Writing for Tax Journal, BKL tax director Helena Kanczula explains the myriad tax issues to consider when structuring a UK acquisition.
Investment into or expansion within the UK involves a clear understanding of the possible tax, financial and commercial risks, and commitments. When structuring an acquisition, it is essential to understand what the tax profile of a target group or enlarged group will look like post-acquisition and in particular, the aspects of the increasingly complex UK tax rules which can affect large groups. This should enable an investor to determine whether steps are taken to take advantage of relevant opportunities and forecast effectively, and prudently the UK and worldwide tax profile going forward.
The current economic uncertainties have impacted the commercial decision-making processes for investors considering expanding into or within the UK. Tax has also come strongly into focus as the UK navigates its way through the current fiscal environment. In this article, I review aspects of an acquisition from a tax perspective but taking a more practical approach regarding some relevant areas. I have focused on an overseas investor looking to expand into the UK, but a number of the following issues would also apply to a UK group looking to expand through the acquisition of another UK group.
There are several aspects of the legislation which can impact on the tax profile of a UK group, so an acquirer will need to review the position carefully. Since 1 April 2017, in particular, there have been significant changes to corporation tax legislation affecting the financing and the use of losses. These may make the modelling of the tax profile for an enlarged group difficult, especially so in the current climate. Nevertheless, there are proactive steps that can be taken to mitigate or avoid unexpected charges.
Financing of an acquisition
Historically, subject to transfer pricing and loan relationship rules, it was advantageous to maintain UK gearing at an appropriate level to secure UK deductions for interest and related finance costs. The corporate interest restriction (CIR) rules (in TIOPA 2010 Part 10) mean that compliance in this area has significantly increased beyond that of its predecessor, the world-wide debt cap.
Use of a UK holding company
Consider the structure set out in figure 1 below. It is assumed that the overseas companies are cash rich and resident in jurisdictions with which the UK has treaties that include suitable non-discrimination articles (see HMRC’s International Manual at INTM41290). It is also assumed that the finance is not within the remit of the unallowable purpose rules (CTA 2009 ss 441–443). Target ParentCo and any other companies in the target group may already be financed through a significant level of debt, which may be refinanced by the acquirer.
Acquisition structure: use of a UK holding company
An overseas group may instead consider it appropriate to finance an acquisition through an overseas vehicle. See figure 2 below for an illustration of this, which assumes HoldCo overseas acquires Target ParentCo directly and provides refinancing for any existing UK loans. UK net debt should be lower under this second scenario as substantial additional loans would not be made to the UK at the transaction date.
In both of these scenarios, an investor may be of the view that there may have been efficiencies if, for instance, the corresponding overseas corporation tax rates in the lending country were lower than the UK rates, particularly for the structure in figure 1. Remember also that jurisdictions offer tax incentives to manage the tax profile. For example, Cyprus and Italy operate a system of notional interest deductions (NIDs) which entitle a lender to deductions against taxable income where equity investment is used to carry out a business activity.
Some aggressive structures have also sought to exploit mismatches in treatment across jurisdictions, although many countries, including the UK, have implemented anti-avoidance legislation as a result of the work the OECD has carried out under the base erosion and profit shifting (BEPS) programme. As a consequence of this work, there are now broader and more consistent tax factors to consider on the financing of new investment into the UK than would have previously been the case before April 2017.
Costs of raising loan finance
Looking at more basic rules on an acquisition, the costs incurred with respect to financing and expenses incurred by a UK company in respect of bringing its loan relationships into existence may be deductible under the principles set out in CTA 2009 s 306A(2). (This extends to abortive costs under CTA 2009 s 329.) It is therefore essential that, where such costs are incurred, the amounts are not lost in general takeover costs and can be separately identified and the impact on the CIR is also considered (see below).
