Complex new rules surrounding corporate interest restrictions could impact property investment companies; increasing their tax liabilities by reducing allowable costs.
What should companies do to ensure compliance and mitigate the effect of the changes?
Applying from 1 April 2017, the Government’s changes to corporate interest restrictions have been introduced as part of the OECD’s base erosion and profit shifting (BEPS) project. The aim of the change is to “ensure relief on financing costs is commensurate with the extent to which a business’s activities are subject to [UK] corporation tax”. The rules are designed to combat attempts by multinational enterprises and other companies to obtain excessive tax relief but could have a wider impact.
Whereas group (or individual) companies were previously able to claim relief on 100 per cent of finance costs incurred during an accounting period, going forward the amount that can be deducted for tax purposes could be restricted if it exceeds a certain level.
How will property investment companies be affected?
Under the new measures, UK companies with a net finance costs of over £2 million across the group could face interest restrictions. With property businesses often borrowing large amounts of capital to fund investment and development activities, some could find themselves exceeding this threshold and be caught out by the changes. It is important that property investment companies have a clear understanding of how the rules apply to them and adopt a meticulous approach when making returns to HMRC. This will help to improve their tax positions in a particular accounting period and avoid potentially-costly penalties.
While SME businesses in the sector are unlikely to have a net-interest expense which exceeds £2 million, larger property investment and development companies with high levels of gearing are more likely to fall into this category. These companies will be required to calculate their annual interest allowance to determine whether interest restrictions apply. If so, they must notify HMRC within 12 months of their year end and complete an interest restriction return. Failing to do so could result in the organisation incurring costly penalties. Businesses which are caught by the interest restriction rules and fail to provide their returns on time could face fines of between £500 and £1,000. Those found to have completed returns inaccurately may be forced to pay tax on up to 100 per cent of their interest expenses, which could amount to a substantial sum. As such, it is important for companies to be clear about when the rules apply to them and be sure to get their returns right first time.
How to calculate net interest
The default position for calculating a UK group’s net interest allowance involves working out 30 per cent of the group’s tax-EBITDA and then comparing this to the group’s worldwide net interest expense. The group’s interest allowance is the lower of these two figures. The difference between the two amounts will then be restricted and reallocated to companies within the group (or to an individual company) as taxable profits for the current accounting period. Prior to reporting interest restrictions, groups will also need to notify HMRC of their intention to do so; in the 2018 Finance Bill the period for doing this was extended from 6 to 12 months from the end of the group’s accounting period.
The good news is that groups which provide rental property can elect to use a different approach for some, or all, of their companies. Instead of applying a limit based on a percentage of earnings, the infrastructure rules change the nature of the restriction so that it only applies where interest is paid to lenders that are related parties, potentially giving relief for 100 percent of interest expense paid to third parties.
There are a number of conditions to consider before this method can be applied, and the rules need to be reviewed carefully to ensure they give a good result. For example, the infrastructure election can be made in each company individually, or as a joint election. A joint election is often sensible, as it will link the entities in the group, meaning that if one company fails to meet the conditions of the infrastructure rules, all of the entities under the joint election revert to getting relief under the fixed ratio method. This prevents the group from being split, which can be an issue if income is booked across companies.
If the conditions for this election are met by a corporate property investor it may therefore be possible to claim full relief for the finance costs incurred, irrespective of the amount.
It should also be noted that for businesses that fall below the £2 million ‘de minimis’ limit, it may be beneficial to file an abbreviated return. In the event that the organisation becomes restricted in later years, this enables the abbreviated return to be replaced with a full return to make use of any unused allowance. The unused allowance is not determined by the £2 million ‘de minimis’ limit but instead the excess of any unused interest capacity, calculated as described above. Any unused allowance can be carried forward and potentially used in the following five years.
As many property companies are used to conducting large-scale investment and development activities that require high levels of debt, exceeding the £2 million limit for net tax interest expenses may be unavoidable. Keeping a clear sight of the impact of the restrictions across the entire group and consideration of whether the infrastructure election is available, will ensure they are best placed to make use of the available relief in each accounting period. Keeping clear and accurate records is also important, allowing businesses to make timely returns to HMRC and helping to ensure that unused allowances can be taken up in future years.
By developing a thorough understanding of the rules surrounding corporate interest restrictions and their specific impact, property companies can avoid incurring unwanted penalties whilst optimising their use of this valuable tax relief.
For more information on the implications of corporate interest restrictions for your Property and Construction business, contact Corporate Tax Partner Lucy Mangan via email at email@example.com or call +44 (0) 1784 497100 .