationship with the UK members of the group could have a material impact on the tax profile of the UK business. Even where the rules do not result in additional corporation tax, the requirement to consider the possible impact across the whole group will give rise to a substantial compliance burden.
James Burton is partner at Allen & Overy LLP.