UK draft tax legislation would modify carried-forward loss rules, limit interest deductions

by Julian Feiner, Dentons

The UK government has been busy preparing draft legislation for changes that are due to take effect from April 1. Two relevant proposals for multinationals are the new rules for carried-forward losses and new interest deduction restrictions. Both were published in draft legislation yesterday, with comments invited over the next four weeks, although last minute amendments are unlikely.

Carried-forward losses

Currently, the UK allows a company to carry forward losses into future years and set those losses off against its own profits. The rules, however, do not allow any set-off in future years against the profits of other companies within a UK group. This should be contrasted with the position in relation to current year losses, where such set-off is permitted.

In a welcome change, the draft legislation provides that carried-forward losses arising on or after April 1 can be set off against the profits of other companies within a UK group.

Coupled with this new flexibility, however, is a new restriction to limit the set-off to 50% of group profits exceeding £5 million per year. For banking companies, the limit is 25%. These restrictions will apply to all existing and future carried-forward losses, not just those arising on or after April 1.

For existing carried-forward losses, therefore, there is no flexibility to set-off losses against profits of other group members, and they will be subject to the 50% limitation from April 1. Carried-forward losses arising from April 1, however, can be used flexibly among UK group members, subject to the 50% restriction on profits exceeding £5 million, calculated on a group-wide basis.

The rules therefore provide some pain for groups with deep existing losses, but potential gains for groups expecting losses to arise after April 1, as they can be used more flexibly in the future.

The changes also serve an underlying policy objective to ensure that multinationals earning profits of more than £5 million per year cannot fully set-off those profits in order to become nil tax paying.

Corporate interest restriction

The UK’s proposed corporate interest restriction implements Action Item 4 of the OECD/G20 base erosion profit shifting (BEPS) recommendations.

The UK is one of the first countries to implement the restriction, although other countries already have similar rules, such as Germany, Japan, and Australia.

According to UK government estimates, only 5% of multinationals will be affected, but the additional forecast revenue of £4 billion from 2017 to 2021 suggests that there could be a significant tax increase, with increased administrative costs and a noticeable impact on UK investment activity.

The current UK rules generally entitle companies to interest deductions if a loan is incurred for the purposes of a trade, subject to transfer pricing, worldwide debt cap, and anti-avoidance rules. There are no formal ratios and the approach varies between industries.

Under the proposed changes:

• A new fixed ratio rule will permit deductions of net interest up to an amount equal to 30% of the UK group’s earnings before interest, tax, depreciation, and amortisation (EBITDA). Any interest that is restricted can be carried forward and deductible if there is sufficient capacity in future years, and spare capacity can be carried forward and used for up to 5 years.

• An additional group ratio rule may provide a higher deduction than the fixed ratio rule by permitting the deductibility of net interest up to the group ratio, which is the group’s worldwide external net interest as a proportion of its worldwide EBITDA, capped at a maximum of 100%.

• The worldwide debt cap will be repealed and replaced by a similar modified debt cap. This will stop groups with little external debt gearing up to the new 30% EBITDA limit.

• Importantly, there is a ‘de minimis’ allowance of £2 million per year for the UK group, which means that groups with low UK net interest expenses should be unaffected by the changes.

• There are specific exceptions, including for public benefit infrastructure. The rules will apply to banks and insurers, unlike the existing worldwide debt cap which excludes them.

Undoubtedly, these changes will have an impact on investment and productivity in the UK. There are concerns that it may increase the cost of capital, particularly in capital-intensive industries such as real estate and manufacturing.

The new rules will also increase administration costs, as companies change their reporting systems.

Moreover, there is underlying concern that, due to the rigid nature of the rules, they may affect normal commercial arrangements that do not involve any ‘base erosion or profit shifting.’

The draft proposal is expected to take effect with minimal changes, so it is imperative for companies to prepare for the new regime.