UK waits on debt tax developments(1)

The private equity industry in the UK will have to live with uncertainty for next 12 months, after which new rules come in governing the amount of tax relief companies can offset against financing costs.

Until that point, headline changes to interest deductibility that appeared in March’s Finance Bill will be fleshed out. Expect further debate over the detail, a government consultation and industry lobbying.

A key change announced by the Chancellor was the introduction of a fixed rate ratio rule that limits corporate tax deductions for net interest expense to 30 percent of a group’s UK earnings before interest, tax, depreciation and amortization (EBITDA). In other word, a cap on the amount of tax relief companies can seek on interest payments of 30 percent of its earnings.

The switch conforms to the OECD’s BEPS (Base Erosion and Profit Shifting) Action Plan recommendations designed to ensure earnings are taxed where they are generated.
It replaces the “arm’s length” standard currently agreed between a UK company and HM Revenue & Customs. This method assesses the fundamentals of each business, can include interest costs on borrowing by its overseas subsidiaries, and can result in interest deductions totalling more than 30 percent of EBITDA.

Currently there is little visibility on how private equity firms will be affected by the introduction of fixed ratio limitation, or how many. The OECD research underpinning the BEPS Action plan was based on listed entities.

In any case, all UK groups with net interest expense above the £2 million threshold will need to review their tax situation. Some firms, depending on the geographic spread and type of their investments, will be affected more than others.

Anyone doing business in Germany, Italy or Spain, for instance, will be familiar with the fixed rate ratio already use in some European jurisdictions. Meanwhile, businesses operating globally are likely to have to reassess their capital structures to be able to obtain a deduction for third party interest expense, for example on bank debt. However, the detail of the worldwide group ratio rule that would determine that amount is still under discussion, with industry advocates seeking a higher rate than 30 percent.

Similarly, the impact of the new rules on shareholder leverage, a typical component of private equity structuring, is unclear. However, tax specialists say the new rules are likely to make placing debt into a company less advantageous from a tax perspective.

On a positive note, infrastructure companies developing “public benefit projects” will be exempt from the 30 percent cap. Qualifying criteria, however, have yet to be decided.

There is a lot of detail to clarify. Over the summer, the government is expected to hold a further consultation ahead of draft legislation expected in the autumn. When the new rules come into effect on April 1 2017, they will apply to both new and existing debt structures.

In the meantime, the industry is expected to lobby the government on grandfathering – permitting the application of the old rules to existing debt structure – to avoid having to remodel business plans priced some years ago. The government is expected to combat this, arguing companies had time to prepare. And as one lawyer noted to pfm, it is difficult to see how grandfathering could be practically implemented in this case.

Although the cost to portfolio companies of private equity firms in the UK is unclear, the new interest deductibility rules are just one element of a tax reform programme introduced by the government that is broadly favourable to business.

Firms should take heart that the rate of corporation tax is low at 20 percent and due to step down further to 17 percent by 2020. Capital gains tax has also been revised from 28 to 20 percent, albeit not on carried interest. These changes might go some way to retaining the UK’s reputation as a tax-generous jurisdiction.