Corporate tax deductions for interest on borrowings will change sooner than originally projected
Sunday Business Post Column
Since my last column, the EU Commission declared that it had decided to send reasoned opinions to us (and Austria) “asking” for the transposition into our law of the interest limitation rule required by the EU's Anti-Tax Avoidance Directive (ATAD). This was done as part of its “monthly package of infringement decisions”. To be clear they’re not “asking”.
This means that tax law will soon restrict the tax relief that companies can take for interest on their borrowings. Okay Ts and Cs apply but, bottom line, the cost of financing will increase when this law comes in.
The European Commission’s website lists what happens during the infringement process. It explains that it follows a number of steps laid out in the EU treaties. Below is a “copy and paste” of that information. I call them “the DEFCONs” with no 5 being endgame.
1. The Commission sends a letter of formal notice requesting further information to the country concerned, which must send a detailed reply within a specified period, usually 2 months.
2. If the Commission concludes that the country is failing to fulfil its obligations under EU law, it may send a reasoned opinion: a formal request to comply with EU law. It explains why the Commission considers that the country is breaching EU law. It also requests that the country inform the Commission of the measures taken, within a specified period, usually 2 months.
3. If the country still doesn't comply, the Commission may decide to refer the matter to the Court of Justice. Most cases are settled before being referred to the court.
4. If an EU country fails to communicate measures that implement the provisions of a directive in time, the Commission may ask the court to impose penalties.
5. If the court finds that a country has breached EU law, the national authorities must take action to comply with the Court judgment.
We tick the first two of these so we are staring at DEFCON3 i.e. “see you in court” unless we act.
According to the monthly package (sounds slightly more palatable!) the Commission explains that we had argued that 'equally effective' interest limitation rules were already in place. In other words, and as Clint Eastwood said in “Heartbreak Ridge” (1986) in a voice that sounded like he was chewing wingnuts that, “we improvised, we overcame, and we adapted” but we got the job done.
So what? This limitation rule was supposed to be implemented by 31 December 2018 to take effect from 1 January 2019. We didn’t do that because the ATAD allows countries to put this off until whichever comes first: the start of 2024 or the point when the OECD made these rules a “minimum standard”. This legal delay applied to countries that had “targeted” rules for preventing Base Erosion and Profit Shifting (BEPS), which were “equally effective to the interest limitation rule” set out in the Directive. The OECD hasn’t yet shifted position so we were looking at a 2024 kick off arguing our rules were “equally effective” to those in the directive. The EU Commission said “mais non mes amis” on our approach.
I liked the bit of the monthly package that said “Neither were the Austrian and Irish measures on the list of national interest limitation rules which the European Commission did consider 'equally effective'” because it’s not a long list: Greece, France, Slovakia, Slovenia and Spain. How long did it take you to read it?
Now for the science bit: Under the ATAD, deductions for “excess borrowing costs” (more to come) are limited to 30% of a company’s earnings before interest, tax, depreciation and amortisation (EBITDA). Bottom line, restrictions may apply to an interest expense whether the related borrowing funds day to day operations, corporate acquisitions or intragroup lending and more.
The restriction is on “excess borrowing costs” which the directive explains as the amount by which “deductible borrowing costs” exceeds interest and similar income. “Deductible borrowing costs” are broadly defined and include interest on debt, payments under profit participating loans, the interest element of finance lease payments, notional interest amounts under hedging arrangements related to borrowings, certain foreign exchange gains and losses on borrowings and the list goes on and on. That’s quite wide and so it’s unlikely that a corporate group wouldn’t have some of these which would have to be restricted.
The ATAD explains that member states may allow standalone entities (i.e. those not in a corporate group) to fully deduct borrowing costs. Additionally, member states may allow taxpayers deduct excess borrowing costs up to a €3 million threshold determined for the entire group. It’s also possible for a lower (or no) threshold to apply. Saying “may allow” means that we can decide our future here and as I’ve said previously in this column the more exceptions to this that can be done the better. One of the things that was drummed into me as a student was cash is the lifeblood of business, so you just don’t mess with that.
Member states can introduce additional exclusions: (i) an “equity/total assets” ratio test, whereby a company may deduct borrowing costs in excess of 30% of EBITDA if it can show that the ratio of its equity to total assets is equal to or higher than the equivalent ratio of the group where certain Ts & Cs are met or (ii) a “group EBITDA” test under which a company may deduct its excess borrowing costs by reference to the group ratio of excess borrowing costs over EBITDA.
The ATAD also allows member states to not apply the restriction to loans concluded before 17 June 2016 (and not modified thereafter). The directive also permits countries exclude third-party loans used to fund a long-term public infrastructure project where the project provides, upgrades, operates and/or maintains a large scale asset that’s considered in the general public interest of the respective country. Certain financial undertakings can be excluded from the interest expense limitation rule which in general comprise regulated entities e.g. banks etc. so these may not go far enough for most companies.
We will likely see this new-fangled restriction in next year’s finance bill. Bottom line, the tax impact of how your corporate group finances itself will change and probably not in a good way. There’s no time like, well right now, to determine how you roll with this one.