High interest rates could be hitting businesses with unexpected tax bills

02 December 2023

The significant increase in the Bank of England official base rate of interest in just over 18 months, from 0.1% in December 2021 to 5.25% in August 2023, is being felt by individuals up and down the country, with increased mortgage costs being a key driving factor in the cost-of-living crisis.

UK companies are also feeling the burden of increased borrowing costs, with many corporate loans being linked to the official base rate. Coupled with the inflationary pressures on their staffing costs and supply chains, the increased interest costs will likely be driving corporate profits down, with the only silver lining being that businesses may at least have the opportunity to obtain tax relief in respect of their interest costs. 

Tax relief obtained on interest expenditure by companies is subject to a number of limitations and anti-avoidance provisions that look to restrict the level of interest costs a company can deduct when calculating its taxable profits. These provisions include the transfer pricing and hybrid mismatch legislation, which potentially restrict tax relief obtained for interest costs on related party loans. They also include the corporate interest restriction (CIR) rules, which apply to all financing and related costs (including on third party loans) and are intended to target highly geared companies. 

The default CIR rules broadly allow groups of companies (including single company groups) to claim tax relief for UK finance costs up to a cap set at the lower of:

  • the net amount of the group’s worldwide finance costs; and,
  • a default 30% ratio of the UK group members’ tax-EBITDA (being their aggregate taxable profits after adjusting for certain items such as tax depreciation (eg capital allowances) and interest).

Alternatively, a group ratio of the UK group members’ tax-EBITDA, based on the group’s worldwide ratio of finance costs to tax-EBITDA, may be used as a basis for the restriction by election. In any event, the cap only applies to the extent a group’s UK finance and related costs exceed an annual de minimis amount of £2m.

A combination of higher interest costs and lower taxable profits is undoubtably pulling more companies into the CIR regime and we would question whether the regime is still suitably targeted at the most highly geared companies or whether it needs a refresh, taking into account the economic environment UK companies are now facing. 

To illustrate the issues arising, we have considered the impact of the default CIR rules on the only UK company in a hypothetical multinational group. Assuming the group’s net worldwide finance costs exceed the UK interest expense and no change in the company’s taxable results other than its interest expenditure, we have compared the impact of the CIR for the years ended 31 March 2021 (FY21) and 31 March 2024 (FY24). As detailed in the table below, this analysis shows that in FY21, the company is able to claim tax relief on its interest costs in full, whereas in FY24, a restriction of £2.5m applies, meaning the company suffers additional tax of £625,000. 

 Year ended 31 March 2021 31 March 2024
Third-party finance £50,000,000 £50,000,000
Interest rate (base rate plus 4.25%) 4.5% 9.5%
Annual interest charge £2,250,000 £4,750,000
Tax-EBITDA £7,500,000 £7,500,000
30% of Tax-EBITDA £2,250,000 £2,250,000
CIR restriction - £2,750,000
Additional tax suffered (@25%) - £625,000

In this scenario, the company suffers additional tax through no fault of its own, and certainly not through attempting to avoid tax. There may be elections, such as the group ratio election, available to improve the position in some cases, but most depend on the results of the wider group and are complex to operate. So, are the CIR rules working as initially intended, or are UK companies being unfairly doubly penalised by the current economic environment? 

Readers can draw their own conclusions, but the UK rules broadly conform with recommendations made as part of the OECD/G20 led base erosion and profit shifting project, so radical changes are unlikely in the near future. In the meantime, companies should consider whether they are likely to be impacted by the CIR and seek professional advice where relevant regarding elections and other actions which could mitigate disallowances.

Beth Barker
Associate director
AUTHOR
Beth Barker
Associate director
AUTHOR