Restrictions On Tax Deductions For Acquisition Financing
The UK has made great strides in reforming its corporate tax rules to make it competitive for UK based multinationals. Corporates are exempt from tax on dividend income and on gains arising on the sale of subsidiaries, but they are still, broadly speaking, entitled to claim an interest deduction in respect of acquisition debt.
The UK Government has considered whether it should restrict the right to an interest deduction on a number of occasions, but each time has decided against any such restriction. There are a number of specific anti-avoidance rules restricting interest deductibility, as well as the more general transfer pricing/thin cap rules and the “debt cap” regime (which looks at the leverage of the UK as compared to the worldwide group). The general principle, however, is that acquisition debt is deductible for tax purposes, even if it is funding the acquisition of assets that are unlikely ever to generate any UK taxable profits.
These rules have proved useful for highly-leveraged acquisitions, with the interest deduction on the acquisition debt being offset (by way of group relief) against the target company’s profits.
In some jurisdictions a general interest restriction has been introduced, with “excessive” interest being denied if the total interest deduction exceeds a certain percentage of taxable profits. This type of rule could have an impact on acquisitions where the target companies are not generating profits taxable in the borrower’s jurisdiction.
Other jurisdictions have started to take a different approach. France has recently implemented a new rule to restrict the interest deduction on debt to fund the purchase of shares unless the French borrower can demonstrate that it or another French-based group company is making the decisions in relation to such shares and the control of the relevant target companies.
Although primarily designed as an anti-abuse provision aimed at the artificial injection of debt-financing into French subsidiaries of worldwide groups, its effect is much wider. Indeed, any French company that has acquired a shareholding since 2004 must now prove that the decision-making process relating to this shareholding is effectively carried out in France.
The concepts here are vague in nature, and it is yet to be seen what needs to be done in practice to prove that such decisions and control are being exercised in France. Is it enough to ensure that there is adequate local management and/or that group senior management based outside of France attend meetings in France at which crucial decisions are made? And how is all this going to be dealt with in practice by those who have been used to making strategic group wide decisions at board meetings or in investment committees? Draft guidelines look at organisational charts showing the decision-making process and evidence of active attendance at shareholders’ meetings or within management boards in France but international groups with centralised governance may struggle to show that a French acquirer has sufficient autonomy.
Where the restriction applies, for eight years following the acquisition the French borrower will have to add back to its taxable income a portion of its interest expenses calculated by applying the average debt financing cost of the acquiring entity to the acquisition price of the relevant shareholding. This can mean that interest is disallowed even if the acquisition had significant equity financing, and can result in the interest deduction being deferred to periods after the financing has been repaid.
In January 2012, the Netherlands introduced a new rule that restricts the offset of acquisition funding costs against a Dutch target’s profits. The effect of this rule will, for example, mean that where such debt is incurred by a single-purpose Dutch holding company which will be part of the same fiscal unity as the Dutch target, the interest deduction will be restricted if and to the extent that (i) the acquisition-debt-to-purchase-price ratio exceeds an "acceptable" ratio, which is 60% in the first year, reduced by 5% annually over the course of seven years, down to a fixed percentage of 25% by year eight, and (ii) the annual amount of interest due on the acquisition debt exceeds €1 million. The rule will affect private equity funds and also foreign corporate groups without existing Dutch operations that acquire Dutch operating companies. Another new rule (which comes into effect from 1 January 2013) was also adopted earlier this year that will restrict the deduction of interest due on loans that are attributed to foreign or domestic participations. The restriction applies to both related party and third party debt. Participations are deemed to be funded to the extent possible out of the parent’s equity; any excess is considered to be funded out of the company’s debt and the corresponding interest will be non-deductible. Participations are only taken into account in so far as the book value does not represent investments in business expansion of the subsidiary.
There is a significant EU issue here. One of the axiomatic freedoms of the EU is that of freedom of establishment. In other words, a company should be free to decide where in the EU it is to be based, and should not be penalised for that decision. Is a rule that restricts interest deductions by reference to “local” profits (so encouraging the group to build up its activities in that jurisdiction) or requires significant local presence contrary to that freedom?
This is not an issue that is going to go away. Each country is clearly concerned about excessive debt being “dumped” in its jurisdiction simply to create tax shelters. The French and Dutch changes are interesting examples of how different jurisdictions are seeking to deal with this, but there is currently no common approach. EU member states will also be concerned that some of these proposals could end up being challenged successfully before the ECJ.
Bredin Prat (France), De Brauw Blackstone Westbroek (the Netherlands) and Slaughter and May (UK) are three of the members of the Best Friends Network of independent law firms. The Best Friend firms regularly work together on an integrated basis to deliver innovative multinational tax advice.
Sara Luder is Head of the Slaughter and May tax practice and advises on most aspects of UK corporate taxation. She has extensive experience of the full range of corporate and financing transactions. She has also been involved in advising on disputes with HMRC. Sara is named as a leading individual in The Legal 500,Chambers UK,Chambers Globaland Chambers Europe. She was awarded 'Best in tax' at IFLR's 'Euromoney LMG Europe Women in Business Law Awards 2012'.
Sara Luder can be contacted via email at email@example.com
Sébastien de Monès is a partner at Bredin Prat specialising in French and international tax. He has developed a particular expertise on tax issues relating to French and cross-border mergers and acquisitions, real estate transactions (incl. SIIC regime) and private equity transactions. He also advises private clients on their personal tax situation. He is listed as a leading individual in The Legal 500 (201102012), World TradeReview (2012), Décideure Statégie Finance Droit (2011-2012).
Sébastien de Monès can be contacted via email at firstname.lastname@example.org
Paul Sleurink is a noted specialist in Dutch and international tax law, particularly in relation to corporate finance, capital markets and investment funds. His practice is strongly transaction driven, with a mixture of M&A, corporate restructuring and structured finance transactions. Chamberssingles him out for his combination of “technical excellence with sound commercial understanding of the business, which helps when it comes to giving pragmatic and informed advice."
Paul Sleurink can be contacted via email at email@example.com