The U.K.’s Proposed Interest Restriction Rule—Too Much Too Soon?

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The U.K. government has been consulting on a proposed “Interest Restriction” rule which will limit the amount of interest expense U.K. companies will be allowed to offset against their income for tax purposes (to 30% of their taxable earnings before interest, tax and amortization). The second consultation phase on the new rule having ended on August 4, the next steps are publication of draft legislation by the end of this year followed by the release of final legislation with Finance Bill 2017 to take effect next April.

It is not surprising that a range of key investor associations have expressed increasing alarm about the proposed introduction of these new limits on deductible interest. Investments in property development and in buying and turning around companies, for example, are usually highly leveraged as the high risk and high returns are expected to more than cover the cost of borrowing. Severely reducing the amount of interest which some investors will be allowed to deduct from their taxable income will increase the tax on their profits, reduce the returns on projects and cause the U.K. to lose the benefits of some of these investments—including some large infrastructure projects and much-needed housebuilding.

It is even questionable whether the new limit on debt finance is needed anyway—HMRC can already draw on a wide range of restrictions to do this, if it chooses, such as the transfer pricing rules, the worldwide debt cap and the allowable purpose test.

With the new legislation expected to come into effect next April, many businesses and advisers in this area have questioned the need for the relative urgency with which the new rules are being finalized and introduced. The government's urgency seems to derive from its wish—having been stung by criticism of “tax havens” among its Crown Dependencies and Overseas Territories and its own “race to the bottom” of corporate income tax rates—to be seen as a good citizen of the international community; thus, the U.K. was the first country to announce that it would adopt the OECD's “country-by-country reporting” of profit and tax paid for U.K.-headed groups, and actually incurred the displeasure of the OECD by introducing the Diverted Profits (“Google”) Tax while the international community was still working out the details of an agreed approach. Now the U.K. has been consulting on and finalizing legislation to introduce the OECD's proposed interest restriction while the OECD is still working up the details of what it intends, and the rush to act coincides with a period of caution about investing at all post-Brexit.

What then should be done? Ideally introduction of the new restriction—if indeed it has to be introduced at all—would be delayed; if not, then “grandfathering” of existing loans and interest deductions should be allowed. Not to do so could cause borrowers to have to refinance, if possible and at some cost, or to suffer worse after-tax profits which may cause their lenders to withdraw part of their funding. Even if grandfathering is ruled out, there is a potential get-out for the U.K. in the form of a public interest test whereby higher interest deductions could be allowed if the project were deemed to be of “public benefit”. This test, as envisaged by the OECD, is quite loosely worded and could allow many projects to continue without a higher tax charge. Certainly, other European countries have shown themselves to be willing to interpret international taxing and spending rules rather loosely where “grands projets” are involved. More generally, the U.K. appears to be the only European country consulting on such a measure. An EU Directive will be implemented soon requiring all Member States to introduce relevant national legislation, but at the moment the country leaving the EU seems the keenest to do so.

Danny Beeton is a managing director at Duff & Phelps and Editor-in-Chief of Bloomberg BNA's Transfer Pricing Forum.

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