UK: Worldwide Debt Cap: Are We Nearly There Yet?

Last Updated: 22 April 2009
Article by Deloitte Tax Group

Most Read Contributor in UK, August 2017

Comment by Ben Moseley, Treasury Tax Director, Deloitte

The most controversial, or at least the most talked about, part of HM Treasury/HMRC's foreign profits reform package, to be introduced in Finance Bill 2009 as announced in today's Budget, is undoubtedly the proposal to restrict tax relief for finance costs incurred by UK members of a group, to that group's aggregate external finance costs.

This article does not seek to examine the merits and demerits of the "debt cap" as a concept, or its place within the foreign profits package (for such a discussion, please Taxation of Foreign Profits Reform - Enhancing UK Competitiveness?), nor does it summarise in detail the debt cap rules themselves (please refer to our previous releases); rather, the below analyses the position we have reached on the debt cap and, critically, what this means for businesses in a variety of key areas.

Background to the Debt Cap

HMRC's original draft rules on the debt cap were released on 9 December 2008. It is widely acknowledged that the cap targeted two main circumstances:

  1. Non-UK parented groups, which leveraged their UK sub-group with a greater (absolute) level of debt than the group's aggregate borrowings; and
  2. (b) UK parented groups, with significant borrowings in the UK from overseas subsidiaries resulting in net UK tax deductions (the theory being, such upstream loans will be unnecessary once the UK has a dividend exemption).

The rules were subject to a consultation period up to 3 March 2009 and HMRC received over 200 responses, no doubt focussing on key overall policy areas (such as whether a restriction on interest deductibility is required given existing anti-avoidance and, if so, is the debt cap the correct approach), the compliance burden resulting for groups who were not in the above two target areas, and more specific problem areas (some of which are explored below).

Who could the Debt Cap apply to?

The cap would apply to "large" groups - broadly meaning independent groups which have at least 250 employees, and an annual turnover of over €50m and/or net assets exceeding €43m.

Within such a "large" group, the companies affected by the debt cap would be the "relevant group companies" - UK tax resident companies which are either the ultimate corporate parent (the top body corporate in the "group" as defined for accounting purposes) or are 75% subsidiaries of this ultimate corporate parent.

Although the cap is part of the foreign profits package, it is important to note that it is not purely international groups who would be affected; wholly UK groups fall within the scope.

Basic Framework

In absolute overview, the operation of the original debt cap rules involved a comparison of:

  • The "tested amount", being the aggregate intragroup finance expense of all relevant group companies; to
  • The "available amount", being the external finance cost of the consolidated group as shown in the consolidated IAS accounts, less UK external finance costs shown in the accounts of UK subsidiaries, less the worldwide finance income again from the consolidated IAS accounts.

If the tested amount exceeds the available amount, there is a disallowance, which can be allocated across relevant group companies as the group sees fit. However, there is also an adjustment mechanism, to strike out intragroup financing income in relevant group companies, to the extent that there is a disallowed amount.

The above does not begin to do justice to the complexity of the drafting, which inevitably resulted in a number of potential inefficiencies and, crucially, a significant compliance burden due to the wide scope as mentioned above.

Update from HMRC

Following the consultation, HMRC released a note on 7 April 2009 setting out proposed changes to the debt cap rules. No updated draft legislation was released at the time, and none has been released in the Budget today - the next set of draft legislation is expected to be contained in the Finance Bill 2009, likely to be available at the end of April or early May. What has been confirmed in the Budget today, is that the debt cap will take effect for accounting periods beginning on or after 1 January 2010. (As an aside, HMRC has announced that the proposed extension to the "unallowable purpose" rules, another potential restriction on finance cost deductibility, will not be included in Finance Bill 2009).

The changes set out in HMRC's note included the following (and click here for more detail):

  • The definition of "ultimate corporate parent" will be revised, to cater for non-corporate parents, dual-listed structures etc. and to exclude (where appropriate) collective investment schemes.
  • The calculation of the "tested amount" will be substantially changed:
    a) The calculation will be on entity basis, being each relevant group company's net financing expense - i.e. finance cost less finance income, intragroup and external;

    b) Foreign exchange gains and losses will be excluded;

    c) Short term debt will be excluded - broadly being debt with a fixed repayment date of less than 12 months and on-demand facilities, but with measures to include amounts effectively re-borrowed;

    d) Amounts below a to-be-determined de minimis will be excluded;

    e) There will be a mechanism to elect to exclude certain loan balances if these would give rise to stranded tax losses, in certain circumstances.
  • The definition of the available amount will also be changed, to the worldwide consolidated group's gross finance expense - i.e. including UK and non-UK but excluding financing income.
  • The basic disallowance mechanism, if the tested amount exceeds the available amount, will remain largely as before; and there will still be an adjustment mechanism to reduce companies' net finance income (external and intra-group) if there is a disallowance.
  • There will be one simple "gateway" test, whereby if the aggregate of the net debt in relevant group companies does not exceed a percentage (expected to be 75%) of the consolidated group's total gross debt, the debt cap rules will not apply to the group.
  • In addition, it will be possible to make a statement that the group is satisfied that the tested amount does not exceed the available amount and therefore the debt cap rules do not need to be applied - the group will need to be able to demonstrate this.
  • Finally, there will be a targeted anti-avoidance rule, to prevent groups taking measures to either reduce the "tested amount", increase the "available amount", or meet the gateway test.
  • There are also significant changes for financial services groups, but these are not covered in this article.

