UK Government published draft legislation on 5 December 2016 in respect of three important areas that directly affect UK infrastructure investments.
UK Government published draft legislation on 5 December 2016 in respect of three important areas that directly affect UK infrastructure investments. These are:
• BEPS4 restriction of UK interest deductions
• Reform of the Substantial Shareholdings Exemption (capital gains exemption on disposal of shares)
• Carry forward of tax losses
The draft rules are extensive and our initial observations on this complicated legislation are set out below. However the legislation is not complete and further detail will be available in January. Based on our discussion with HMT this week, they understand it might be frustrating not to have received the draft tax law on matters such as the Public Benefit Infrastructure Exemption and Group Ratio Rule (this was a government work capacity/ volume issue), they hope the information issued this week gives further insight into the proposed framework of the rules. There is an opportunity to provide some further input before the rest of the draft law is published.
Summary of measures
Following the public consultation that took place over the summer of 2016, draft legislation has now been issued that sets out the proposed new rules in relation to the restriction of corporate interest for UK tax purposes. The legislation is due to come into force as of 1 April 2017. Where a group (defined as IFRS consolidated group) has a period of account that spans this date it will need to consider two separate periods for the purposes of preparing the relevant calculations. Allocations between periods should be made on a just and reasonable basis.
The draft legislation and HMT/HMRC consultation response confirms that the key elements of the rules are consistent with the proposals set out in the original public consultation document:
• The rules will apply to net tax interest expense after the application of all other UK legislation that may restrict interest relief (i.e. transfer pricing, unallowable purpose, reclassification as equity etc.);
• The Fixed Ratio Rule (FRR) will limit a group’s UK tax deductions for net tax interest expense to 30% of its tax-EBITDA (earnings before interest, tax, depreciation and amortisation);
• A group may apply the Group Ratio Rule (GRR) if this results in a better position. The GRR will be calculated with reference to accounting EBITDA but then applied to UK tax-EBITDA. The legislation confirms that the amount of interest that can be deductible under the GRR is capped at 100% of tax-EBITDA.
• There will be a de-minimis allowance of £2 million per annum which means that groups will be able to deduct net tax interest expense of at least £2 million per annum;
• There will be a modified ‘debt cap’ rule (MDCR) that will cap the amount of net tax interest expense deductible under the new rules at the global net adjusted interest expense of the group. This rule will now apply from 1 April 2017 and is designed to replace the World Wide Debt Cap legislation which will be repealed from that date;
• There was a surprise with the classification of what would be related party debt into external debt for GRR (and PBIE) purposes where at least 50% of a class of issued debt is held by third parties. This represents an attempt to allow shareholder debt in circumstances where a material amount of that debt is willingly held by third party lenders on the same terms.
• There will be provisions to allow the carry forward of excess tax interest (indefinitely) and excess capacity (for five years – extended from three years following industry submissions).
Public Benefit Infrastructure Exemption
There will be a Public Benefit Infrastructure Exemption (PBIE) that will apply to certain businesses and will remove qualifying interest from the new rules. The exemption only applies on interest paid to lenders which are not related parties and which only have recourse to the income or assets of companies qualifying for the PBIE.
The definition of Public Benefit will be drawn much wider than originally suggested. Legislation is not available in this respect (it should come out in January 2017) however the government has suggested that the exemption applies to qualifying companies carrying out qualifying activities.
Sectors covered by the PBIE
• HMT/HMRC have taken on board the detailed submissions from industry to, firstly, include such an exemption and, secondly, to broaden this exemption to a wider range of sectors than those that would have satisfied the proposed definition in the original proposals.
• Whilst no draft clauses are yet available, the conceptual structure of the proposed law is set out in the Consultation Response which we have had the opportunity to test discretely with HMRC/ HMT in the past months. The principle underpinning the exemption is the identification of ‘qualifying activities’ being the provision, upgrade, or maintenance of ‘public benefit infrastructure’ and the undertaking of ‘public benefit services’ or ‘integral services’ using that infrastructure.
• The widening of the exemption compared to the original proposals comes from the decision to extend the concept of ‘public benefit services’ beyond those procured by a public body (such as in the case of PPPs) to also include those provided ‘in consequence of ‘specific arrangements’ made by Parliament … to ensure universal provision to the … general public’. ‘Specific arrangements’ for these purposes includes ‘those where Parliament has arranged for the market to provide the services to all those seeking them, or to all such persons that are licensed to use them under provisions made by Parliament’.
• It would seem that the industry-led submissions regarding the ‘spectrum’ of infrastructure ownership and funding models and the variety of ways in which the government intervenes to ensure delivery (i.e. ‘universal provision’) of essential services and protect the consumer has been worthwhile. The PBIE should cover sectors where there is some underlying legislation governing the sector (e.g. delegated statutory authority, control, licence or restriction etc.) and/or a body established by statute regulating the sector (e.g. to ensure satisfactory provision, quality and continuation of the relevant facilities/ services etc.). This should capture a range of sectors including those with some market risk (such as non-regulated airports and ports), as well as sectors with targeted support from government-led market frameworks (e.g. electricity generation) alongside those with more conventional economic regulation (transmission and distribution networks, water, regulated airports etc.).
