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Budget 2016: Interest deductions to be capped to 30% of earnings

Budget 2016: Interest deductions to be capped to 30% of earnings

  • United Kingdom
  • Tax planning and consultancy - Budget



The government announced in the Budget that it intends to introduce new rules to limit the tax deductibility of interest expenditure to 30% of taxable earnings in the UK or based on the net interest to earnings ratio for the worldwide group. 

This is in line with the OECD’s recommendations as part of its “base erosion and profit shifting” (“BEPS”) project, but pre-empts finalisation of the OECD’s recommendations.  

The government has not yet published any legislation and will continue with a new consultation this year.  There are, however, several issues associated with the introduction of the cap that we will in particular, be monitoring as the detail becomes clearer.  Specifically, these are concerns about: 

  • whether or when the measures will apply to income tax as well as corporation tax;
  • whether the cap will apply to 3rd party debt as well as internal debt;
  • how the rules will calculate a group’s earnings for the purposes of the cap;
  • how the cap will be applied amongst connected entities and groups; and
  • how the cap will interact with changes to use of losses and carried forward losses also announced in the Budget.

Further thoughts on how this applies to the UK real estate industry are set out below.

Will the cap apply to external as well as internal debt?

The OECD report, dated 5 October 2015, recommends that the restriction should cover interest on all forms of debt, plus payments economically equivalent to interest and expenses incurred in connection with the raising of finance.  This would include external debt.  The Budget statement did not specifically state whether or not the UK’s rules will apply the cap to external debt, but the industry, on the whole expects the UK to follow the OECD’s recommendations.  Nonetheless, it is understood that the government is sympathetic that much of debt in real estate transactions is a commercial rather than a tax tool and agrees that the risk of BEPS is low when 3rd party debt is secured on real estate, particularly where both the borrower and the lender are in the UK.  However, it is considering how and whether this can be aligned to the OECD recommendations. The BPF is lobbying for external debt to be excluded from the UK rules.

Is the £2m threshold on a group or single entity basis?

This is a frequently asked question.  The OECD’s recommended approach permits ‘supplements to the fixed ratio rule’ including a de minimis threshold. The Chancellor in the Budget suggested that this would be set at £2m in the UK.  The Budget did not, however, expressly clarify how the £2m threshold would apply. The OECD report states that “where a group has more than one entity in a country, it is recommended that the threshold be applied to the total net interest expense of the local group” i.e. that the de minimis is at least to apply at group (not company) level, at least within the same jurisdiction.  

It seems that the UK will also apply the de minimis at group level, but, from the Budget announcement, it seems that this would be applied at the level of the worldwide group.  This is in line with the existing worldwide debt cap rules for corporation tax purposes and so itis perhaps unsurprising this is the position the UK will take.  At para 6.7 of the report, the government offer a simple example of how a de minimis threshold of £1m would work in practice:


(£000's) Group A Group B Group C
Net interest expense 800 1,200 1,200
Calculated cap on net interest Calculation unneccesary 900 1,100
Interest deduction (net) 800 1,000 1,100

The position would seem to depend in the first instance on whether the de minimis threshold is met and then beyond that on whether the net interest exceeds the 30% cap or any fixed ratio alternative.

The UK consultation document also refers to a proposal to exclude SMEs.  Again, how this is defined (and, indeed, whether this will be in addition to or whether they are intended to be covered already by the £2m cap) is something we will monitor.

How will the 30% test be calculated?  

The UK consultation gives a very simple example of how the 30% cap would apply.

UK company with taxable EBITDA (£m) 600                                                           
Net interest expense (£m) 200
Net allowable interest (£m) (being £600m x 30% cap) 180
Interest restricted (£m) 20

Recognising some groups are highly leveraged for non-tax reasons, the Budget included the OECD’s recommended approach to include a ‘group ratio rule’ allowing an entity with net interest expense above the 30% ‘fixed ratio’ to deduct interest up to the level of net interest/EDBITDA ratio of its worldwide group. It is anticipated that the new rules would replace the existing worldwide debt cap rules for corporation tax purposes.

How is EBITDA calculated for this purpose?

The basic definition of EBITDA is earnings before interest, taxes, depreciation and amortisation.  However, it is not clear that this general definition will be the one used for the purpose of the interest cap.  The industry has widely expected the rule will be set against a company’s earnings before interest, taxes, depreciation and amortisation (EBITDA).  However, this is potentially not in line with the OECD’s recommended approach, which may add back net interest expense.

Para 89 of the OECD report states that, for the purposes of determining an entity’s EBITDA, you: 

a)    take the entity’s taxable income;

b)    add back net interest expense; and

c)    add back depreciation and amortisation.

The above suggests that the OECD is interpreting EBITDA to be earnings after interest, but before taxes, depreciation and amortisation.  Adding back net interest like this potentially means that the  OECD’s rules operate disproportionately from an economic perspective between companies with high interest income and those companies other income, such as rental.  This does not seem right, so we would expect something to change here. We wait to see the UK’s detailed proposals.

Will the rules apply to income tax?

It seems that the new UK proposals will, in the first instance, only apply to corporation tax: not to income tax.  It is understood that HMRC are quite aware of this distinction and that the rationale has been considered.  Apparently, there is quite enough to do at the moment to get a rule that works for corporation tax, so that these rules may come in first. However, in line with the OECD proposals, it is anticipated that the rules will extend to income tax in due course.

Will there be any other exclusions?

It is intended that there will be an exemption for public benefit infrastructure projects, which are generally very highly geared.  However, it is anticipated that this exemption will be relatively limited in practice. 

The UK REITs are also looking to be carved out of the regime, given that they already have an effective cap on use of interest through the interest-cover test. 

Other issues

An argument has been put forward that all this change could be avoided by an efficient transfer pricing mechanism (which it is, of course, intended to have as well, under the BEPS proposals).  It is likely, however, that this argument will not prevail.  This is due not only to it being out of step with the OECD proposals, but also because, as we have seen recently, transfer pricing is a fairly blunt tool and so it is harder for HMRC to police it as rigorously as it would like.  It remains to be seen also how the new rules will interact with the other proposals around interest restrictions for individuals with buy to let mortgages.

The UK report also recognises the potential impact of the new rules on banking and insurance.  The OECD is currently conducting further technical work in this area, and we anticipate that the UK government will wait for those findings before further detail is announced for these sectors. 


The measures are to come into effect on 1 April next year. This is likely to be in advance of the finalisation of the BEPS proposals and, so, in advance of equivalent rules in other jurisdictions planning to adopt them, with implications around competitiveness for UK businesses in the interim. Oddly, as is becoming more common, it seems that on present timing, we are also unlikely to have final UK legislation at the time the rules are introduced.  This will give rise to issues around uncertainty and risk.  After that, there will potentially be even more change, if, once the OECD proposals firm up, the UK then seeks to align with them.  Given the implications for businesses operationally, this timing should therefore be reconsidered. There does not, however, seem to be any intention on the part of the government so far, either to slow down the process or to allow any grandfathering for existing arrangements.


The implications will no doubt have major consequences for many real estate and private equity real estate businesses.  Lenders are already looking carefully at pricing and covenants.  Time will tell how much the change will influence investor behaviour or change practice and structuring, but it certainly will impact on modelling and returns.  These measures will, of course, accelerate the tax take for the government, and so, it is unlikely that the proposals will go away.

Please view our dedicated Budget 2016 hub here. It will give you access to our watch list, our contributors and relevant articles and tweets.

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