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Reform of Corporation Tax Losses and Corporate Interest Restriction Regulations

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The Corporate Interest Restriction is one of two strands of the Governments modernisation of the UK tax system; with the other strand being the reform of corporation tax losses. My blog of 25 June made reference to the impact of the Corporate Interest Restriction (CIR) Regulations. Although it was mentioned in the context of both inward investment and property investment it is not restricted to those two arenas.

For many years the UK has been at the forefront of the Organisation for Economic Corporation and Development’s best practice, including measures against Base Erosion and Profit Shifting (BEPS). One of the strands of BEPS is prevention of excessive tax deductions for financing costs. Typically the financing would be intra-group with the lender being in a tax advantaged jurisdiction and therefore high levels of intra-group debt or higher interest rates would save the group tax.

CIR for groups with UK interest deduction over £2m

CIR came into force on 1 April 2017 and only has a fiscal consequence for groups whose UK interest deduction is more than £2m. £2m was taken by the UK Government as being a sum which excluded the vast majority of organisations from the legislation. If UK interest is more than £2m then there are formulaic calculations to determine the tax relief which can be claimed. Tax relief can be claimed on sums as great as 30% of EBITDA (as adjusted for tax). The Government acknowledges that this ceiling can be particularly restrictive for certain groups and therefore it is possible to apply a different ratio; one which is more dependent on external financing and UK profitability. However, this alternative strategy needs management and therefore the relevant election should not be made before medium term profit forecasts are developed.

When the interest restriction applies a group company should be appointed to notify HMRC of the group’s interest restriction and how the group wishes for that restriction to be allocated amongst the group companies. In the absence of the election HMRC can allocate the restriction pro-rata between the companies and HMRC’s allocation may not be appropriate for the group’s tax profile.

Corporation Tax Loss Relief

CIR was not the only new matter introduced on 1 April 2017. There was a revision to the fundamentals of corporation tax loss relief which became effective from the same date. Prior to 1 April 2017 unrelieved trading losses could only be carried forward and offset against future profits of the same trade. Other types of losses had their own specific restrictions.

From Spring 2017 there was a relaxation of the use of carried forward losses in a way to generate greater flexibility. However, conversely there was a restriction on the amount of the brought forward loss which could be offset in any one year. The relaxation applies to all corporates with the restriction only applying to larger, more profitable, companies. This mismatch is designed to assist the SME sector.

The relaxation allows losses to be carried forward against total profits of the same company and therefore makes them more flexible. Additionally losses can now be carried forward against subsequent profits of certain group companies, and not just the future profits of the loss making company. Before accessing this flexibility there are certain conditions to be met and those conditions cannot be assumed to be satisfied. They need to be checked.

The restriction occurs if losses exceed £5m. Prior to April 2017 brought forward losses could be offset against subsequent income without a ceiling. From 1 April 2017 the first £5m of brought forward losses can be used without restriction. However if profits of the later period are greater than £5m then only 50% of the profit above £5m can be offset by losses brought forward.

Although the Government feel that setting a restriction above £5m will remove all SMEs from the legislation I do not believe this is the case. It is common for our property development clients to have phenomenal years as sites come up for sale. If there are brought forward losses (e.g. due to the cost of financing in the period of building) then our clients cannot guarantee that all the losses are available for offset against subsequent profits. We are having regular discussions with property clients about sales forecasts and the extent that sales may occur over a number of years. Although a spread of sales is more common for residential development it may also apply to commercial sites.

1 April 2017 was a watershed for corporation tax in the UK with the introduction of both CIR and the group loss relief rules. Undoubtedly there are groups who will benefit greatly from the new rules and also groups which will experience restrictions.

Overseas businesses setting up UK subsidiaries

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With the Brexit deadline looming we are finding greater amounts of interest from overseas businesses wishing to set up in the UK. For some of these businesses (e.g. those based in the Republic of Ireland) the reasons for expanding into the UK are self-evident. Others come to the UK for more subtle reasons, such as benefiting from the relative weakness of Sterling.

Ease of company incorporation in the UK

Features of the UK landscape are the ease of company incorporation and the ability to have company directors who are all non-UK residents. When compared to the Republic of Ireland our 17% corporation tax rate is unattractive. However this does not appear to dampen the appetite for Irish businesses setting up subsidiaries in the UK.

