Unprecedented Cash Tax Pressure on Distressed Businesses
Distressed businesses and their investors are forecasting cash tax outflows now, where previously many could have looked forward to a tax-free turnaround. Interest costs and brought forward losses will no longer fully shelter taxable profits. Real cash tax outflows will need to be funded, sooner than expected. Following the result of the Farnborough Airport case this week, groups will also struggle to get cash back for losses incurred in insolvent subgroups. Decision makers need to be taking these changes into account now.
Cash tax costs in turnaround - 1. Cuts to tax relief for interest costs
From 1 April 2017, the UK joins many other European countries in adopting a restriction to tax relief for interest costs. Where group net interest costs exceed £2m, tax relief will be limited to 30% of group UK tax-EBITDA. A “Group Ratio Rule” allows more heavily leveraged worldwide groups to claim additional tax relief for third party interest costs.
Distressed businesses will be disproportionately affected by this change.
- Funding cash tax in the turnaround period will be particularly difficult.
- Although heavily leveraged, many will not see the benefit of the Group Ratio Rule as their debts may be disregarded as related party debt. Shareholder debt and cross-guaranteed debt will be affected, even where such debt only arises from a lender’s previous debt for equity swap. Extra tax relief will also be denied even where investors “collaborate in a more general sense” in the financing of the group.
Cash tax costs in turnaround - 2. Changes to tax relief for losses
From 1 April 2017, the amount of annual profit that can be relieved by carried-forward tax losses will be limited to 50%, subject to an allowance of £5m per group.
The allowance will help avoid negative impacts on many distressed businesses - but at the larger end of the scale brought forward losses will no longer fully shelter taxable profits. Funding cash tax in the turnaround period will be particularly difficult for distressed businesses.
In better news, the carry back of losses is protected from any changes and new losses will become more flexible - losses arising from 1 April 2017 can be carried forward and used to shelter any taxable profits arising across a whole group.
The changes apply to all but capital losses (which remain under the old regime).
Banks are already restricted in their use of losses arising from the financial crisis to 50% of profit. This restriction is further tightened from 50% to 25%.
Anti-avoidance rules will further complicate matters, as the Government seeks to maintain protections against loss-buying and to prevent businesses circumventing the changes.
Cash tax costs in insolvency - 3. Groups will now struggle to get cash back for losses incurred in insolvent subgroups
This week, HMRC won a key tax case at the First Tier Tribunal denying a solvent group cash tax repayments that it had claimed by offset of economic losses made by a subsidiary in Receivership. HMRC has often challenged group relief in insolvency but until now have not taken the issue to court. While this decision is not binding on taxpayers at this stage, group relief claims where at least one company is in insolvency are nevertheless likely to be refused by HMRC in the first instance and this may have a real impact on timing for insolvency cases. It may be years before businesses get certainty in the form of a judgment from the Court of Appeal. Taxpayers will need to put forward a strong argument to distinguish their facts and those of this case if they are to secure cash tax repayments going forwards.