Worldwide debt cap
The measure
Draft legislation was published today which aims to address several issues identified relating to the application of the new worldwide debt cap rules. The worldwide debt cap rules were introduced in Finance Act 2009 and operate to limit UK corporation tax deductions for finance expense to no more than the gross finance expense suffered for the relevant period by the worldwide group.
The issues addressed in the draft clauses are those noted in the HMRC technical paper on proposed amendments to the debt cap rules published on 10 November 2009. The main changes are:
1. Accounting mismatches under the gateway test
2. Preference shares
3. Protected companies
4. Guarantee fees
5. Group treasury companies
6. Ancillary costs
7. Partnerships
8. Securitisation companies
Who will be affected?
All large groups are impacted by the debt cap rules - inbound investors, outbound investors and wholly domestic groups. See above for the expected impacts of particular changes on different investor groups.
When?
The debt cap rules apply to large groups for periods of account beginning on or after 1 January 2010.
The changes are welcome but are not expected to be the last changes to the debt cap rules. Several other problem areas are being discussed with HMRC, especially regarding the treatment of derivatives under the debt cap, and further legislative amendments are anticipated in 2010. Whilst it is a positive development that HMRC are working to address these issues it is disappointing that it has taken so long to address these issues when many of them were identified before the Finance Act was passed in the summer, and some matters, such as the ongoing debate regarding derivatives, will not in fact be addressed in statute until the rules are in force for many groups from 1 January 2010.
The biggest single criticism of the debt cap rules is the large compliance burden the rules place on many large groups who do not in fact suffer any tax cost as a result of the rules. The rules are complex and the compliance burden associated with them seems disproportionate to the number of groups who anticipate they will pay more UK tax as a result. The draft legislative changes published today demonstrate this complexity and many of the difficulties identified stem from the fact that the rules require a comparison between accounting measures of interest and tax measures, which creates numerous unexpected results. Our advice is therefore for groups to calculate what they expect their position under the debt cap to be now, in order to understand whether any of the anomalies which can arise when applying the detailed rules are relevant to them.
1. Accounting mismatches under the gateway test:
The gateway test applies to remove those groups who pass it for the relevant
period from the scope of the detailed debt cap rules where UK net debt is
less than 75% of the worldwide gross debt. This requires a comparison of the
group's worldwide gross debt (per the consolidated balance sheet) with net
UK debt (per each entity's standalone balance sheet). As these may both be
drawn up under different GAAP there is the possibility that liabilities may
be treated differently under each measure which could create distortions.
The proposed changes eliminate this by imposing a common standard of
measurement - the value of a liability of the worldwide group (as per the
consolidated balance sheet) must be used to compute the value of the
liability for the UK company. This change will be applicable to those groups
(largely inbound investors) who expect to pass the gateway test because they
have debt outside of the UK.
2. Preference shares
This amendment makes it clear that preference shares will not be regarded as
debt for the purposes of applying the gateway test.
3. Protected companies
Under the detailed debt cap rules, if a group has a disallowance of finance
costs but does not file a return within 12 months of the end of the period
to allocate this disallowance to relevant companies, there is a default
allocation of the disallowance made between relevant group companies that
have finance costs. This amendment will allow groups to irrevocably elect to
treat companies as 'protected' for these purposes, such that disallowances
under the default allocation cannot be allocated to these entities. This is
important where, an allocation of disallowance to this company could breach
banking covenants or affect its credit rating. If the UK group contains no
non-protected companies then this election will not be available. However,
any entity which is a dual resident investment company (under section 404
ICTA 88) will automatically be prevented from having a disallowance
allocated to it under the debt cap rules. This is because a non-trade
deficit of a dual resident investment company cannot be group relieved and,
if a disallowance of finance expense were allowed to such a company under
the debt cap rules this would effectively give the same result as allowing
group relief.
4. Guarantee fees
When a guarantee fee is paid between group companies or is imposed under the
transfer pricing rules, today's changes include this as finance income for
the purposes of the debt cap. This amendment provides consistency of
treatment by also including gurantee fees received as finance income under
the debt cap.
5. Group treasury companies
The debt cap rules include an election whereby a group company which meets
the definition of a group treasury company can be elected out of the debt
cap rules so that all of its finance expense and income is not included in
the debt cap calculation. This election is irrevocable and only applies
where all group treasury companies within a group are elected out where
there is more than one. To qualify as a group treasury company, under the
existing rules, all the income of any UK company undertaking treasury
activities is aggregated and at least 90 per cent of the total amount must
be qualifying treasury revenue (as defined). However, the definition of
treasury activities is widely drawn and can include the situation where a
trading company with surplus cash makes a loan to another group company.
This would mean that the trading revenue of this company is included when
considering whether the 90 per cent threshold is met, which would mean many
groups would be unable to take advantage of this election. The draft
legislation amends this by removing the aggregation requirement and applies
the 90 per cent threshold to each UK company separately. This is a welcome
amendment to address a defect in the original legislation which has been
lobbied on for many months. However, if groups are considering making the
group treasury company election they should consider carefully what impact
this will have on their overall debt cap position. If a group treasury
company is in a net income position (as many will be), making this election
may not in fact be beneficial to the group as a whole.
6. Ancillary costs
This change makes it clear that ancillary costs, which are included in the
available amount (ie the gross amount of finance expense of the worldwide
group) mirrors the definition of allowable charges and expenses for the loan
relationship rules as defined under section 307 CTA 2009. This change was
felt necessary by HMRC to put beyond doubt the fact that losses on
derivatives used to hedge group borrowing are not included in the available
amount. There is a potential mismatch between the exclusion of derivatives
from the available amount and the fact that if a derivative is accounted for
at fair value in a UK company's accounts (such that there is a fair value
movement on both the derivative and the loan relationship), this fair value
movement will be included in the tested expense amount. This has not yet
been addressed under the debt cap rules, although it is an area HMRC are
considering and a new regulation making power has been proposed today to
enable HMRC to address this via secondary legislation in due course.
7. Partnerships
An inconsistency was identified under the debt cap rules where a UK company
is a corporate partner in a partnership and the partnership incurs finance
expense. This is particularly relevant for sectors which use partnerships as
common joint venture vehicles, such as the real estate industry. The issue
arises because specific tax rules in the loan relationship provisions deem
finance expenses incurred by a partnership to arise for tax purposes in the
UK partner company. Therefore, if the partnership is not included in the
group's consolidated finance expense for accounting purposes this could mean
that the finance expense is not included in the group's available amount but
the finance expense deemed to arise in the UK corporate partner for tax
purposes would be included in the tested expense amount. This legislative
change removes this inconsistency by changing the definition of the
available amount where finance costs are incurred by a partnership. The
amount to be included in the available amount will now be the amount of the
partnership borrowing costs divided between the partners according to their
profit shares. If the partner is a consolidated entity then this amount will
be included in the available amount. This will be a welcome change for those
groups who would have been disadvantaged by the previously identified
inconsistency of treatment.
8. Securitisation companies
Companies which fall within the special tax regime for securitisation
companies (within FA 2005) will, under today's draft amendments, be excluded
from the debt cap rules. This is a welcome change and we understand that
HMRC are continuing to discuss the impact of the debt cap rules with
representatives of the securitisation industry to ensure that the impact on
the rest of the group to which the securitisation company belongs by making
this change is reflected appropriately.