If, post-acquisition, the group in figure 1 or 2 is ‘large’ for the purposes of UK transfer pricing purposes, the level of debt introduced into the UK via HoldCo UK or Target ParentCo UK and interest charged thereon will be subject to arm’s length principles.
The UK Target ParentCo and any existing companies may be already within the CIR rules. This does not negate the need to ensure that a UK group is compliant when self-assessing its transfer pricing position, as amounts disallowed under the CIR could be relieved over future periods, at least in part.
The fact that there are no UK safe harbour limits for debt to equity or interest cover is a source of frustration for some overseas investors. There are opportunities for UK thin cap agreements, which may be appropriate in more complex scenarios (see TIOPA 2010 Part 5 and Statement of Practice SP 1/12, which is supplemented by guidance in HMRC’s manuals). The cross-border position should be reviewed to determine whether the overseas country views thin capitalisation as a transfer pricing issue, and the opportunities for mutual agreement procedures should be considered.
Acquiring groups which are not heavily geared may look to refinance a UK target group with internal loans. However, the CIR rules may deny full relief for UK interest on the refinancing, even where the level of UK net debt and interest charged accords with arm’s length principles.
Other OECD jurisdictions have introduced interest deduction limitations, and these rules are broadly equivalent to the UK rules which apply a headline deduction of 30% of earnings before interest, taxation, depreciation and amortisation (EBITDA) as the default before any cap applied based on the worldwide group’s gearing. In our experience, investors increasingly have greater understanding over the way in which this rule may affect them. Nevertheless, during the acquisition process, projections should be made, based on a range of outcomes, to determine the impact of the CIR rules. This can be particularly difficult for groups operating in sectors with volatile profit profiles or which are more susceptible to economic turbulence.
Note that in determining net UK interest expense, the CIR rules apply after any other rules affecting the treatment of finance costs, including the transfer pricing rules, cross-border rules such as the hybrid legislation and other provisions of the loan relationship rules. It is always essential to have a clear understanding of the financing of the wider group.
FRM or GRM?
While restrictions based on UK EBITDA may be generally understood by clients, there is a general misconception that the use of carried forward disallowed interest is flexible. It is therefore prudent to explain that disallowed finance costs which are carried forward under the CIR cannot be utilised as flexibly over future periods. That said, there are opportunities for groups to achieve a more beneficial result than under the standard fixed rate method (FRM), which restricts deductions to a maximum of 30% of UK EBITDA (provided the cap referable to the worldwide group facilitates this).
For groups with a significant level of external debt, an election for the group ratio method (GRM) to apply may provide a better result. This replaces the 30% ratio with a ratio based on the ratio of debt to worldwide group EBITDA. However, under the GRM, the calculations exclude amongst other expenses, related party debt from the calculations. Therefore, for common scenarios such as loans provided by major shareholders, the deductions under the FRM may be higher for a particular accounting period. Cash rich groups with modest levels of external debt may be unable to claim the headline levels of deductions. In a worst case scenario, this could limit interest deductibility to the relevant cap for the worldwide group or £2m of interest, if lower.
There are certain other elections within the legislation which should be considered and can increase tax efficiency to a degree. The elections operate in a narrow set of circumstances. The following examples illustrate the targeted nature of these and some of the pitfalls.
Public infrastructure election
Special relieving provisions apply to qualifying companies involved in the provision of public benefit infrastructure (TIOPA 2010 s 438). Where applicable, relevant amounts of tax interest expense are excluded from the calculations. However, as the company must meet the public infrastructure income test, or be operating a UK property business, this election will be of limited application. Examples of the type of business which might qualify are given in HMRC’s Corporate Finance Manual (at CFM97130). The interest which is excluded from the calculation of UK interest expense cannot be related party debt and for elected companies, their UK EBITDAs are assumed to be zero.
For companies financed by a mixture of related and non-related debt, the FRM or GRM often produces a broadly equivalent, or better, result. Furthermore, the election is not revocable for a period of five years. On a UK acquisition, the financing of companies which may have made such an election may impact on the level of net interest deductions available which the target group previously benefited from. The revocation of the election may be appropriate although there is a similar five year wait before a company can elect back in.