Structuring for expansion into the UK

When considering expansion into the UK there are a number of decisions which have to be taken about structure. As identified in my blog on the development of the UK corporate tax landscape it is important to model the impact of financing on the UK results as well as modelling the quantum of any opening year losses.

Withholding taxes after Brexit

Typically Irish ownership would access the benefits of the EU Interest and Royalties Directive in order to avoid withholding taxes on intra-group interest payments. In advance of the UK withdrawal from the EU in 2019 the terms of the UK tax treaty may be more relevant and making it more important to register as a borrower under the treaty passport scheme.

As the UK does not have an outbound dividend withholding tax, our departure from the EU does not make dividend withholding taxes a concern. Although this may be efficient as a mechanism for the repatriation of profits out of the UK the impact of dividend income receipts in the home state would still need to be understood.

UK Boards and non-UK Directors

Many inward investment groups have non-UK directors on their UK Boards and this is a common mechanism to enable commercial control of the UK subsidiary by home state persons. Like many countries the UK has a concept of management of control for company tax residency and the impact of our domestic rules should be considered when determining directors numbers, residence and their powers.

Audit requirements

Even if the UK company may not be expected to be particularly large, one still has to consider consolidated accounts and their audit requirements in the home state. This may lead to obligations to audit the UK subsidiary and for the UK auditors to have tight reporting deadlines in order to fit in with group timetables. Typically our audit teams are required to audit the financial statements of the UK subsidiary which have been prepared under UK GAAP and provide GAAP adjustments for overseas parent consolidation. Although this is not necessarily relevant for investment from the Republic of Ireland it can be an important factor to timetable into UK work when reporting to other countries, such as the US.

Future visa requirements

No business is a success without the right people. Expansion into the UK regularly results in staff coming to the UK to manage the early development of the UK subsidiary. Nationals from EU countries have not had to consider visa issues. This may change in the future. The group parent should not assume that its employees can come to the UK without visas. For example an Irish parent company may second staff to the UK to manage the early stage of the UK subsidiary without considering that the staff are, say, Australians working in Dublin. Visa requirements for any secondments need to be explored.

Sending staff to the UK

The UK has tax breaks for movements of staff which may be of benefit. The extent to which the transfer is a temporary matter of a few months or a long term matter should be identified at the outset. This is to ensure that social security is paid to the right country and any relevant terms of bi-lateral social security agreements are applied. Even a short term transfer may result in PAYE obligations or reporting requirements which need to be managed.

Longer term staff transfers inevitably result in the individuals falling into the UK income tax net. Planning for salary equalisation is important when offering the individual a long term transfer. Also whilst developing their total remuneration package it is important that the impact of share options granted to secondees is understood in the UK and home state.

For both secondees and UK employees the HR policies associated with UK employment need to be identified and where appropriate, group policies flexed to meet UK employment laws.

Plan for setting up in the UK

The decision to come to the UK is a relatively easy one for many overseas businesses faced with the uncertainty of Brexit. For our friends in the Republic of Ireland it is possibly an easier decision to make, especially given our close histories, legislative approach and common language. However that does not prevent the need for planning by any group considering coming to the UK at both the tax level and the employee level. We are finding that the most successful businesses are those which engage with us on these matters at an early stage.

Higher or Lower? Getting the price right for intra-group transactions

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Setting the right price for transactions between group companies is one that many boards ask themselves in order that each group company’s profit and loss fairly reflects the underlying nature of transactions. For many items an external market can act as a reference point, making this task relatively straightforward. However, this becomes more difficult when dealing with more complex transactions such as:
• Recharging management team time
• Recharging rent
• Charging for the use of intangible assets such as customer lists or licences
• Provision of finance amongst group companies
For these transactions it is not just the directors of companies that get vexed by the question of what is the right price?

International Groups in HMRC’s sights

Where groups trade internationally, the disparities in global corporation tax rates provides for groups to take advantage of more favourable tax rates. Therefore, unsurprisingly tax authorities take a keen interest in the amounts charged for intra-group transactions. In the period between 2011/12 – 2016/17 HMRC secured an additional £5.9 billion of tax receipts by challenging the transfer pricing arrangements of multinational trading groups.
Therefore, what can international groups do to get the price right? And avoid both the time and expense of a tax enquiry.

