UK: Reform Of Taxation Of Foreign Profits - The Worldwide Debt Cap

Last Updated: 25 August 2009

Article by Michael Bell, Erika Jupe and Philip Moss

Originally Published on 7th July 2009

Taxation of Foreign Profits Proposals

It has been confirmed that certain elements of the taxation of foreign profits package will now be introduced, as follows:

  • New legislation will restrict the amount of finance expense allowable for UK tax purposes (known as the Worldwide Debt Cap, "WDC").
  • A dividend exemption will be available for all distributions which fall within an exempt class and are received on or after 1 July 2009.
  • Consequential changes to the controlled foreign company (CFC) regime as a result of the dividend exemption, namely the abolition of the acceptable distribution policy exemption and non-local holding company exemption, (subject to transitional rules).
  • Abolition of the Treasury consent rules for capital movements outside the UK and the enactment of a reporting regime for high value transactions instead.
  • The proposed changes to the debt and derivative contract unallowable purpose rules will not be introduced at this stage.

The main focus of this note is the worldwide debt cap and the restriction on the finance expense allowable for UK tax purposes. These rules will need to be considered by groups when embarking on new financing transactions but also apply to existing finance. The new rules are still a work in progress as consultation continues with industry and advisers.

Dividend Exemption

The dividend exemption covers both UK and non-UK dividends. This will replace the current exemption for UK dividends so that UK dividends will now be taxable unless they fall within an exempt class. This means that companies receiving UK dividends, which were previously exempt, will now have to ensure that any relevant dividend falls within one of the new exempt classes.

However, the exempt class categories should mean that, most UK – UK dividends will remain exempt and the dividend exemption should enable tax efficient repatriation of foreign profits to the UK. This will enhance the competitiveness of the UK as a holding company jurisdiction.

Worldwide Debt Cap (WDC)

In June 2007, when the first consultative document was published, HMRC stated that it needed 'targeted reforms to the UK's interest relief rules – especially, but not exclusively, to ensure the rules are robust following the introduction of the [foreign dividend] exemption'. The Government explained that it saw no need to generally restrict interest relief currently given and proposed no 'major changes'.

HMRC may not have viewed the introduction of a worldwide debt cap as a major change but the resulting consultation and drafting process has been by no means straightforward. The new rules are complex and will add a significant compliance burden on all groups to determine each year if the rules apply.

HMRC's basic proposal is that interest claimed as a tax deduction by UK members of a multi-national group should be restricted by reference to the group's total consolidated external finance costs. In HMRC's view, if a UK sub-group has higher actual finance costs than the entire group's overall external finance costs, this strongly indicates that the UK sub-group's finance costs are not commercial and should be disallowed to some extent. Although the new rules are targeted primarily at groups with a UK parent which has upstream loans from overseas subsidiaries, the rules are much more extensive. In particular, the WDC rules will deny a tax deduction even where transfer pricing rules have been complied with – this will cause particular difficulties for multi-national groups.

The intention of HMRC is to ensure that direct external borrowing costs of UK companies remain allowable for tax purposes but to allow deductions for intra-group borrowing only if the borrowing costs of that intra-group lending do not exceed the net finance costs of the worldwide group.

Where are we now?

After much consultation and redrafting of the initial draft provisions, HMRC has published clauses to introduce the WDC rules within the Finance Bill 2009. These will no doubt be subject to further debate and amendment before the Bill becomes law in July this year (and further changes have already been proposed).

The new rules are currently expected to take effect in respect of accounting periods commencing on or after 1 January 2010.

Which companies will be affected by the rules?

Groups of companies which are classed as 'large' (under EC rules) and which contain at least one UK company (or a company with a UK permanent establishment), are caught by the WDC rules.

Therefore, a 'large' group consisting of only UK companies will need to comply with the rules.

A small or medium sized group will fall outside the rules. (Appendix 1 to this note sets out the rules to determine what is a small, medium or large group for these purposes.)

Gateway test

The WDC rules will only apply to relevant large groups in any accounting period, where the UK net debt of the group exceeds 75% of the worldwide gross debt of the group. This is known as the 'gateway test'. If the total net debt of UK group companies is less than 75% of the worldwide group's gross debt then the rules will not apply to that group.

The UK net debt is the total of the average net debt of each UK company (being relevant liabilities less relevant assets) over the accounting period in question. It is important to note that if an individual company has net debt of £3m or less this is ignored for this gateway test. The worldwide gross debt is calculated by only looking at the relevant liabilities at the end of the current and preceding periods of account of the worldwide group, and it takes no account of the group's assets.

Therefore, even a large group may fall outside the WDC rules if it fails the gateway test. It is expected that the gateway test will be more applicable to inbound groups where debt is lent into a UK subgroup from the wider group than outbound transactions where debt is lent by the UK subgroup to the wider group.

Even with the introduction of the gateway test a significant number of companies could be affected by the WDC rules, including many groups based entirely in the UK and those with UK headquarters.

How do the rules work?

Broadly, the rules work on the assumption that the group's net external debt can be used to 'frank' the intra-group interest costs of UK members of the group.

