As part of the new reality of business, companies are having to deal with an unprecedented amount of change. This may be related to Covid-19, Brexit, technology, the economic downturn, or a multitude of other pressures and challenges that need to be addressed.
Corporate Tax can’t be cast aside
Corporate tax is often down the pecking order at times like this, but it should never be cast aside, as dealing with change will undoubtedly have tax implications for the business. This article addresses change and its corporate tax impact across a number of important business areas such as financing, losses and devaluation of assets, working in new locations and inter-company transactions.
Financing the business
During the current economic turmoil, cashflow management is increasingly important and many companies will look to secure additional loan funding either from third party lenders or from other group companies. It is easy to overlook some of the tax impacts associated with increased borrowings, but careful tax planning at the outset can prevent tax leakage and further cashflow problems later.
HMRC may consider a company to be thinly capitalised where its group borrowings exceed the amount which it would or could have borrowed from an independent lender, without the support of its wider group. Where this applies, interest charges are disallowed for corporation tax purposes to the extent that they arise on the excessive amount of the loan. Thin capitalisation can result not only by a company borrowing excessive amounts from a fellow group company, but also where a company borrows excessive sums from independent lenders with the support of group guarantees. High debt to equity ratios and low interest cover can be indications that a company is thinly capitalised and companies in this position are advised to seek advice as to the deductibility of their interest charges.
Corporate interest restriction
The deductibility of interest for corporation tax purposes may be restricted where the total net interest charge of all UK companies in the group exceeds £2m in a 12-month period. Where this limit is exceeded, the deductible amount of interest is calculated using one of two formulas (either the fixed ratio method or the group ratio method), with the ability to choose whichever gives the best result. Groups that do not utilise their full interest allowance in any period can carry forward the unused balance for use in later periods, but formal claims must be made. Careful planning is recommended to ensure companies structure their borrowings to maximise the tax deductibility of interest and to protect any unused interest allowances for future use.
The UK’s hybrid mismatch rules counteract tax mismatches where the same item of expenditure is deductible in more than one jurisdiction or where expenditure is deductible, but the corresponding income is not fully taxable. The rules can catch cross-border inter-group financing, particularly where loans have the characteristics of both debt and equity and the return on the funding is treated as tax-deductible interest in the UK, but as non-taxable dividends in the jurisdiction of the lender. Where this is the case, the hybrid mismatch rules prevent the UK company from claiming a tax deduction for the corresponding untaxed amount. The hybrid mismatch rules are complicated, and it is important to structure debt funding correctly to ensure group tax efficiency is maintained.
The application of withholding tax often gets overlooked when arranging cross-border financing. Many countries, including the UK, impose withholding taxes on payments of interest overseas and if relief is not available under the terms of a tax treaty, the tax can become a permanent expense, significantly reducing the amount received by the lender. Many tax treaties provide for reduced or even zero withholding tax rates, but often treaty benefits must be formally applied for before interest payments are actually made. Understanding the withholding tax regime of the borrower’s jurisdiction can help to avoid tax leakage on interest payments.
Debt write offs
Sadly, it is sometimes the case that loans become non-recoverable and must be written off. Many business owners automatically assume that tax relief will be available on non-recoverable loans, however losses on connected party debt are rarely tax deductible. On the flip side, the credit arising to the borrower on the unpaid debt is usually not treated as taxable income for UK tax purposes. To ensure the correct tax treatment of non-recoverable debt, it is important to review the relationship between the lender and the borrower and the circumstances in which the debt arose.
If cross-border intercompany balances are to be waived, novated or written off, then it’s important to consider how best to achieve the objectives given the different tax implications in each country: for example, a debt waiver could be taxable in some jurisdictions.
Losses and devaluation of assets
Covid-19 and the associated actions to tackle the pandemic are likely to some extent to have an impact on the profitability of a large majority of businesses. In many cases it may be that companies incur unexpected overall losses or that losses increase. Furthermore, assets held by the company may potentially lose value impacting the accounts profit/loss position. It is important companies understand the impact of this on their corporate tax position.
The first step is for companies and groups to have clear sight of the likely current period tax losses in the company or group together with any brought forward losses from earlier years. The previous projections may now be out of date and should be updated for the latest management information.
When considering corporation tax payments that may be due, cash is king, and having sight of the likely taxable profits for the year will ensure that the company or group is in the best position to accurately calculate estimated corporation tax payments for the current period and ensure excessive payments are not made. If quarterly instalment payments have already been made based on higher expected profit levels it is possible to ask HMRC for these to be refunded.
