When financing your business operations through borrowing, one of the main considerations will be whether the interest cost is deductible, and to what extent if it is. In the UK, the interest expense a corporate borrower incurs is generally deductible under the loan relationship rules when calculating corporation tax. However, there are several provisions that might limit or deny this deduction.
This article sets out some of the points to consider, but does not cover the connected party rules, loans related to management buyouts or shareholder loans, or the tax position of any individuals involved.
Any arrangements which have a main purpose of enabling a company to obtain a loan relationship tax advantage will be counteracted by the making of reasonable tax adjustments to loan relationship debits and credits. For this rule to take effect, it’s not necessary for any party to have a tax avoidance purpose. Although if any party does, then it’s likely that the rule will apply.
Whether this applies is decided on the evidence available, so it’s helpful to record the purpose of borrowing and reasons for the structure.
If the loan relationship has an unallowable purpose, the interest deduction will be denied. This denial is to the extent that the interest is attributable to that unallowable purpose.
An unallowable purpose is not within the business or other commercial purposes of the company. A tax avoidance purpose does not align with the business purpose if it serves as the main reason for the company’s involvement in the loan relationship.
The burden is on the borrower to prove that they do not have an unallowable purpose. It is vital to ensure that documentation is maintained and the commercial rational for entering a loan is recorded, as well as any restructuring that occurs.
A number of recent tax cases in the courts have examined this rule. These found that the unallowable purpose principles may apply if an otherwise commercial transaction is efficiently structured with tax considerations in mind, which could prevent tax relief for some, or perhaps all, interest. Businesses like certainty and unfortunately in some cases there will be a risk of denial for corporation tax relief for arrangements that were not tax driven.
For corporation tax purposes, while interest costs are deductible, distributions are not. Interest can be recharacterised as a distribution in two circumstances:
If it represents more than a reasonable commercial return for the use of the principal amount of the loan, the return could be seen as excessive. Loans which include a discount or premium element can affect this.
Interest can be recharacterised as a distribution to the extent that it is results dependent. Those loans with a fixed rate of interest, or one based on an independent floating rate, will not be caught by this.
Leveraged loans will often include a ratchet interest rate, which links the rate of interest to the ratio of debt to earnings, (often EBITDA). Provided that the ratchet is inverse, i.e. as earnings go up, the interest rate goes down, this is permitted.
Unlike many other jurisdictions, limited recourse loans are caught by these provisions and interest deductibility will be denied. It’s important to ensure that there is no clause in the loan documentation which limits the liability of the borrower to pay interest if its financial performance restricts its ability to do so.
The UK transfer pricing legislation seeks to ensure that transactions between related parties are carried out on an arm’s length basis. Certain exemptions can apply including for small and medium sized enterprises.
If transfer pricing rules apply, their effect is to deny the borrower a tax deduction for any part of the interest that exceeds an arm's length rate of interest. This also relates to a portion of a loan that exceeds what would have been made on arm's length terms. This is because the rules adjust the terms, amount and availability of the debt for both parties to what would have been on an arm's length transaction.
Even if the transfer pricing rules do not apply, the loan relationships code has its own arm’s length rules which will often need to be considered by SMEs.
Interest deductions are denied for equity notes (i.e. 50 year or longer securities held by associated persons).
The CIR limits the amount of interest expense and certain other financing costs that large businesses can deduct when calculating their profits subject to corporation tax.
They do not act to restrict tax relief for interest on a loan-by-loan basis but are a general, structural restriction on tax relief.
The rules are complex but have a de minimis of £2m of interest expense and so are generally only relevant to large companies.
A hybrid mismatch occurs when a financing structure includes a hybrid entity or hybrid financial instrument which has the effect that the borrower gets a tax deduction, but the lender has no corresponding taxable income, or where hybrid arrangements lead to a double deduction.
The UK rules are complex and aim to counteract these arrangements by either denying a UK interest deduction or by bringing an additional amount within the UK tax charge. These are generally only relevant to cross-border transactions.
This provision is aimed at interest-free and other non- market loans that would otherwise lead to asymmetrical tax treatment between the borrower and the lender.
A tax deduction is denied for any part of a discount that is not recognised as a loan relationship credit of the lender where the lender is not a corporate person or is resident in a tax haven.
If you are considering borrowing additional funds or restructuring your existing loans and would like to know more, please get in touch with our Tax partner, Phil Blackburn (philblackburn@lubbockfine.co.uk) or our Director, Robert Hoad (roberthoad@lubbockfine.co.uk).