Joint venture companies
An acquiring group may hold investments in joint venture (JV) companies and not consolidate fully the results of the JV company into the accounts used for the purposes of calculating the worldwide results. Normally, the interest expense of a JV company will not, therefore, be reflected in the CIR calculations, and it could increase group earnings for the purposes of calculating group EBITDA and so affect the GRM.
If this would have a material impact on the calculations, groups should consider making a relevant election under TIOPA 2010 s 473 to include an appropriate proportion of interest in the calculation of group interest.
The calculation of interest – to be included in the worldwide net group interest expense when calculating the external caps – may include capitalised interest that will not be debited to the relevant company’s profit and loss account in the same period. There may be a mismatch between the cap and the treatment in the UK company’s accounts and corporation tax return if the interest does not relate to a relevant asset. An irrevocable election may be made under TIOPA 2010 s 423 to align this treatment.
In practice, this is most likely to affect companies which develop land and buildings. However, a review should be carried out in respect of the risk of disallowances which may be increased by mismatches between accounting and UK tax rules, as the election may affect areas such as employer’s pension contributions and share acquisitions. HMRC’s guidance at CFM96600 provides a good overview of the rules.
Despite the fact the CIR rules having been with us for nearly six years, there remains a high level of uncertainty as to how some of the more complex aspects operate when acquiring a group.
Whilst the general position is that brought forward disallowed amounts cannot be accessed flexibly, there is nevertheless limited scope within the rules to access brought forward amounts and, if UK tax-EBITDA is significantly higher in a period subject to the financing of the worldwide group.
It goes without saying that it is important to comply with the administrative aspects of the CIR, including nominating a reporting company within the requisite deadline (which is generally within 12 months of the due date). As there is currently no onus on HMRC to accommodate the appointment of a company after this date, this appointment should always be made within the deadline.
Anti-hybrid rules: application to loans and other charges
The UK hybrid mismatch rules in TIOPA 2010 Part 6A were introduced to counteract cross-border mismatches and may deny or restrict deductions or bring income into charge depending on the nature of the relevant mismatch. Financing is a key area where the application of these rules needs to be considered. As noted above, the rules apply before the application of the CIR rules.
As there is no motive test, full consideration should be given to how cross-border transactions will be treated for tax purposes in relevant overseas territories. This involves a full review of the acquirer’s funding commitments. Assumptions regarding the overseas treatment of finance can be misunderstood or overlooked. Open to counteraction is a scenario where an overseas entity has made elections to treat subsidiaries, including UK companies, as branches.
The key recommendation here is to ensure that the overseas finance and advisory teams are aware of the potential for UK adjustments if there would not be counteraction in another jurisdiction. Procedures must be put in place to ensure that UK finance teams are consulted regarding any future overseas transactions or planning which could affect UK deductions.
As noted, jurisdictions such as Cyprus provide for NIDs to be claimed by entities which finance their operations through new equity and allow deductions to be claimed against income. Such incentives may then have some further influence on how finance is introduced into the UK. The OECD has not included NIDs within BEPS actions, although certain jurisdictions (such as the US) do include NIDs within the scope of their mismatch rules.
One area of increasing focus in the current economic climate is the position regarding the acquisition of companies which are party to loan relationships with third party lenders where the loans have been impaired.
CTA 2009 contains various deemed release rules under which loan relationship credits can arise. For example, CTA 2009 s 361 can apply in a situation where there is an acquisition of the debtor company and a company in the acquiring group also acquires impaired debt from the lender.
Careful review of all third-party commitments is required, especially for any companies in financial difficulty. The corporate rescue exemption at CTA 2009 s 361D could mitigate the credit arising to the borrowing company if a release takes place within 60 days after the time the connected purchaser becomes a party to the loan relationship.