If there are tax losses, efficient use may provide for UK tax repayments, for example by way of claims to carry back losses against the prior year’s taxable profits or by group relief to other UK group companies, increasing cash flow. The UK tax rules for corporate entities changed in April 2017 including making them more flexible and it is important to understand if the losses available arose pre or post April 2017. What options are available and what is most tax efficient will depend on the individual circumstances.
When estimating the tax position, whilst the losses per the accounts are the starting point to calculate tax losses, certain items such as the downward book revaluation of fixed asset investments or properties will not be tax deductible so adjustments need to be made to the accounts figures. Revaluation of properties held in stock, for example by property developers, would however be deductible for tax purposes.
It is clear as the days roll on that many businesses are having to deal with a new way of structuring their operations. Adjustments are needing to be made, often to the international footprint of the business, as management and employees find themselves working from new locations.
It is important for tax reasons to keep a close track on what is happening and where, as this will be of keen interest to a tax authority. This is not only relevant from a payroll perspective, but it could give rise to a new taxable presence for the company itself by virtue of creating a Permanent Establishment (PE) or through a change in the location of the effective management of the company.
Where staff are now operating from new locations, maybe through having returned to their home country as a result of Covid-19, this presence could result in the need to register for and pay corporate taxes with the host country. This will always come down to applying the facts to the local laws and the application of the relevant tax treaty (if there is one), as well as considering any recent guidance that has been provided by the tax authority.
For instance, in the UK, HMRC have clarified that it does not consider that a non-resident company will automatically have a taxable presence after a short period of time in the UK, and that whilst the habitual conclusion of contracts in the UK could also create a taxable presence, it is a matter of fact and degree as to whether the habitual condition is met. Guidance will vary between countries, and it should be noted that not every situation is at country level, such as in the US where State tax rules must also be separately assessed. Companies should therefore carefully review where they have staff working and ensure that they understand how the local tax rules may be applied to their activities.
Corporate tax residence
There is also a concern that recent location changes may affect the place of effective management of a company. This could occur where directors are performing board duties and making key decisions from a new location. The implication here is that the corporate tax residence of the company may have changed and with it the possibility that exit taxes and new taxing rights arise.
The OECD have provided guidance on this issue as have some countries tax authorities. The OECD view is that temporary changes should not affect the location of the effective management of a company, as it is necessary to consider how meetings have been held over the determination period. It is felt that all relevant factors must be considered, and not just the exceptional and temporary position, in order to determine where a company has it place of residence.
It’s not always easy, but it is suggested that where there have been location changes, groups should seek to identify where the place of management of each company is likely to reside and whether there could have been a change in its tax residence. As always, companies should ensure they main a record of the facts and circumstances for production to a tax authority if required at a later date.
The current focus of any business must of course be on protecting the future and assessing all the current risks to the business and how these can best be managed. Cash management is key, but it is also important to review how the global business strategies and operations may have changed and to consider the transfer pricing opportunities and risks for the business.
These are unusual times and for most groups, it’s certainly not “business as usual”. What is arm’s length in the current climate is likely to be very different from what’s arm’s length when it’s business as usual. Group’s may need to quantify and adjust transfer pricing policies for exceptional events such as one-off costs like redundancies or increased expenses or reduced sales due to Covid-19. All changes to staff, productivity and sales, delivery and supply chain variations, intellectual property valuations, head office services, and how risk is being assigned across the group should be reviewed.
Transfer pricing policies should cover the full range of intergroup transactions including sales of goods and services, intellectual property, financing transactions and management charges. The tax position in each country should be considered including expected profit and loss profiles and what charges are now appropriate, and whether actions can be taken, to remove inefficiencies.
Different transfer pricing rules apply around the world and exemptions for small or medium sized groups may apply in some countries. Where exemptions don’t apply, documentation will be important for penalty protection. Transfer pricing documentation should always capture the functions, risks and assets employed by each group company and the value that company brings to the group’s operations. It should be updated at least annually and/or as business models change.
With all the change that is being imposed on business, there is likely to be an increased focus from global tax authorities. Every country will want to protect its tax base and transfer pricing is an obvious area for tax authorities to raise enquiries and challenge pricing policies. Governments are responding in unprecedented ways to support their economies and who knows how things will develop and what actions governments will take so that their tax base is not significantly eroded in the future.