From Brexit to COVID-19, and the resulting economic downturn, 2020 has had a significant impact on businesses globally. Change is happening fast, and as businesses continually adapt to their changing circumstances, so comes the need to change the corporate tax focus.
The cash flow of the business is likely to be top of the priority list. Although corporate tax will fall down this list, it should never be cast aside. Tax is inextricably linked to cash flow, with aspects such as tax-efficient funding, loss utilisation and devaluation of assets all now coming into focus. Careful planning at the outset can prevent tax leakage and further cash flow problems down the line.
Financing the business
From a tax perspective, there is a fundamental difference between funding through debt or equity. Companies funded by debt can obtain a tax deduction for interest and other finance costs. In comparison, there is no tax deduction for dividends paid on equity. However, several restrictions can limit the tax-deductibility of interest. These include transfer pricing (thin capitalisation), corporate interest restriction and the hybrid mismatch rules. Loan finance can also bring with it other tax implications such as withholding tax on interest and dealing with debt write-offs.
Where companies borrow from other group companies, the UK transfer pricing rules will need to be considered. For companies that do not benefit from the transfer pricing exemption for small and medium-sized enterprises, this will require an assessment of whether the company has been ‘thinly capitalised’. I.e. does it have enough capital to support its debt?
Thin capitalisation would occur when a loan from a fellow group company exceeds the amount which could have been borrowed from an independent lender. It could also be through borrowing excessive sums from independent lenders with the support of group guarantees. High debt to equity ratios and low-interest cover can indicate that a company is thinly capitalised. Companies in this position are advised to seek advice as to the deductibility of their interest charges.
Corporate interest restriction
The deductibility of interest for corporation tax purposes may be restricted where the total net interest charge of all UK companies in the group exceeds £2m in a 12-month period. Where this limit is exceeded, the deductible amount of interest is calculated using either the fixed ratio method or the group ratio method, choosing whichever gives the best result. If the full interest allowance is not used, the balance can be carried forward into later periods, but formal claims must be made. Careful planning is recommended to ensure companies structure their borrowings to maximise the tax-deductibility of interest and protect any unused interest allowances.
The UK’s hybrid mismatch rules counteract tax mismatches where the same item of expenditure is deductible in more than one jurisdiction or where expenditure is deductible, yet the corresponding income is not fully taxable. The rules can catch cross-border inter-group financing. This is particularly relevant where loans have the characteristics of both debt and equity, and the return on the funding is treated as tax-deductible interest in the UK, but as non-taxable dividends in the jurisdiction of the lender.
In this situation, the hybrid mismatch rules prevent the UK company from claiming a tax deduction for the corresponding untaxed amount. The hybrid mismatch rules are complicated, and it is important to structure debt funding correctly to ensure group tax efficiency is maintained.
Withholding taxes are often overlooked when arranging cross-border finance. Many countries, including the UK, impose withholding taxes on payments of interest overseas. If relief is not available under the terms of a tax treaty, the tax can become a permanent expense, significantly reducing the amount received by the lender.
Many tax treaties provide for reduced withholding tax rates, which must often be formally applied for before interest payments are made. Understanding the withholding tax regime of the borrower’s jurisdiction can help to avoid tax leakage on interest payments.
Sadly, it is sometimes the case that loans become non-recoverable and must be written off. Many business owners automatically assume that tax relief will be available on non-recoverable loans. However, losses on connected party debt are rarely tax-deductible. Conversely, the credit arising to the borrower on the unpaid debt is usually not treated as taxable income for UK tax purposes.
To ensure the correct tax treatment of non-recoverable debt, it is important to review the relationship between the lender and the borrower and the relevant circumstances. If cross-border intercompany balances are to be waived, novated or written off, it is important to consider how best to achieve the objectives, given the different tax implications in each country.
Loss utilisation and devaluation of assets
The events of this year are likely to impact the profitability of a large majority of businesses. Many companies may incur unexpected overall trading losses, and assets held by the company may potentially lose value, impacting the accounts profit/loss position.
The first step is for companies and groups to have a clear sight of the likely current period tax losses in the company or group together with any brought forward losses from earlier years. The previous projections may now be out of date and should be updated for the latest management information.
The difference it can make
When considering corporation tax payments that may be due, cash is king, and having sight of the likely taxable profits for the year will ensure that the company or group is in the best position to accurately calculate estimated corporation tax payments and ensure excessive payments are not made. If quarterly instalment payments have already been made based on higher expected profit levels, it is possible to ask HMRC for these to be refunded.
Efficient use of any tax losses may provide for UK tax repayments, by way of claims to carry back losses against the prior year’s taxable profits or by group relief to other UK group companies, increasing cash flow. It is important to understand if the losses available arose pre or post-April 2017 since the UK tax rules changed at that time. What options are available and what is most tax-efficient will depend on the individual circumstances.
When estimating the tax position, whilst the losses per the accounts are the starting point to calculate tax losses, certain items such as the downward book revaluation of fixed asset investments or properties will not be tax deductible so adjustments need to be made to the accounts figures.
In part 2, we take into account the international considerations from a corporate tax perspective, as business owners and employees return to their home countries and work from new locations.
Menzies is a top 20 leading firm of accountants, finance and business advisors that operate out of a network of offices across Surrey, Hampshire and London, providing our clients with easy access and local knowledge. Described as the ‘best performing firm outside of the top 10’ by Accountancy Magazine, Menzies has over 400 employees and an annual turnover of more than £40m.