However, the relevant conditions for this exemption must be satisfied. First, the transaction under which the rights to the debt are acquired must be at arm’s length and in the absence of the release, there would be a material risk that the borrowing company would be unable to satisfy its commitments over the next 12 months. (See the article ‘Debt restructuring: deemed releases’ (Paul Pritchard), Tax Journal, 18 June 2021, for a good summary of many of the issues we are encountering in this area.)
The UK has an extensive range of double tax treaties. Accordingly, it should be possible for withholding taxes to be mitigated in respect of relevant payments which are made overseas.
The fact that UK dividends are not subject to withholding taxes and participation exemptions could apply to the income in an overseas jurisdiction may mean that there are some commercial advantages of equity finance.
As regards interest, the UK withholding tax procedures should be complied with, and application should be made to apply treaty rates to loans on which ‘yearly’ interest will arise before payments made.
It may be appropriate to apply for a treaty passport, which can reduce the administration associated with applying for the relevant rates of withholding taxes on loan interest. For a UK borrower, HMRC must be informed, using form DTTP2, about a passported loan; this must be done at least 30 working days before the first interest payment for which the direction is intended to cover.
Certain financing arrangements are not subject to withholding taxes. This includes the issue of listed bonds under the Eurobond exemption and the issue of deeply discounted securities where the discount is not treated as interest paid.
We have received queries as to whether acquisition structures involving shareholder loan notes listed on, say, a Channel Islands Stock Exchange are susceptible to changes to how they are viewed from a withholding tax perspective. HMRC consulted on this in 2012 when consideration was also given to dispensing with the distinction between ‘short’ and ‘yearly’ interest. However, most of the proposals were not implemented and the position has not been revisited.
For royalties, the compliance requirements for withholding taxes are less rigid: ITA 2007 s 911 provides that a person may make payment with the relevant amount of relief from UK tax, provided that the payer has a reasonable belief that the recipient is entitled to benefit from the terms of a relevant double tax treaty. It is good practice, though, to ensure that this belief is documented.
Certificates of residence and certificates of good standing
Expansion of an overseas group into the UK or expansion of a UK group may increase the opportunities for trading overseas. Customers based in other jurisdictions will often request certificates of residence in order to make payments without applying relevant local withholding taxes or applying reduced rates.
HMRC offers an online request facility, which operates more efficiently than was the case when requests were made only by post. In our experience, however, customer requests for certificates are generally made when payments become due, which can delay payment. The claiming of relief for turnover taxes through the UK company’s corporation tax return in isolation is rarely advisable as at best, expenses may need to be allocated to the foreign income if the tax is admissible for relief.
Whenever a UK business transacts with a new customer overseas, information should be sought as to whether a certificate of residence will be required, and application made as soon as possible. It may also be necessary to check the requirements of the specific territory as local forms may need to be certified.
For some purposes, a letter of confirmation from HMRC may be appropriate. This will not cover the provisions of a relevant tax treaty but does provide a statement by HMRC that to the best of their knowledge and belief, a company is resident in the UK. A certificate of good standing may also be requested in some scenarios. This is a formal document issued by Companies House to confirm that a company is registered and compliant with its filing requirements.
There are of course, many other rules which an acquirer should bear in mind when seeking to model the tax profiles of a target UK group. The following is not an exhaustive list but highlights some of the current key areas. These factors may also affect how any CIR disallowance is allocated.
The super-deduction and special rate first year allowances which were introduced in 2021 will not be available for expenditure after 31 March 2023. Groups which are seeking to make investment have a short window in which to ensure that expenditure is incurred before 1 April 2023. For significant expenditure commitments, the rules within the general capital allowance legislation which to push back the date expenditure is incurred for long credit periods, see CAA 2001 s 5 which requires specific care.
