Real Estate Finance - Tax Deductibility of Payments of Interest
09 February 2017
The Finance Bill 2017 will introduce new rules to restrict the amount of profits that can be offset by interest expense for corporation tax purposes. The rules, which will implement one of the recommendations of the OECD BEPS Project, take effect from 1 April 2017. The Government has now published in full the draft legislation.
This bulletin summarises the new rules generally, discusses the exemption for real estate borrowers and considers some of the possible implications for non-resident landlords of being brought within the scope of corporation tax.
The rules will limit interest deductibility by reference to EBITDA ratios and there has been widespread concern as to their impact on real estate finance and other markets where high interest to EBITDA ratios are often seen. However, the draft legislation published at the end of January included provisions that may be very significant, and helpful, for the real estate sector. In a nutshell, there is a general exemption from the rules for third party debt advanced to a company that carries on a property rental business provided that certain conditions are satisfied. These conditions include limitations on the scope of the security package, which will need to be considered where a borrower is seeking to rely on the exemption. Although third party debt will fall outside the scope the cost of electing into the exemption is that shareholder debt will not be deductible for these companies.
The rules will only apply to companies that are subject to corporation tax, so, at least at the outset, they will not apply to non-UK resident companies that hold UK property as an investment. However, the Government has announced its intention to launch a consultation in the spring on bringing these companies within the scope of corporation tax. As a result, it will be important for non-resident landlords to monitor the position and the progress of the consultation.
The Interest Deductibility Rules
General Effect of the Rules
The 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 exactly the same.
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 £2 million 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 (interest and EBITDA are each calculated under specific tax rules). This is broadly equivalent to an interest cover ratio (i.e. an interest cover ratio below 3.33:1 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 tend to be highly geared, a company 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 worldwide group instead of the fixed 30% limit.
Where deductions are restricted, they can be carried forward to future years, provided that the ratio in those future years is not exceeded. If there is spare capacity (ie the full amount under the cap has not been used) it will be possible to carry this forward for up to 5 years.
The Group Ratio Rule
Even if the exemption for real estate companies does not apply, the group ratio rule could mitigate the impact of the new regime for real estate investors. As long as there is not a disproportionate amount of leverage in UK companies within the group (or significant non-UK EBITDA), the general effect is likely to be that interest on third party debt remains deductible. In calculating the worldwide group’s interest to EBIDTA ratio, interest paid on loans from related parties and loans that are profits dependent are not taken into account, so in most cases it will only be interest on the group’s third party commercial debt that can be used to calculate the overall interest to EBITDA ratio.
The definition of a group for these purposes will obviously be very important. For borrowers that are ultimately owned by an investment fund a key question will be whether the test applies across the fund's whole portfolio, which could produce anomalous results, or more narrowly. This will clearly depend to some extent on the way in which the fund holds its investments. There is, however, a provision in the definition of group for these purposes that may mean that conventional fund structures do not need to apply the group test across the whole portfolio. The basic group test is based on the definition of group for the purposes of international financial reporting standards and will include all consolidated subsidiaries of the ultimate parent company of that group. There is, however, a specific exemption where a subsidiary is accounted for as an investment at fair value and not consolidated on a line-by-line basis. Master holding companies in fund structures often constitute investment entities that may hold their interests in the underlying investment vehicles at fair value. Where this applies, the ultimate parent of the group for these purposes will be one tier below, so it may not be necessary to apply the group ratio test across the whole portfolio, but rather by reference to each sub-group.
Exemption for Real Estate Companies
It has always been contemplated that the rules would introduce some form of exemption for “public benefit” infrastructure to ensure that these projects continued to attract private investment. The draft legislation includes an exemption for these arrangements, but in the latest version this exemption has been expanded to cover not only conventional PFI projects, but also to include loans to UK resident companies that carry on a property rental business. This is a very significant concession for the real estate sector, although there are a number of conditions that must be satisfied in order for the exemption to apply.
The exemption is available on an elective basis and applies to interest paid on loans from unconnected lenders to “qualifying infrastructure companies” whose activities consist of the provision of public infrastructure assets. A building (or part of a building) that has a useful life of more than ten years and is held as a capital asset is treated as a public infrastructure asset if the company carries on a UK property rental business that involves letting the property to an unconnected tenant on a lease with an effective duration of 50 years or less.
