Corporate interest restriction ‘devil is in the detail’ – derivative contracts

Corporate interest restriction ‘devil is in the detail’

This week’s article looks at how the regime applies to derivative contracts.

1000

Also on KPMG.com

This is the thirteenth of our series of articles looking at some of the detail of the new corporate interest restriction (CIR) rules which will apply from 1 April 2017. This article has been updated for changes made in the draft legislation issued on 13 July 2017. Certain aspects of the rules are intended to minimise volatility in the application of the interest restriction rules if derivatives are accounted for at fair value. However, this may result in an additional compliance burden.

There is a disallowance to the extent the net tax-interest expense for UK companies exceeds the interest capacity which is based on a percentage of tax-EBITDA or, if lower, a modified debt cap limit based on a measure of net interest-like expenses taken from the group accounts, but is always at least £2 million.

Derivatives which are within the scope of the CIR rules

For the purposes of the CIR rules, the following matters are included/excluded in respect of derivatives.

  • Include debits and credits from derivative contracts which relate to interest, currency and index of prices or corporate debt;
  • Exclude debits and credits from derivative contracts which hedge risks arising in the ordinary course of a trade where the contract was not entered into in relation to the capital structure of the worldwide group; and
  • Exclude debits and credits in respect of an exchange gain or loss.

Where derivative contracts are accounted for at fair value, exchange gains and losses are calculated using spot rates of exchange.

Optional transitional rule to apply the Disregard regulations when calculating net UK tax-interest expense/tax EBITDA

By way of background, the Disregard regulations apply, broadly, to amend the treatment of derivatives which are accounted for at fair value so that taxable profits and losses are recognised in line with the item which is being hedged by the derivative, e.g. a borrowing.

Under the CIR rules, an election can be made which is intended to exclude fair value movements from the net tax-interest expense and tax-EBITDA so as to reduce the volatility of such amounts. This could be relevant if a company is not applying the Disregard regulations in its computations but it would be beneficial to do so for the purposes of the CIR rules.

The election:

  • Effectively applies certain parts of the Disregard regulations when calculating the net UK tax-interest expense and tax-EBITDA;
  • Only applies to contracts entered into before 1 April 2020, is irrevocable and must be made by 1 April 2018;
  • Must be made by all companies (other than dormant companies) which were members of the group on 1 April 2017; and
  • Only applies for the purposes of the CIR rules and does not apply generally in the computations.

Debt cap - mandatory treatment of derivative contracts

The debt cap is a measure of the net financing cost derived from the income statement in the group accounts, which may include fair value movements on derivatives.

Broadly, where derivative contracts are accounted for at fair value in the group accounts and are acting as a hedge on a group basis then the group-interest in the debt cap amount must be calculated as though certain provisions in the Disregard regulations apply. For these purposes, the group is effectively treated as if it is a single company and the adjustments take account of derivatives in non-UK companies.

The intention is to remove fair value movements and include amounts in line with the item that is being hedged by the derivative contract.

The same principles are applied for both the fixed ratio method and group ratio debt cap limits.

Group ratio percentage - mandatory treatment of derivative contracts in the calculation

For each period, a group can elect to calculate the interest allowance using the group ratio method. This is calculated as a percentage by dividing a measure of net group-interest expense by group EBITDA, with both numbers based on amounts in the group accounts.

Net group interest expense includes certain amounts from specified derivative contracts (as described above). Amounts from derivative contracts not included as part of group-interest are included within group-EBITDA.

As with the debt cap calculations, broadly, where derivative contracts are accounted for at fair value in the group accounts and are acting as a hedge on a group basis then the group-interest and group EBITDA must be calculated as though certain provisions in the Disregard regulations apply. Again, the group is effectively treated as if it is a single company.

The previous articles in this series can be found here:

For further information please contact:

Rob Norris

Mark Eaton

Tax Matters Digest

View KPMG's weekly newsletter covering the latest issues in taxation and government announcements relating to tax matters.

 
Read more

Connect with us

 

Request for proposal

 

Submit

KPMG’s new-look website

KPMG has launched a state of the art digital platform that enhances your experience and provides improved access to our content and our people, whatever device you are on.

 
Read more