The above is, of course, all very interesting but the key question is…

What does this all mean?

The proposed changes are likely to mean that the debt cap impacts UK and non-UK parented groups in very different ways. This is considered below, along with a selection of the key specific issues raised in respect of the original rules:

Non-UK parented groups

As stated above, one of the aims of the debt cap is to prevent overseas-parented groups from leveraging UK sub-groups, with debt in excess of the total debt of the consolidated group.

HMRC see this as generous, compared to regimes in other jurisdictions which, for example, limit interest deductibility based on an allocation of the total debt of the consolidated group to the local sub-group. However the original definition of the "available amount" as a net figure (i.e. costs less income) would have disadvantaged groups with both external debt and cash.

The revised proposed definition of the "available amount", as the group's gross finance costs, should improve the position. Likewise, the proposed gateway test is expected to mainly apply to inbound groups, such that if this is passed, the detailed debt cap measures do not need to be considered and the compliance burden for such groups should drop away.

However, there will still inevitably be non-UK parented groups who feel that the debt cap applying on top of existing anti-avoidance (in particular transfer pricing rules, which should limit UK finance deductions to an arm's length level of debt for the sub-group) is unnecessary, particularly as these groups are in many cases unlikely to benefit from the positive aspects of foreign profits reform (i.e. the dividend exemption).

Therefore we are likely to see further debate and consultation on this, depending (as ever) on the detail of the revised draft rules.

UK parented groups

One of the main themes of the consultation process was the compliance burden that the debt cap would impose on groups not necessarily within the target of the debt cap - particularly, wholly UK groups (whose net intra-group deductible finance costs will tend to be Łnil) and UK parented groups without significant upstream loans.

The revised rules may offer some limited relief from this compliance burden; for example wholly UK groups which borrow externally into a group treasury company, and then lend on to ultimate traders, should be able to take advantage of the voluntary declaration mentioned above, that the tested amount does not exceed the available amount.

For large groups, however, the position will rarely be so simple. Groups with complex intra-group financing positions will find themselves needing to still go through the complexity of the debt cap calculations, either to work out their disallowances and income adjustments as before, or to satisfy themselves that the declaration can be made.

The absence of a gateway test along the lines of that previously proposed by HMRC, to compare deductible intra-group financing expense to taxable intra-group financing income, is likely to disappoint UK-parented groups.

Therefore again, HMRC's proposals are unlikely to be the end of the debate for UK headed groups; both on the detail and on the over-riding policy - i.e. given that the UK already has CFC rules (which are of course to be reformed) and there will be targeted anti-avoidance within the dividend exemption to prevent the artificial location of, inter alia, finance income in low-tax paying jurisdictions, is the debt cap really required?

Treasury Companies and Cash Pooling

HMRC's proposed changes should reduce the complexity of the debt cap rules for group treasury companies, and hopefully for companies containing the group treasury function, in relatively simple circumstances. If a treasury company borrows (externally and intra-group) and lends on at a margin, the company will not typically have a net finance expense and therefore will not be within the scope of the debt cap.

This could remove one potential problem of the original rules, which in some circumstances could have penalised groups for locating treasury functions in the UK rather than overseas.

This net measure of the tested amount and the proposed exclusion of short term debt could also simplify the effect of the rules on cash pooling activities, although as always the precise wording of the revised legislation will be critical here.

Foreign exchange hedging

The removal of foreign exchange differences from the tested and available amounts should remove the unintended effects of the debt cap rules on simple FX hedging strategies. However, the application of the cap where consolidated groups and individual UK companies account in different currencies appears uncertain.

Stranded losses

The proposal to enable companies to exclude certain loan balances from the debt cap rules where stranded losses would otherwise result, is positive but could create further complexity. HMRC's proposals also only appear to deal with the situation where brought forward losses exist already, and not where the debt cap could effectively move deductions from a trading company (where deductions, if not used in the current year, will tend to be more flexible) to a holding / financing company.

Also, this measure would not help foreign parented groups who suffer an increase in overseas taxes (through CFC equivalents or reduced foreign tax credits), where net taxable income moves from one UK subsidiary to another.

Compliance burden

The gateway test may remove the compliance burden for a number of inbound groups, and the ability to make a declaration that the rules will not apply, along with the net measure of the "tested amount", will also simplify matters for some groups. However on the whole, the debt cap is still likely to result in group tax functions needing to prepare potentially complex calculations to either apply the cap or to properly make the declaration - including for groups that do not fall within the basic target area of the cap.

So, are we nearly there yet?

HMRC's proposed changes would appear to substantially improve several areas of the debt cap rules and therefore represent a step in the right direction. However, the devil is likely to be in the detail and therefore, before the revised rules are published in the Finance Bill, it is difficult to say how close we are to a workable set of provisions.

What is clear is that there will be further debate on a number of points of detail (not least the compliance burden, which does not seem to have been eased for, e.g., wholly UK groups with complex intra-group positions), not to mention the big picture policy behind the cap. Therefore we may be on the right track, but it's likely that there is a long way still to go before groups can plan for the debt cap with any certainty.

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