Exemptions for SMEs not straightforward

Firstly, the good news is in the UK, HMRC provides an exemption to most small and medium size enterprises (SMEs). To qualify as medium the business will have no more than 250 employees, annual turnover less than €50 Million and a balance sheet of less than €43 million.
However, this UK exemption may not apply in the following circumstances:
• Transactions with overseas subsidiaries where the UK does not have a double tax treaty including the appropriate non-discrimination article
• Where HMRC has issued a transfer pricing notice to an SME which is party to a transaction relevant to a patent box claim
• Where an SME elects that the exemption from the transfer pricing notice should not apply
• Where HMRC issued a transfer pricing notice to a medium sized enterprise
Furthermore, while the UK has an SME exemption, not all territories have one and their thresholds may stipulate different criteria. Therefore, where a group trades globally it is worth considering this issue even if at first glance it seems the SME exemption is available.

OECD Guidelines

The first port of call for determining the right price are the OECD [Organisation for Economic Co-operation and Development] guidelines. These are globally accepted as the bible for providing methodology on calculating an appropriate price and the documentation which needs to be in place. Allowing for review of the pricing policy following its implementation and ongoing monitoring. At their core is the principle that transactions are at arm’s length.

Advanced Pricing Agreements (APAs)

After determining an arm’s length pricing policy, to provide additional comfort that the price is right, a group may wish to obtain an advance pricing agreement (APA) from tax authorities. Thereby agreeing the principles for calculating the price with the tax authority. The degree of certainty obtained can vary from non-binding opinions through to a form of advanced clearance on the transfer pricing policy. HMRC does not offer a simplified process for SMEs for an APA. However, other territories such as France and the USA do provide a streamlined APA process for SMEs. While, APAs do add an initial administrative burden, the clarity they provide on whether the price is right, avoids any nasty tax surprises further down line.

Overall setting the right price for transactions between group companies is not straightforward and is an issue which tax authorities globally are increasingly taking a keen interest in. Even where groups may be able to take advantage of the UK SME exemption, when trading internationally, groups need to be vigilant that these exemptions apply in other territories. Where groups do need to consider an appropriate transfer price, the best starting point are the OECD guidelines, which at their heart are based on the arm’s length principle. Finally, having determined an appropriate transfer pricing policy, to mitigate against any nasty tax surprises down the road it is worth considering obtaining an advance pricing agreement from the relevant tax authorities.

Transfer Pricing – Coming out of the OECD

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The OECD put it quite succinctly when they stated that “in an increasingly inter-connected world, national tax laws have not kept pace with global corporations, fluid capital and the digital economy, leaving gaps that could be exploited by companies to avoid tax in their home countries by pushing activities abroad to low or no tax jurisdictions.” This undermines the fairness and integrity of tax systems.  The project, which quickly became known as BEPS (Base Erosion and Profit Shifting), looks at whether or not the current rules allow for the allocation of taxable profits to locations different from those where the actual business activity takes place, and what can be done to change this, if they do.

The project, driven by the G20 nations, commenced in July 2013 with an Action Plan identifying 15 Actions which would help governments address this challenge. The Action Plan is provided for implementation in three phases between September 2014 and December 2015.

In respect of the SME market, whether an inbound investor into the UK or a UK headed outbound group, Action 8 (changes to transfer pricing rules in respect of intangibles) and Action 13 (changes to the transfer pricing rules in relation to documentation requirements) are the most relevant. The intangibles Action will be re-enforced by further detail to be released in the next 15 months.  As such there is uncertainty about parts of the intangibles report which may be clarified in due course. This Action acknowledges that intangibles can be hard to value and there is emphasis on detailed function analysis, application of databases and the assumptions around risk profiles.

Action 8 suggests that the arms-length principles may not be relevant for intangibles. There may be measures to eliminate cash box entities which often transact at arms-length rates.  The OECD is considering treating these as lenders in a group structure.

Action 13 covers transfer pricing documentation and country by country reporting.

The OECD accept that transfer pricing requirements can differ between jurisdictions. Standardisation of approaches and documentation is therefore beneficial to both tax authorities and international business

The three objectives of this Action are to ensure that taxpayers consider appropriate costs, provide tax administrations with sufficient information to perform risk assessments and provide tax administrations with sufficient information to conduct initial enquiries. This tries to balance the tax authorities’ needs for relevant, reliable, data whilst managing compliance costs for the MNE.