They work by requiring the group to compare the total net finance expenses of the UK members (taken from corporation tax computations) (the "tested amount") with the gross external finance expense of the whole group (taken from the consolidated accounts) (the "available amount"). Any excess of the tested amount over the available amount is disallowed, but the group may reduce the amount of UK taxable receipts to match the disallowance that arises.

Tested amount

As a simplification of the original proposals, when calculating the tested amount only UK companies with a net finance expense are taken into account. When calculating the tested amount, each company is looked at individually and account is to be taken of all intra-group and external finance costs and finance income of the company in question.

It is important to note there is a de minimis threshold which means that if a company has net deductions of less than £500,000 or net income of less than £500,000 then this is treated as being nil for the purpose of the calculations. Therefore, any companies with finance expenses below £500,000 will not be taken into account when calculating the tested amount.


It is proposed that all financial services businesses will be excluded on a group wide basis when determining the tested amount. The measures are intended to exclude businesses from the WDC rules where debt forms an intrinsic part of the way in which that business is conducted and, helpfully, the WDC rules also assist private equity backed companies by only looking at the company level for the tests.

Available amount

The available amount is the worldwide group's gross consolidated finance expense in both the UK and outside the UK. To the extent that the tested amount exceeds the available amount there will be a disallowance of deductions for finance expenses equal to the amount of the difference. If the available amount is greater than or equal to the tested amount there will be no disallowance and no further action required under the WDC rules.

Disallowance of deduction

The group can allocate any disallowance between the UK group companies as it chooses, subject to the fact that the disallowance can only be allocated to group companies with net finance expenses and cannot exceed that company's net finance expense.

If there is a disallowance then the group can make a compensating adjustment in respect of intra-group finance income received by the UK group members. Such adjustment can only be made to companies with net finance income but can be made against income from both external and intra-group lending.

Basis of calculation

The rules have been drafted on the basis that the relevant groups will draw up accounts in line with International Accounting Standards (IAS). If the relevant companies draw up non-compliant accounts any tax adjustments will be based on what the position would have been had IAS been used. This will be an interesting point in practice as, whilst HMRC say that there is no requirement for a group to produce full consolidated accounts conforming with IAS, if the accounts are prepared in a materially different way then it is likely that the group will have to effectively prepare IAS compliant accounts to work out if the WDC rules apply.

How do the WDC rules tie into existing legislation?

HMRC's intention is that the transfer pricing rules will be applied before the application of the WDC rules. It is also HM Treasury's intention where the late paid interest rules (i.e. those governing when a company may claim a deduction for interest) apply, they would also apply before the WDC rules apply.

See Appendix 2 on how this legislation will interact with the existing legislation.

In relation to the interaction of the WDC rules with the CFC rules, a consequential amendment is expected to ensure that profits of a CFC apportioned to a UK group company are not doubly taxed in respect of any finance expense payable to that CFC.

HM Treasury has promised that these points of detail will be published on HMRC's website in due course. We will keep you updated as further details are published.

Areas still under consideration

Two areas are still under particular consideration following significant comment from businesses and advisers when first published by HM Treasury. These are in relation to the exclusion of financial service companies from the WDC rules (as discussed above) and the new 'Targeted Anti-Avoidance Rule' that was also proposed (TARR). As a result of substantial changes made to the draft rules in early April, HMRC's intention is now to introduce a TAAR that will cover all aspects of the WDC rules. The TAAR appears to be widely drafted to capture any tax advantage where the main purpose or one of the main purposes is to enable a tax advantage.

WDC and current economic conditions

Whilst the WDC rules continue to be scrutinised and consulted upon, the reality of managing a group through these difficult economic times continues.

How best to deal with a group's burdensome debt (even before the WDC rules come into effect) is becoming an increasingly common question and options include buying debt at a discount, waiving it or a debt for equity swap. It is worth noting that, whilst a debt capitalisation will generally be used to help release a company from debt, where it is struggling with that debt, the capitalisation would also help a group in respect of the WDC rules by removing group debt.

Debt capitalisations can hold many tax pitfalls, but with careful planning many of these can be avoided.

In a very simple debt for equity swap you would see cash being used by a creditor to subscribe for shares and the debtor using that cash to pay off the loan. This is relatively simple for tax purposes and the main concern is usually what the base cost of the shares is, particularly if the transaction was not at arm's length.

However, in reality things are never this straightforward and tax issues can arise from other methods of debt capitalisation such as debt being waived in consideration for the issue of shares.

Such a debt capitalisation is governed by the loan relationship rules and, provided a debt is waived in compliance with these rules, a tax charge should not arise on the borrower.

If you are considering the restructuring of your group's debt and would like further advice or assistance please contact any member of our team.


Appendix 1

Small, medium and large entities

  SME Large
Max annual turnover €50 million > €50 million
Max annual balance sheet total €43 million > €43 million
Max no of employees 250 > 250

NB Paragraph 67, Finance Bill 2009 defines a group as "large" if no member of the group at any time is a small or medium sized enterprise as defined in the Annex to Commission Recommendation 2003/361/EC of 6 May 2003 and summarised in the table above.


Appendix 2

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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