British businesses have traditionally favoured debt finance – which can include loans and certain lease finance costs – over equity finance.
But this could change from next April, with the introduction of restrictions on larger companies’ ability to deduct the costs of their debt finance from their corporate tax liability.
Limit for the large
The new rules will only apply to organisations with more than £2million of UK finance costs a year. But while this threshold will ensure that Britain’s army of SMEs is not affected, the limiting of such an important tax break for many larger companies could net the Treasury a substantial tax windfall.
Under a new “fixed ratio” rule, companies will only be allowed to deduct debt finance costs of up to 30% of their UK EBITDA.
Historically, the amount of finance costs for which a UK entity could claim corporation tax deductions was based on an “arm’s length” standard, which relied on an assessment of the fundamentals of each business. This frequently led to deductions of much more than 30% of EBITDA.
Back to BEPS
The new rules are more than just a tax grab on larger companies. They are the latest in a series of measures designed to prevent multinationals moving profits made in one country to another in order to avoid tax – a practice known as Base Erosion and Profit Shifting (BEPS).
Earlier this year the UK introduced laws requiring larger companies operating across multiple jurisdictions to give full details of how the business is structured.
Such companies must now file tax returns to HMRC showing not just their UK revenue, but which also reveal the relationship between all sister companies and any subsidiaries across the international group.
But whereas the idea behind these enhanced disclosure requirements was to force greater transparency on multinationals – and thus limit tax avoidance – the limiting of corporate interest deductibility is a standalone, and more indiscriminate, structural restriction.
Is equity finance the answer?
Companies that pay more than £2million a year to service their debt costs could take a substantial tax hit as a result of these changes.
However, for most, equity finance is unlikely to emerge as a panacea – as interest is generally tax deductible but dividends paid to shareholders are not.
The changes are thus likely to reduce the current bias towards debt funding, but not eliminate it.
In fact, given that the new rules contain some leeway – a “Group Ratio Rule” may allow multinational companies with high levels of third party debt to deduct additional financing costs – in many cases the most likely outcome will be changes to intra-group funding arrangements rather than external funding raising.
Such complex and important changes – and their implications for individual organisations – need thorough research. Next April may seem a long way off, but now is the time for affected companies to assess the potential impact and plan accordingly.
For more information, please contact:
Andrew Jones, Corporate Tax Partner
T 020 7874 7823