Taxation of Foreign Profits and the Debt Cap

What is HM Revenue and Customs' (HMRC's) latest commentary on the Debt Cap - part of its review of the taxation of foreign profits?

How have we got to where we are?

In the 2008 Pre-Budget Report, the Government announced a package of reforms in respect of the taxation of foreign profits, to be introduced in Finance Bill 2009. Draft clauses were released for consultation on 9 December 2008, together with explanatory notes.

In order to allow adequate time for consultation, the draft clauses for the worldwide debt cap portion were released at an earlier stage of development than is usual, with the expectation that further changes would be needed. Updated draft clauses and additional guidance notes were published to deal with particular exclusions from the worldwide debt cap measure on 26 January 2009.

What is HMRC's 'current thinking' on the Debt Cap?

On 7 April 2009, HM Revenue and Customs (HMRC) issued further commentary on the proposed Debt Cap, which is part of its review of the taxation of foreign profits. What is clear is that the Debt Cap seems to be here to stay, and that a broad outline is now known. There is no set implementation date, but it appears that both the Treasury and Ministers intend to push ahead with the new legislation with some urgency. The intention remains to bring it into force at the same time as the proposed dividend exemption.

The Debt Cap is still expected to apply only to large groups (broadly groups with more than 250 employees and turnover exceeding Euro 50m or a balance sheet exceeding Euro 43m).

The aim of the rules is to restrict the ability of UK companies to deduct interest for tax purposes essentially where UK finance costs are higher than consolidated global financing levels. However, the way this will be achieved is substantially different from what had been proposed previously.

The calculation of the UK finance costs will be based upon an entity by entity calculation using total net finance expense. This will then be compared against the gross consolidated finance expense (including the UK). The calculation should be somewhat more straightforward than the previous proposals.

There is also greater clarity in the commentary on the proposed exemptions and reliefs, in particular the so called 'Gateway Test'.

The Gateway Test would mean that, where the total net debt of UK group companies is less than 75% of the gross debt of the worldwide group, the group is excluded from the Debt Cap rules. For many groups, the Gateway Test will take them out of the Debt Cap without having to perform the more detailed calculations.

Revised draft legislation has not yet been published, and there remains some significant uncertainties. The Debt Cap calculations are still likely to be complex where the Gateway Test is not passed. Nonetheless, the proposals do represent a step in the right direction.

What are the other exemptions and relief's included in the announcement?

In addition to the above provisions the commentary includes reference to:

• Accounts based on UK, USA, Canada, Japan, China, India and Korea GAAP can be used if no accounts are drawn up under International Accounting Standards
• A de minimis limitation and an exclusion for genuine short-term debt will be included
• There will be a continued group wide exclusion for some financial services groups
• The exclusion of collective investment schemes from the definition of group parent, so that portfolio companies are considered separately
• The exclusion of foreign exchange movements from the calculations
• Disapplication of the rules may be available where the adjustments would result in 'stranded' loan relationship deficits or management expenses that could not be relieved in the accounting period

Nick Farr, Tax partner at Grant Thornton says: "At this stage, we recommend that companies should continue to monitor their broad position with a view to identifying the possible overall impact at a high level, and consider an appropriate plan of action. Formal calculations and strategies to manage any resulting exposure and planning will be necessary once the detailed legislation and implementation date is finalised."

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