Note that the rules on the quantum of brought forward losses which can be used are restricted to 50% of relevant profits after the deductions allowance from April 2017 (see below), so capital allowances may have been disclaimed by groups with significant losses. Where a company has large pools of unclaimed capital allowances, the capital allowance buying anti-avoidance rules in CAA 2001 Part 2 Chapter 16A ss 212A–212 should be reviewed. At lower levels of excess, the rules these should not affect genuinely commercial acquisitions; however, when they do apply, they can restrict the use of the allowances to the existing trade rather than, say, generating losses (which can potentially be group relieved).
The research and development credit (RDEC) will increase to 20% from 13%, from 1 April 2023. Qualifying groups should review where genuine research and development (R&D) activities are focused, as claims will going forward be limited to UK work (subject to some exemptions).
If an SME group is acquired by a large group, the UK target is considered to be large for the whole period in which the acquisition takes place (see HMRC’s Corporate Intangibles Research and Development Manual at CIRD92000). An acquirer will therefore need to factor into its pricing the fact that R&D SME deductions or cash credits may not be available. Where pre-acquisition credits are significant, the timing of the acquisition could be reviewed to manage that position.
Current year losses
If an acquiring group already holds UK companies and there are current year losses within the target group or acquiring group, the level of current year losses that can be surrendered between 75% group members may require apportionment between pre and post acquisition periods. This might mean that the order in which such losses are surrendered requires careful review to maximise efficiencies.
Brought forward losses
A significant change from 1 April 2017 was the ability to surrender brought forward losses to fellow 75% group members. The legislation (found in CTA 2010 ss 269ZA–269ZZB) restricts the flexibility of their use and the rules are also subject to the de minimis cap of £5m. Further, on a change of ownership, UK companies of an acquiring group are unable to claim losses from the target group members for the following five years. Consideration should also be given to allocating any CIR disallowances to consenting members with losses.
Other restrictions on a change of control
As regards trading losses, major changes to the trading activities can mean there is a disallowance of losses going forward under CTA 2010 ss 673–676 if the changes occur in a five-year period beginning no more than three years before the change in ownership. The rules can also bite where, at any time, there is a significant revival of trade following a change in ownership. HMRC has said it will not apply these rules if the revival follows forced closures as a result of the Covid-19 pandemic (see HMRC’s Company Taxation Manual at CTM06390). Nevertheless, a purchaser would invariably look to rationalise UK activities which are struggling. There is a lower risk of these rules applying if changes are implemented merely to improve efficiencies and keep up with market conditions.
Other anti-avoidance rules also apply to non-trading losses, including excess management expenses and loan relationship deficits. Again, a careful review is required in order to preserve relief.
Capital losses are less flexible and can only be utilised against relevant chargeable gains. Losses realised on the disposal of assets that were sold before a company joins a group can be used in a prescribed way under TCGA 1992 Sch 7A para 1.
From April 2020, capital losses are included in the carried forward losses restriction – which again, means that the restriction for 50% of profits by losses, subject to the £5m de minimis cap for a 12-month period, applies.
It may be that a target group was not previously subject to the strict transfer pricing requirements in the large company arrangements. However, post-acquisition, these matters may apply to any intragroup transaction. The OECD’s global minimum tax (Pillar Two) rules which are expected to apply for accounting periods beginning 31 December 2023 will also see increased focus internationally on cross border matters.
Note also that for international groups with a consolidated group turnover of €750m or more, cross-border country-by-country reporting may be in point and Pillar Two will also apply.
After the turbulence of 2022 and with a general election due before the end of 2024, there are a number of uncertainties when reviewing investment decisions, and these are compounded by the complexity of UK tax rules. UK tax advantages are unlikely to be a key driver for making an acquisition, but there are areas which it is essential to review and model to ensure that the UK tax position can be modelled.
The article was published in Tax Journal Issue 1607 and is available to subscribers on the Tax Journal website.
In this video, Helena explains how BKL advised an overseas group on structuring and financing its acquisition of a UK-headed group.