Rising interest rates put the focus of CFOs and Treasurers on how to manage higher borrowing costs. However, for many leveraged UK companies, there can be a second, less visible consequence. The higher interest costs do not necessarily result in an equivalent increase in corporation tax relief.
Rising finance costs can push interest deductions into the UK’s Corporate Interest Restriction (CIR) legislation, creating an additional cash tax pressure at precisely the point when debt servicing is already consuming more cash.
With the main rate of corporation tax at 25%, this interaction between financing costs and the tax rules is increasingly important for CFOs, tax directors and treasury teams.
The Corporate Interest Restriction
Loosely, the CIR is designed to restrict the amount of a group’s net financing expense that is deductible for UK corporation tax purposes.
The regime includes a £2 million annual de minimis amount for a group. Above this, the standard fixed ratio method broadly limits deductions by reference to 30% of tax-EBITDA. The detailed calculation is considerably more complex and alternative calculations, including the group ratio method, may produce a different result.
Higher interest rates can change the position surprisingly quickly.
A business which historically had sufficient capacity to deduct all of its financing costs could find that rising interest expense takes it beyond its available CIR capacity, even though the amount of debt itself has not increased.
The result is that the additional financing cost may not generate immediate tax relief.
A double squeeze on cashflow
This can produce an uncomfortable combination.
The business has to find additional cash to meet its increased interest payments, while potentially also paying more corporation tax than would have been expected if the additional interest were fully deductible. Essentially, tax becomes payable on phantom profits that have already been paid away in interest.
For example, if a business incurs an additional £1 million of interest expense but that amount is restricted under CIR, the immediate corporation tax effect could be as much as £250,000 at a 25% tax rate compared with a position in which the expense was fully deductible.
That does not necessarily mean the tax relief is permanently lost. CIR rules provide mechanisms under which restricted interest may potentially be relieved in later periods if sufficient capacity becomes available.
However, deferred tax relief does little to solve an immediate cashflow problem.
For businesses carrying significant levels of floating-rate debt, this makes CIR forecasting an important component of cash tax forecasting rather than simply a year-end compliance exercise.
Which businesses are most exposed?
The issue is particularly relevant to businesses and sectors that typically operate with significant leverage, including:
- real estate and property investment
- infrastructure
- logistics and other asset-intensive businesses
- private equity-backed groups
- acquisitive businesses carrying significant external or shareholder debt.
Businesses approaching refinancing or a significant acquisition should also consider the potential tax outcome alongside the headline interest rate and covenant implications.
Intercompany financing also deserves attention
For multinational groups, higher interest rates can have broader consequences.
Intercompany financing must satisfy the UK’s transfer pricing rules, and changing market conditions can affect an arm’s-length assessment of both the amount of debt and the interest rate charged.
Groups should therefore consider whether existing transfer pricing policies and supporting documentation remain appropriate, particularly where loans are floating rate, have been refinanced or renewed, or where the borrower's financial position has changed materially.
It is also important to distinguish CIR from transfer pricing. A financing expense can potentially be restricted under either regime, for different reasons. Passing an arm’s-length transfer pricing analysis does not automatically mean that the resulting interest will be deductible under CIR.
Don't forget the cost of paying tax late
Higher interest rates can also affect businesses with outstanding tax liabilities.
HMRC's late-payment interest rates are linked to the Bank of England base rate through a statutory formula. A higher base rate can therefore increase the cost of carrying overdue tax liabilities.
That makes accurate forecasting particularly important for groups where higher financing costs, CIR restrictions and wider cashflow constraints are occurring at the same time.
What should CFOs and tax directors be doing?
Businesses with substantial debt should consider stress-testing their tax position rather than waiting for the year-end CIR calculation.
In particular, groups should consider:
- Modelling CIR under different interest-rate scenarios to understand when restrictions could arise.
- Reviewing carried-forward interest and unused capacity and whether these could affect future deductions.
- Comparing the fixed ratio and group ratio positions, including whether a group ratio election could improve the outcome.
- Reviewing debt structures and refinancing plans before new arrangements are entered into.
- Revisiting transfer pricing support for intercompany financing, including debt capacity as well as pricing.
- Building CIR into cash tax forecasts, particularly where covenant headroom or liquidity is tight.
How Crowe UK can help
Crowe UK can help businesses assess the potential impact of the CIR, model the effect of refinancing or changing interest rates, review group ratio opportunities and consider the interaction with transfer pricing and wider financing arrangements.
Early modelling can help identify potential restrictions before they translate into unexpected corporation tax liabilities and cashflow pressures.
For further information on the above, please get in touch with your usual Crowe UK contact.
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