Real estate and interest deductibility

From April 2017, UK tax law will be amended to impose new restrictions on the deductibility of interest for corporation tax payers. The UK Government is taking this step in order to make the UK’s interest deductibility rules compliant with the OECD’s Base Erosion and Profit Shifting (BEPS) Project.  The key aspects of the proposed restriction are:

• Restriction of the deductibility of net interest expense to 30 per cent of a UK group's EBITDA;

• The option to substite the 30 per cent EBITDA restriction with a higher ratio where the group’s worldwide third party borrowing capability justifies use of that higher ratio; and.

• Replacement of the existing debt cap rules

For real estate and infrastructure, which are typically highly leveraged, the proposed restriction is expected to have a particularly harsh impact on the economics of any project or investment.

Along with the publication of the Finance Bill 2017, HMRC published a response to consultation, which includes a proposed, and much welcomed, exemption for real estate. The proposed exemption will apply to interest cost on third party debt where that debt finances the provision of rental property to third parties. At first blush, this would appear to mean that interest on third party bank debt will remain deductible in full after April 2017.

The UK’s exemption from the interest deductibility rules for public benefit infrastructure projects is based on the OECD’s recommended exemption. There would be a debate as to whether real estate, that does not otherwise fulfil the public benefit criteria that public benefit infrastructure projects must fulfil, is within the intended scope or spirit of the OECD exemption. Although it is also difficult to see that the OECD would have any way of ensuring that the UK only include in its domestic tax legislation an exemption which is fully compliant with the OECD’s views, there may well be some tension at the policy level. In particular, the UK Government may be careful to ensure that the exemption from the interest deductibility restriction does not apply to real estate lending in a way that is significantly more beneficial than the exemption for public benefit infrastructure projects. 

At this stage, we only have comments in a response to consultation to go on, and there are a number of questions which will not be answered until the draft legislation for the exemption is available (expected mid to late January 2017). These include;

• what constitutes third party debt; it seems likely that only debt provided by a lender who is not connected with the borrower transfer (for pricing purposes) will be exempted.

• will the exemption extend to debt taken to finance the development of property which will ultimately be let to third parties, or only properties which are already in the investment phase?

• what will constitute an acceptable security package from HMRC’s perspective?  HMRC have indicated that parent company guarantees will be unacceptable. Although the rationale for this may seem open to challenge, particularly where the group is entirely UK based ( such that there can be no real BEPS risk in the structure), the OECD exemption for public benefit infrastructure projects also requires the absence of parent company guarantees. It would therefore seem likely that this will also be a feature of the real estate lending exemption

• how much ancillary activity can a property rental business or group have without losing the proposed exemption?

When there is clarity over the answer to these questions, real estate companies will need to review their finance structures, particularly from a security perspective, to test how they are affected.  Until there is clarity, the prudent course of action may be to take debt at the property holding company level, attempt to keep the security package to property and PropCo share security only, or attempt to negotiate with the lender the obligation to revisit the security structure once the detail of the exemption is clarified. For lenders, there may be a tension between seeking to maximise the security package and ensuring that any debt cost is tax deductible.