Companies with large amounts of debt have become very familiar in recent years with the need to apply the corporate interest restriction (CIR) rules to work out how much of their interest costs are deductible for tax purposes. These rules have been causing headaches for companies and their tax advisors since 2017. However, the impact of the COVID-19 pandemic on many businesses may mean that companies which have not previously had to concern themselves with the detail of the CIR rules may now need to do so. Some may even find themselves unable to claim a tax deduction for interest paid to external banks.
The CIR rules were developed as a result of the OECD initiative to clamp down on tax avoidance by multinational corporations. In general terms, the rules are intended to link the amount of interest a company or group can deduct to their economic operations in the UK. For those interested in the detail, the amount of interest a company can deduct is linked to its ‘tax-EBITDA’ – 30% under the fixed ratio rule and up to 100% of tax-EBITDA under the group ratio rule. A ‘debt cap’ also applies to limit interest deductibility in the UK to the group’s net-interest expense.
The problem for many companies following a year in which COVID-19 has hit their results is that, whether their ratio is 30% or 100%, it’s all irrelevant if their tax-EBITDA is nil. As if this wasn’t bad enough, many companies have had to increase their debt over the past twelve months, resulting in increased interest costs which under CIR may not be deductible.
For many businesses with significant levels of debt, high levels of EBITDA have meant that previously they suffered little or no restriction in the amount of interest qualifying for tax relief. However in sectors significantly impacted by COVID-19, such as the hospitality and the travel industry, heavy losses in 2020 could result in a CIR disallowance as groups find themselves restricted to the £2 million de minimis. That’s a real problem if your annual interest expense is £25 million.
The carry-forward rules within CIR should enable most of these businesses to deduct that restricted interest expense in coming years as their results recover. However this won’t be true for all businesses. Most likely to be impacted are those groups whose operations are largely in the UK and which have undergone a change in ownership (perhaps as a consequence of the pandemic). Although their results may recover, the operation of the ‘debt cap’ within the CIR rules, which limits interest deductibility to the group’s net interest expense, may prevent these groups ever having the capacity to deduct large amounts of disallowed interest.
To be clear, we are talking about groups not being able to claim a deduction for bank interest paid – not because the interest isn’t a bona fide expense but because COVID-19 decimated their earnings following which the ownership of the business changed. An unwelcome sting in the tail and surely not a scenario which was envisaged when the rules were introduced.