• The Consultation Response states specifically for the first time the sectors they expect would be covered by these definitions as (i) water, gas and electricity transmission, interconnectors, distribution and supply, (ii) thermal (coal and gas), renewable and nuclear energy generation; (iii) port and airport operators; and (iv) the rail network. It is not clear whether telecom infrastructure (regulated by Ofcom through a general authorisations regime rather than a licence regime) is intended to be covered, and this will need to be clarified in due course.
• Integral services: The concept of qualifying activity for the purposes of the PBIE has also been clarified to include integral services being ‘ancillary services that are customarily provided using the … public benefit infrastructure … where such services enable public benefit infrastructure to be provided on an economically viable basis’. This is a welcome clarification which should result in the PBIE being applicable across the ‘value chain’ of a UK infrastructure business and not just to the company which contains the ‘core’ infrastructure asset. For example, this may include the retail component of an airport, which in effect subsidises the cost of the infrastructure itself. This may make the PBIE a more meaningful exemption and a viable alternative to the Group Ratio Rule in some cases.
• The Consultation Response document made a surprise reference to “the provision of rental property to unrelated parties”. There is therefore a recognition that some elements of real estate will qualify as public benefit infrastructure (albeit not property development) due to steady income flows. This appears positive from the perspective of some aspects of the real estate sector.
• Notwithstanding that certain sectors were named in the Consultation Response we understand this reflects an expectation rather than a definite intent of what is in and out of PBIE and it will be a case of applying the law to the facts in hand. In the initial years of applying new law, we expect non-statutory business clearances may need to be sought on a case by case basis from HMRC to obtain certainty.
Financing covered by the PBIE – third party vs. related party debt
• The Consultation Response acknowledges that a large section of the industry had argued for the PBIE to cover not only third party debt, but also arm’s length related party debt. The government have decided not to extend the PBIE to related party debt (other than through grandfathering of a limited sub-set of public benefit projects – see below), so it remains applicable to third party debt only.
• The benefit of the PBIE is therefore that it should at least provide more certainty in terms of ‘banking’ long-term financing tax assumptions at the outset of geared investments in public benefit infrastructure, a position that had been under threat through the long consultation process.
• Related party debt is still subject to restriction above the fixed ratio/ group ratio caps. However, a concession has been announced for scenarios where a related party (broadly an investor with a 25% or more interest, or parties acting together in a capital structure) holds debt and at least 50% of that class of debt is held by third parties. In that circumstance, the debt held by the related party will be treated as third party debt for the purposes of the rules. This may enable institutional investors with a preference for investing in a portion of the debt as well as the equity in a structure the ability to lower external leverage without tainting the third party treatment of the debt they own.
Grandfathering of existing arrangements
There will be a limited scope grandfathering provision on related party debt. The deductibility of interest payable to related parties can be preserved where all PBIE conditions are met and even so only to the extent the loan was agreed prior to 12 May 2016. The grandfathering is limited to cases where 80% of the qualifying company’s expected income has been materially fixed for 10 years or more by long-term contracts with, or procured by, public bodies or their wholly owned subsidiaries.
In effect, this should protect shareholder debt in certain PPP/ service concession arrangements and will be a welcome relaxation to the PPP sector (a question mark still exists in relation to the waste sector given its mix of commercial and public body revenues). Whilst limited in its scope, this is nevertheless indicative of some effort on the government’s part to protect investor confidence and mitigate damage to assumed returns, given the initial stance adopted in the consultation process that grandfathering would not be considered in the absence of an evidenced systemic risk to the sector.
Group Ratio Rule
• Many expressed concerns that the Group Ratio Rule (GRR) in the original proposals did not initially fulfil Government’s objective of allowing all external debt commensurate with UK commercial activities to be fully deductible due the various differences between accounting and tax-interest / tax and group-EBITDA.
• The rules will now provide for adjustments in the calculation of the relevant numerators/denominators of the ratios to better align Tax and Accounting measures and enable groups (particularly large UK groups such as airport and water utilities) to more comfortably claim their third party interest year on year.
• These adjustments include but are not restricted to:
o Optional election to exclude fair value (FV) movements on derivatives from the definition of tax-EBITDA (to operate in a similar way to the disregard regulations);
o Optional election to apply various adjustments to Group EBITDA to more closely align this with tax-EBITDA for the purposes of the GRR;
o Changes to the definition of Group Interest for the purposes of the GRR.
Detailed rules are incorporated in the draft legislation on how the new provisions will be administered. Specifically there is a new requirement to complete a new ‘interest restriction return’. The administrative and compliance process for applying the new rules is likely to be particularly onerous for UK Groups and adds another layer of complexity to the already comprehensive legislation in this area.