In order for the exemption to apply the following further conditions must be satisfied:
1.all but an insignificant proportion of the company’s asset value must be derived from the building or from shares or loans to other qualifying infrastructure companies and all but an insignificant proportion of the company’s income must be derived from the rental activities or returns from such shares or loans. These conditions mean that it is likely that only property-owning SPVs (of the holding company of a group of property-owning SPVs) are likely to fall within the exemption: loans to trading companies that are secured on their real estate assets will not qualify;
2.the recourseof the creditor must be limited to the income, assets or shares of a qualifying infrastructure company (whether the borrower or another company). As only UK taxpaying companies can be qualifying infrastructure companies, this provision would prevent a loan to a UK borrower that is cross-collateralised with non-UK assets from qualifying for the exemption. It should, however, be possible to cross-collateralise across a group of UK real estate companies;
3.the amount of debt lent to the UK real estate companies in the group cannot be significantly higher than other debt lent to companies that are not qualifying infrastructure companies (i.e. non-UK real estate companies or UK real estate companies that have not elected into the exemption), after making appropriate adjustments to take account of the number and nature of assets held by the relevant entities and all other circumstances that are relevant to determining what is a reasonable level of indebtedness for the companies concerned. In essence, this “comparative debt test” can be seen as a more approximate version of the group ratio test, although it is tested by reference to principal rather than interest.
The effect of a making an election if all of the conditions are satisfied is that the third party debt is not subject to restriction under the rules. However, the election will effectively prevent the borrower from claiming any deduction for connected party debt.
Consultation on Non-UK Companies
The Government announced in the 2016 Autumn Statement that it is considering bringing all non-resident companies receiving taxable income from the UK into the corporation tax regime. At Budget 2017, the government will consult on the case and options for implementing this change. The Government wants to deliver equal tax treatment to ensure that all companies are subject to the rules which apply generally for the purposes of corporation tax: this includes restrictions on deductions for of corporate interest expense.
The key question is whether “equal tax treatment” extends to ensuring that capital gains arising to non-UK resident investors in UK land on the sale of that land are subject to corporation tax in the same way that they would be if they arose to UK residents. This would mark a very significant change the treatment of offshore investors in commercial real estate but initial indications are that this is not the government’s intention. Non-UK resident investors in residential real estate are already within the scope of capital gains tax and the position should be monitored closely.
If the rules focus only on income and not capital gains, then the effect of any such changes would be less unwelcome. Although coming within the scope of corporation tax would require non-UK investors to take account of the limitations on interest deductions, the new rules on hybrid instruments and the existing provisions of the loan relationships rules that are in some ways more complex than the equivalent regime for income tax, the obvious benefit is that the corporation tax rate is reducing to 17% in 2020 compared to the applicable income tax rate of 20%.
Implications for the Real Estate Finance Market
Lenders can no longer assume that all interest payments on their loans to UK resident SPVs holding real estate assets will be deductible. Indeed it may be that lenders work on the basis of a cautious assumption that interest will be deductible only up to 30% of EBITDA.
Following the introduction of these rules, the tax position of different borrowers investing in similar assets could vary significantly depending on the circumstances. Although in most facility agreements, the interest cover ratio and other financial covenants are tested on a pre-tax basis, borrowers may have to get used to lenders increasingly looking to diligence the tax treatment of the holding structure.
If the borrower is looking to rely on the exemption for qualifying infrastructure companies, then the parties will need to consider the effect of the restrictions on the security package. In these circumstances, lenders will want to assess whether there are material benefits for the borrower in relying on the exemption compared to following the group ratio rule.
If the consultation on non-UK companies does result in these entities being brought within the scope of tax on capital gains, it would have a material impact on not only the investors themselves, but also their lenders. Although secured lenders would still expect to rank senior to any tax liability, it would make enforcing over the shares in a company with an embedded taxable gain much less attractive.
The group ratio test and the exemption for qualifying infrastructure companies both give rise to an advantage in borrowing from unconnected lenders as opposed to related party debt. In many cases, shareholder debt is deductible under current law provided that it is lent on arm’s length terms. It is likely to be harder to claim interest deductions on shareholder loans in the future, so paradoxically one effect of the legislation may be to encourage more groups to seek additional third party debt, which may provide opportunities for mezzanine lenders.
A property developer that intends to sell the building once completed will not generally qualify as a company carrying on a property rental business. As a result, it will not be able to elect for the qualifying infrastructure companies exemption. Expenses, including interest, that are incurred during the development phase are often capitalised as part of work-in-progress for accounting purposes. In that case, the interest expense will typically arise in the period in which the asset is sold (whether the building as a while or the relevant unit to which the expenses are attributed if there are sales of units on an individual basis such as on a residential development) and so it will be necessary to apply the fixed ratio and group ratio tests in that period. The “transactions in UK land” rules introduced in Finance Act 2016 mean that even non-UK resident developers will be subject to corporation tax in respect of their development profits.