UK Interest Deduction Cap and NRLs / UK Property Trading

(A)   UK interest deduction cap & NRLs

The UK government (“UK Gov”) are currently consulting on applying an interest deduction cap of 30% EBITDA, with a de-minimis group amount of £2 million interest payments, per annum, below which the cap would not apply.  Our analysis of the original proposals concluded that the new rules only applied to UK corporation tax payers and not to income tax payers such as non-resident landlords (“NRLs”).

Our conclusion has clearly also been noted by other respondents to the consultation and picked by UK Gov. In their follow-up consultation, UK Gov are now proposing to widen the interest cap to non-resident landlords to create a “level playing field” with UK corporate landlords.

If this legislative change goes ahead, then:

Illustrative impact

• Where a property portfolio held by an offshore investor / fund has an EBITDA of circa £10 million which would otherwise be sheltered by (say) £9 million of interest costs resulting in taxable profits of £1 million and tax of £200,000 pa.
• The interest cap would restrict interest costs to £3 million leaving £7 million of income subject to income tax at 20% = £1.4 million pa i.e. an increase in tax of £1.2 million pa which could have a very dramatic impact on cash flows and yield.

Possible structuring / exit strategies

A key beneficiary of this legislation is likely to be UK REITS (and their private UK alternatives the property authorised investment funds or “PAIFs”) who are tax exempt at the property income level and are only taxed on distributions to non-exempt investors (so a UK pension fund would not suffer any tax leakage). One exit strategy may therefore be a sale to a REIT.

The alternative is to consider establishing a UK REIT or PAIF. This would involve the need to diversify the property assets held in one “wrapper” and to ensure that the vehicles are listed / widely held.

Timing and effect of legislation

The updated draft legislation is expected in early Dec and will come into effect on 1 April 2017.

Whether or not UK Gov listens to the representations that have been made regarding the adverse impact on the UK property sector, which is perhaps more highly leveraged than any other, or allow existing loans to be “grandfathered” remains to be seen. We will be keeping a close eye on this and will update you as soon as anything concrete is known either way on this.

(B)    UK Property Trading

HMRC have also brought in new rules to ensure that UK property trading will be subject to UK corporation tax, which are now in operation (FA 2016). These are likely to impact in two specific areas for most NRLs:

1. The distinction between investment and trading, with a wider category of activity characterised as taxable trading (vs the more beneficial tax exempt investment gain position for NRLs) than before, in particular the notion of “partial trading”, whereas previously property ownership was either characterised as investment or trading but not both simultaneously.
2. The above interest restrictions will also apply to property trading ventures, although the £2 million pa de-minimis is likely to be helpful here for all but the larger development projects.

(For completeness, the more aggressive “no PE” and fragmentation strategies implemented by some offshore developers will also no longer be effective).

24 October, 2016

For further information, please speak to your engagement partner or Bas Kundu, Head of Property Tax at Simmons Gainsford, bas.kundu@sgllp.co.uk tel: 020 7291 5867 

Disclaimer: this Tax Alert has been prepared for general information purposes only and does not constitute advice.