The guidance notes are helpful in providing clarity in a number of respects. There are, however, a number of areas not explicitly catered for and where care will be needed to ensure compliance.
An IREF is an Irish regulated fund which derives more than 25% of its value from underlying Irish real estate. Since FA16, these funds withhold tax at a rate of 20% on distributions and redemptions, funded from IREF profits, to non-exempt investors. Exempt investors include Irish regulated funds, life assurance companies and pension funds and their EEA based equivalents, along with Irish charities and credit unions.
FA19 introduced an income tax liability of 20% for an IREF where:
- The total debt incurred by the IREF exceeds 50% of the cost of the IREF assets; and/or
- The ratio of the IREF profits plus property financing costs compared to the property financing costs is less than 1.25:1.
As a general principle, third-party debt should be excluded from the remit of the rules, but with the application of complex anti-avoidance provisions this will not always be the case. Certain situations may result in third-party debt not being viewed as ‘genuine’ third-party debt, meaning the debt and associated interest would be subject to the debt and finance cost restrictions as outlined above.
Helpful clarifications in IREF guidance
There are some helpful clarifications contained in the guidance notes.
- While the legislation technically applies slightly different calculation methodologies between the three month period up to 31 December 2019 and periods thereafter, the guidance confirms that the rules in respect of the periods thereafter may be applied to all periods.
- The amount which can be charged to income tax in any accounting period is capped at the total amount of the property financing costs in that accounting period (i.e. the amount subject to tax in a period cannot be greater than the actual financing costs for that period).
- Third-party borrowings used to pay certain costs associated with the purchase of a property, such as stamp duty or legal fees, will be treated as being used to acquire the property itself. This is a welcome clarification of the technical position, which states that any third-party loan must be used entirely to purchase or develop a property in order to be allowable as genuine third-party debt.
- Similarly, third-party borrowings which are used for both allowable and non-allowable purposes may be treated as two separate loans, which ensures that the allowable portion of a loan will not be impacted by non-allowable expenditure, despite the fact that they may form part of the same agreement.
- Third-party borrowings taken out by a direct or indirect investor in an IREF and onlent to the IREF on the same terms will be treated as third-party debt, provided that this arrangement arises because the bank providing the financing requires security at a higher level in the structure, and provided that certain other conditions are also met. It will be necessary to consider the fact pattern carefully of each case in order to ensure that the third party borrowings qualify.
- Funds borrowed to purchase property must also be borrowed ‘at or about the time’ of the purchase in order to be considered third-party borrowings. The guidance provides a carveout in certain situations where the purchase is initially funded by shareholder equity (not including shareholder loans) and third-party debt is introduced ‘a reasonable time’ later, a term which is not defined in the guidance. In order to avail of this carveout the purchaser must be able to demonstrate that their intention was always that the acquisition be financed by third-party debt.
- The guidance confirms that the debt and interest restriction tests should be applied on a daily basis but where there are no unusual movements or arrangements taken to reduce the charge to tax, calculations may be performed at the financial statement end date.
- The guidance confirms that where a lender becomes an associate (i.e. a connected party) of the IREF due to the enforcement of a security, the third-party lender should not be considered an associate. Enforcement action should not therefore create a tax charge by virtue of the lender being considered associated with the IREF as a result of that enforcement action only. This applies where the lender takes ownership of the IREF through enforcement of the debt or where a third-party agrees to transfer ownership of the IREF to the lender.
- Where an IREF holds assets through a partnership, the guidance has confirmed practitioner’s expectation that calculations should be performed by reference to the IREF’s proportionate share of the partnership’s income statement and balance sheet as if such amounts were derived/held by the IREF directly.
Areas needing attention in IREF guidance
There are some clarifications in the guidance notes that may need close attention.
- Per the legislation, third-party debt used to purchase an asset from an associate will only be considered genuine-third party debt in very limited circumstances. The guidance does helpfully provide a carveout in certain circumstances where an associate must borrow and purchase the property because regulatory approval for the IREF is yet to be received. However, there are a number of legitimate commercial scenarios where an IREF could acquire property from an associate that have not been addressed.
- The guidance also confirms that debt incurred to purchase shares, rather than a physical premises, will not be considered genuine third-party debt in any circumstances. This will be an important practical consideration in future acquisitions.
- The legislation contains limited situations in which refinancings of third-party debt may continue to be treated as third-party borrowings used to acquire the property, and the guidance introduces further conditions that must be satisfied for this to be allowed. Therefore, potential refinancing should be carefully managed.
- Borrowings and related interest in respect of non-IREF assets will be counted towards the debt and interest restrictions of the IREF in specific situations.
- Revenue confirms that certain historic transactions may have necessitated the purchase of both an IREF and non-IREF asset at the same time, such as the purchase of a portfolio of assets or of a property and its associated operating company. In these specific cases, Revenue will allow the profits and the costs of the assets associated with the non-IREF asset to be included when calculating the debt and interest restriction tests.
- The guidance provides that financing costs will count towards the interest restriction when ‘released’ through the income statement. In the case of capitalised interest, it will likely be treated as released when the related property is depreciated and/or where the property is disposed of. Therefore, where a significant amount of interest was capitalised over the construction of an asset, the charge to income tax in the year of disposal may be significant. This should be kept in mind, where possible, in determining the treatment of interest during the construction period of an asset.
Areas of uncertainty in IREF guidance
There are some areas, however, where uncertainty remains.
- Legislation provides that certain EEA-based entities, including regulated funds, are entitled to an exemption from IREF withholding tax. The guidance notes stipulate that for a foreign fund to be considered equivalent to an Irish fund (and therefore entitled to exemption) it must be equivalent to an Irish unit trust, ICAV or PLC, but not a REIT. European funds can take many different forms, so this criteria of equivalence to certain prescribed Irish legal forms introduces some uncertainty.
- The guidance also provides that the determination of whether a foreign pension fund should be viewed as equivalent to an Irish pension fund, and therefore exempt from IREF withholding tax, should be considered with reference to the objectives and purpose of the foreign pension scheme in comparison to Irish pension schemes. This is a much narrower interpretation than the previous guidance, which broadly required that the scheme was subject to a supervisory and regulatory arrangement equivalent to that applied in Ireland, and will introduce significant complexity in determining whether a foreign pension fund should be regarded as equivalent.
Three actions for IREFs to take now
Assess the impact of new guidance
IREFs should assess the impact of these provisions on their financing and other arrangements. The legislation is already effective and applied from 9 October 2019 onwards. Careful modelling and consideration of these rules will be needed. The impact of the guidance notes will need to be factored into the calculation of tax charges in the first round of filings, due on 10 December 2020.
IREFs need to be prepared for the 31 October 2020 tax filing, extended to 10 December 2020 in light of COVID19. Appropriate controls should be put in place to manage filing and payment obligations including preliminary tax. We are happy to assist you in managing this tax compliance process.
Ongoing considerations for IREFs
IREFs should actively consider the potential impact of the new rules on future acquisitions and changes to their capital structure, including whether their existing capital structure is appropriate.
We are here to help you
PwC’s Real estate tax team have extensive experience in modelling the potential tax implications of this new legislation and, where appropriate, considering alternative holding vehicles. We also have significant experience managing IREF compliance obligations. If you would like to know more, contact us today.