High interest rates could be hitting businesses with unexpected tax bills

The significant increase in the UK’s official base rate of interest over the last 18 months (from 0.25% in January 2022 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 UK companies may have the opportunity to obtain tax relief in respect of their interest costs. 

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

The CIR rules broadly allow companies to claim tax relief for finance costs either in line with the group’s worldwide finance costs (if applicable) or, if lower, up to 30% of their tax-EBITDA, being their taxable profits after adjusting for certain items such as capital allowances and interest. However, a combination of higher interest costs and lower taxable profits is undoubtably pulling more companies into the CIR regime. On this basis, we question whether the regime is still targeted at the most highly geared businesses or whether the regime needs a refresh, taking into account the economic environment UK companies are now facing. 

We have considered the impact of the CIR rules on a single entity group and have compared the results for the years ended 31 March 2021 (‘FY21’) and 31 March 2024 (‘FY24’), with all other factors except for interest expenditure (eg capital allowances etc) being equal. This shows that in FY21, the company would have been able to claim full tax relief for its interest costs, whereas in FY24, they would be restricted on £1.735m, meaning the company suffers additional tax of £434k. See the table below for further details. 

Year ended	31 March 2021	31 March 2024
Taxable profits	£5,000,000	£5,000,000
Capital allowances	£300,000	£300,000
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	£7,550,000	£10,050,000
30% of Tax-EBITDA	£2,265,000	£3,015,000
CIR restriction	-	£1,735,000
Additional tax suffered (@25%)	-	£433,750

In the example above, the company suffers additional tax through no fault of their own, and certainly not through attempting to avoid tax. So, are the CIR rules working as initially intended, or are UK companies being unfairly penalised by the current economic environment? 

The UK government could look to modify the existing rules to restrict relief on borrowings from related parties to the extent that these exceed 30% of tax-EBTIDA, allowing companies to claim a full tax deduction for interest expenditure on commercial third-party borrowings. This could be a fairer way of applying the CIR provisions, as initially intended. However, given the current economic and political landscape and the impact on public finances, we believe it is unlikely that this will make it to the top of the government’s priority list ahead of the Autumn Statement this month.