An update by Iain Kerr on the reform of the substantial shareholdings exemption as confirmed in the Finance Bill 2017, providing an overall simplification to the trading conditions.
Note to the reader: The measures examined in this article have been removed from Finance Act 2017. We understand that the Financial Secretary to the Treasury has notified the House of Commons that these delayed measures are intended to be reintroduced at the earliest opportunity post-election. The expectation is that if the measures are reintroduced, this would occur in a summer Finance Bill soon after the election, and we recommend that business assumes that the start date of these measures remains as 1 April 2017 until there is an announcement by Ministers.
From 1 April 2017, if reintroduced, a new corporate interest restriction (“CIR”) regime will disallow interest-like expenses to the extent that the net tax-interest expense for UK companies (broadly, finance charges taken from the UK tax computations) exceeds the interest capacity.
The interest capacity is based on a percentage of tax-EBITDA (earnings before interest, tax, depreciation and amortisation) or, if lower, a modified debt cap limit, but is always at least £2 million. The percentage to be used is derived from either the fixed ratio method or, by election, the group ratio method.
The legislation which was included in Finance (No. 2) Bill 2017 reflected a large number of changes to the draft legislation issued on 26 January 2017. Key changes, in the context of M&A transactions, are as follows.
Group ratio method and related parties
For the group ratio method, interest like expenses arising on amounts owed to a related party are excluded, thereby reducing the capacity to deduct interest.
Related party borrowing includes third party borrowing where a related party provides a guarantee, indemnity or other financial assistance. There was concern that third party debt could be excluded from the group ratio calculation simply because, for example, a parent has guaranteed its subsidiary’s third party borrowing. However, this rule will now not apply to a related party guarantee which is:
Persons are treated as related if, for example, one is entitled to receive 25% of income available for distribution or 25% of the assets available for distribution on a winding up of the other. Helpfully, this has been revised so that it only applies for persons who have an equity like interest in the borrower. So, interest on a third party normal commercial loan should not be excluded from the measure of group interest even if the lender would be entitled to more than 25% of the assets of the borrower on a winding up, perhaps because of the nature of their security rights.
There is a new exclusion where persons become related as a result of certain corporate rescue type transactions, using similar wording to reliefs in the loan relationship rules. Persons will not be treated as related parties, broadly, where they would otherwise become related as a result of a release of a loan relationship and it is reasonable to conclude that, without the release and associated arrangements, there would be a material risk that, at sometime within the next 12 months, the borrower would be unable to pay its debts.
Relief for amounts which have previously been disallowed
Net interest-like expenses which have been disallowed under the CIR rules can be carried forward indefinitely and utilised in a later period subject to the limits applying for that later period.
The restriction on relief for interest is based, in part, on a measure of the net financing cost recognised in the income statement in the group accounts, known as the debt cap. The debt cap rule has been amended to make it easier to utilise interest expenses which have been disallowed in an earlier period. This can be modelled when assessing expected cash flows in relation to an acquisition.
A priority rule has been included so that it is clear the CIR rules should be applied after the hybrid and other mismatch rules. The interaction of these two sets of rules is discussed further in another article on Hybrid mismatch rules – practical implications.
Transitional treatment on 1 April 2017, including final period under the worldwide debt cap regime
Where consolidated accounts for the group straddle the commencement date of 1 April 2017, financial statements are treated as drawn up for the period to 31 March 2017 and from 1 April 2017. A similar provision will now apply for the final period of the worldwide debt cap provisions to 31 March 2017.
The CIR regime represents a major reform of the tax treatment of financing transactions. Those adversely impacted will not just be multi-national groups but can include groups which only operate in the UK. Inevitably, even for those groups which do not suffer a disallowance, there will be a significant additional compliance burden.
The large number of changes reflected in Finance (No. 2) Bill 2017 will take time to digest. However, many of the changes result from HMRC’s engagement with interested parties as part of the consultation process which has been approached in a positive and open manner and the changes are expected to improve the rules.
We would encourage groups to model the impact of the new rules to assess the potential impact on cash tax payments and start to consider what elections may be of benefit.
For further commentary on the measures included in Finance (No. 2) Bill 2017, visit our website here.
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