Taking into account the broadening of the PBIE and the correction of flaws in the GRR this should mean that infrastructure businesses should more comfortably be able to deduct their third party interest expense. This has been the position the industry has sought to justify from the outset of the consultation process given its low-risk BEPS status, particularly having regard to third party funding arrangements. There will be much work to do in understanding the detail when the legislation is released in January and investors/ companies will need to consider whether they could and would elect for the PBIE or rely on the GRR, which itself has options for election.
Relaxation of conditions for the investor company
For disposals on or after 1 April 2017, the condition that the company making the disposal must be a trading company or member of a trading group has been withdrawn.
The withdrawal of the investor trading condition removes many of the difficulties/ uncertainties surrounding the existing rules, not least for UK subsidiaries who may not have full visibility of the wider group and the challenges of applying the UK grouping test to non-UK entities. It will also enable groups with mixed trading/ investment activities to access the exemption for disposals of trading businesses and it will no longer be necessary to navigate the problematic conditions of the liquidation condition of the subsidiary exemption.
Qualifying institutional investors
A further extension of the exemption has been introduced for companies owned by qualifying institutional investors. The list of qualifying institutional investors contained in the legislation comprises: UK and overseas pension schemes, life assurance businesses, sovereign wealth funds, charities, investment trusts and widely marketed UK investment schemes.
Where a company making the disposal is ultimately owned by a qualifying institutional investor, the condition that the company being sold must be a trading company or holding company of a trading sub-group has also been withdrawn. This means that disposals of investment companies, for example real estate SPVs, can qualify for the exemption.
Where the company making the disposal is owned at least 80% by qualifying institutional investors, gains/ losses on disposal of shares will be fully exempt. A proportionate exemption will apply to a company owned more than 25% but less than 80% by qualifying institutional investors.
The ownership condition in the company can be direct or indirect but not traced through a listed company. Therefore companies controlled by investment funds where the investor base is substantially made up of qualifying investors should be able to benefit from the extended capital gains exemption on exit, either fully or on a pro-rata basis. Also, where the qualifying institutional investor condition is met, the substantial shareholding requirement itself has been extended to cover any shareholding with an acquisition cost of at least £50 million (in cases where the 10% minimum holding would not be met, so lower stakes can qualify).
However this is still not ideal for conventional ‘alternatives’ fund managers as they are not qualifying institutional investors in their own right, despite representations, including that of KPMG, pushing for this. Such fund managers will therefore need to consider whether they meet the full exemption based on their own investor base and whether they can identify >80% qualifying institutional investors or whether they fall into the 25% to 80% range for the partial exemption. We expect some funds to meet these conditions and therefore find it easier to establish/ use UK holding platforms particularly for their real estate activities. In our experience many funds may fall below the 80% (or not be able to forecast with certainty their investor base e.g. at fundraising stage) and therefore such funds may still find it difficult to utilise UK platforms with certainty.
There are two aspects to the reforms originally announced in the 2016 Budget:
• From April 2017, there will be a new restriction on the amount of profit that can be offset by brought-forward losses. The use of brought forward losses against current year profits in a UK group will be subject to an annual £5 million allowance. Above this allowance, there will be a 50% restriction in the profits that can be offset by losses brought forward; and
• There will be greater flexibility over the types of profit that can be relieved by losses incurred after that date. Essentially trading and other losses arising from April 2017 are carried forward against total taxable profit. Capital losses continue to be treated separately.
The changes will take effect from 1 April 2017. For accounting periods spanning the commencement date, there will need to be an apportionment with the old and new rules applying to the profits and losses either side of 1 April.
Key Changes since previous proposals
Companies will now be able to set post-April 2017 losses against total profits in future accounting periods. Companies will also be able to apply in-year reliefs across income streams at their discretion and the requirement to use pre-April 2017 losses before post-April 2017 losses will be removed.
Further, when a company ceases to trade, it will be able to carry forward losses without restriction for use against profits of the final 36 months of trading and a company’s losses will not automatically expire when it goes into liquidation. This will be helpful for fixed term projects, e.g. PFIs and OFTOs.
A notable general change includes the move to change the proposed definition of a ‘Group’ for these purposes which will now be based on the existing group relief definition (75% ownership with additional criteria) rather than the use of the IFRS 10 consolidation definition as originally proposed. This is coherent with the existing group relief legislation and a logical move.
KPMG continues to have serious reservations about the complexity of the computational steps. Companies need to retain parallel computations used solely to calculate the amount of loss available for relief which will also need to be reflected in any deal modelling.
KPMG has been involved in the consultation process on these tax reforms
conveying views from the infrastructure industry. We are due to meet with HMT
again shortly and therefore we are delighted to receive any questions and
comments that we can pass on.
For further information please contact our
infrastructure tax team:
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