The conclusion is a single master file and a number of local files. The master file will provide a summary of the entirety of the organisation; from organisational structure to intra-group activities and international tax profiles.

This will be supplemented by a local file which meets local tax jurisdictions requirements and provides local tax authorities with evidence to substantiate charges affecting the local country. A country by country report then allows local jurisdictions to understand the impact of transfer pricing within the cumulative results of the group.

Although these proposals may not change the transfer price adopted by a country it may require greater background evidence to be retained by local jurisdictions. The OECD have not given a feel for the process to phase in Action 13.

In conclusion; intangibles have always been a difficult area and it is not surprising that the OECD’s response still requires clarification. The use of a master file, with local variations, is welcome as a start to international harmonisation of compliance requirements.

The Case for the Defence

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Some years back one of my clients established an Indian subsidiary to undertake ongoing programming work that had been undertaken in the UK. My client was a loss-making business, VC backed, in a technology sector, and it decided to outsource these functions to India to reduce its cash burn rate.

We were staggered to receive a report from the Indian division of a Big 4 firm advising that the profits the Indian authorities would expect the Indian subsidiary to declare were the profits that would be made by a US firm providing the same service. That sounded to me like nonsense – if the notional US firm made a 10% uplift on a $2m cost base comprising staff cost and little else, the Indian authorities, on a cost base equivalent to no more than $400K, would be required to make a 50% uplift. I couldn’t believe that independent software companies in India were winning overseas business that would generate anything like that kind of number.

And so it transpired. Working with another Indian accountant, we identified a collective of local independent software businesses offering the same type of service. We analysed their results, we adjusted them to reflect the fact that our Indian company was fully protected by its parent against almost all business risks to which they were exposed, and we concluded the profits the Indian company should declare were equivalent to a 10% mark-up on cost.

Strictly in accordance with OECD guidelines. Obviously we’d have been on stronger grounds were India a member of the OECD, but at least we had a result based on an analysis justifiable by internationally recognised standards. Importantly, we had a result that would be acceptable in the UK as well as being defensible in India.

Roll the clock forward a few years, and what do we find? Here, in the UK, a founder member of the OECD, we have politicians grandstanding about global companies not paying their fair share of tax, we have protest movements invading multinationals’ retail outlets and cajoling consumers to purchase elsewhere. Why? Because the global companies concerned, operating strictly in accordance with OECD guidelines on Transfer Pricing, appear to suffer a lower rate of Corporation Tax on UK-generated business than that suffered by indigenous businesses operating only in the UK.

Take Amazon as an example. It has significant UK turnover – £7.6Bn in the past 3 years – on which it’s paid next to no Corporation Tax. It achieves that turnover because large numbers of UK citizens rate its service as excellent – it’s simply that much better than its competitors. But does it earn its profits here? Its business is predicated on its technology platform, which wasn’t developed here, isn’t owned here, and isn’t maintained here. Without that platform it has no business. It works on tight margins only improved through global purchasing procedures, again not based here. So why should profits attributable to facilities operating outside the UK be taxed here? The simple answer is they shouldn’t. If the UK seeks to tax those profits here, then what about the territories where those profits are being earned? Should they just accept a UK unilateral declaration that it is taking over taxing powers on profits attributable to them, or should they turn round to Amazon and continue levying tax as they do currently? Should Amazon be required to pay tax twice on the same profits?

Exactly the same scenario applies to Google. It’s the world’s favourite search engine, but it isn’t here and an insignificant proportion of its profits are attributable to UK activity. So why should it be subject to anything other than an insignificant amount of UK Corporation Tax?

But the grandstanding doesn’t stop at multinationals. The latest in the firing line is The Ritz Hotel. Mentioned in a BBC article. Why? Because its shareholders aren’t resident here, and the company, whilst profitable, pays no Corporation Tax.

But the UK business tax regime has never taxed profits as they appear in a company’s accounts. It taxes adjusted profits figures, and once those adjusted profits are determined, it allows tax losses in one group company to be offset against tax profits of another. Has that suddenly become a sin?

It’s time the media and the politicians found some other outlet for their spleen. Seeking to tarnish the names of legitimate commercial enterprise because the result of their obeying the rules doesn’t satisfy some ill-thought-through sense of what’s right simply establishes in the observers’ mind the sheer stupidity, even cupidity, of the protagonists.