Interest Limitation Rules
Most notably, the highly anticipated Interest Limitation Rules (ILR) will be introduced into Irish tax legislation, taking effect for accounting periods beginning on or after 1 January 2022. The ILR is a fixed ratio rule that seeks to link a taxpayer's allowable 'net borrowing costs' directly to its level of earnings, by limiting the maximum net deduction to 30% of tax-adjusted EBITDA.
The introduction of these rules represent a fundamental change to the Irish tax system and may have a significant impact on the Alternative Funds industry, as the ability to avail of a tax deduction on interest payments is restricted. In particular, the ILR will be of most relevance to highly leveraged entities, such as the Irish Section 110 vehicle.
Definition of interest equivalent
Firstly, the ILR applies to 'net borrowing costs' and as such, any interest (or equivalent) expense sheltered by interest (or equivalent) income will not be subject to a restriction. As such, Section 110 vehicles operating credit strategies are unlikely to be as impacted by the rules as others.
The Finance Bill definition of interest includes not only interest itself but also amounts under derivative instruments connected with the raising of finance, the interest elements of foreign exchange gains and losses and the finance element of finance lease payments. Also specifically included are the interest equivalent elements of the profit and loss movements on financial assets and liabilities. This is potentially very wide for all industries within FS as it could sweep in all or some of the unrealised fair value movements on a range of financial instruments which might not otherwise be considered as interest or interest equivalent. Furthermore, it is positive that the interest limitation legislation recognises the commercial reality that an element of an aircraft operating lease rental is equivalent to interest income, thereby allowing a lessor to reduce its net interest expense.
As there is potential for interpretational differences in this area, it is important that clarifications are provided by way of Revenue guidance in order to provide a degree of certainty for taxpayers, particularly with respect to investments in deeply discounted debt positions. It is worth noting that these definitions apply to both income and expense amounts.
The ILR is subject to some exceptions where there is a limited risk of base erosion or profit shifting. These exceptions include:
- where the Irish taxpayer's net borrowing costs are less than €3 million;
- where a company is a stand-alone company, being a company that has no associated enterprises or permanent establishments and is not consolidated for financial statements purposes with any other entity;
- Long-Term Public Infrastructure Projects, being a project to provide, upgrade, operate or maintain a large-scale asset in the general public interest; and
- interest on legacy debt, being debt the terms of which were agreed before the terms of the ILR were agreed on 17 June 2016.
As expected, the Finance Bill does not provide for a financial undertakings exemption which is understandable as these entities often generate net interest equivalent income and an interaction with financial undertakings and grouping provisions was not permissible.
Grouping provisions – Interest group
As anticipated, the Finance Bill provides for the application of ILR using an elective "group approach" (i.e. calculating the interest restriction at the level of a local group of companies (an "interest group")). The draft legislation provides that the "interest group" will encompass all companies within the charge to corporation tax in Ireland that are members of a financial consolidation group, as well as any non-consolidated companies that are members of a tax loss group.
From an Alternative Funds perspective, the reference to "within the charge to corporation tax" is particularly important as it can in certain instances bring particular regulated fund structures (such as the ICAV) within scope of the interest group definition. The ICAV-Section 110 structure is particularly popular in Ireland and the ability to enter an interest group (and disregard/aggregate intragroup transactions) has the potential to be very beneficial from an ILR perspective, given the ICAV is a fully equity funded structure. Many alternative asset managers view this as the structure of choice going forward and it provides the potential for non-interest yielding strategies to also be efficiently held in this structure.
Grouping provisions – Worldwide Group and Single Company Worldwide Group
The draft legislation also allows for two additional "grouping" reliefs from the ILR linked to a worldwide accounting group containing the taxpayer; the Worldwide Group and the Single Company Worldwide Group (SCWG).
Where the Irish taxpayer is part of a consolidated worldwide group (Worldwide Group) for accounting purposes, the indebtedness of the overall group at worldwide level may be considered for the purposes of providing additional relief. There are two provisions with respect to Worldwide Groups, namely;
- An equity-escape carve-out from the ILR: The legislation focuses on the ratio of equity to total assets. If the ratio of equity to total assets of the Irish taxpayer is no lower than two percentage points below the Worldwide Group's ratio of equity to to total assets then the equity ratio rule applies and no interest restriction arises.
- A group ratio rule: The group ratio rule calculates the group's exceeding borrowing costs as a percentage of its EBITDA (using the group's consolidated financial statements). If the group's percentage is higher than 30%, the taxpayer is permitted to use the higher figure when calculating any interest restriction amount.
Ireland has also recognised that many small to medium enterprises could potentially have been at a disadvantage as they generally do not meet the definition of a "stand-alone entity" nor do they meet the consolidation tests for the group carve outs. The draft legislation has therefore introduced the concept of the SCWG, being a company that is not (1) a member of a Worldwide Group, (2) a member of an Interest Group or, (3) a stand-alone entity. Where a taxpayer meets the definition above, it can avail of the group carve outs by calculating the relevant ratios as if it was a member of a consolidated group and then adjusting for transactions with associated enterprises (as defined in anti-hybrid legislation).
Both provisions above, but particularly the SCWG provisions, will be extremely welcomed by the Alternatives industry as many structures are likely to fall within the definition of a SCWG. However, analysis of potential associated enterprise transactions will be key in applying these rules (see below for further detail).
Separately, the Finance Bill also included a number of amendments to the existing anti-hybrid legislation. The definition of an "entity" has been broadened and now applies to "an association of persons recognised under the laws of the territory in which it is established as having the capacity to perform legal acts", along with "any other legal arrangement of whatever nature or form, that owns or manages assets".
From an Alternative Funds perspective, the expansion of this definition will need to be considered in the context of investment structures containing partnerships without separate legal personality (which did not previously fall within the definition of an 'entity'). The ability to trace-through these partnerships for anti-hybrid rules has been removed, which may necessitate a review of the application of the rules for investment structures with such partnerships within their structures.
This will be an important point to consider for Alternative Funds with this fact pattern as it may impact historic "associated enterprise" analysis completed for anti-hybrid purposes and as noted above, the definition of "associated enterprise" is also important when considering the value of the SCWG provisions from an ILR perspective.
Anti-Reverse Hybrid rules
The Finance Bill has also introduced reverse-hybrid rules, targeting mismatch outcomes typically arising as a result of an entity being considered transparent in Ireland, but opaque in another jurisdiction, resulting in the double non-taxation of an income item or gain. These rules will be effective for tax periods commencing on or after 1 January 2022 and will need to be considered for popular Irish alternative investment structures such as Investment Limited Partnerships, unregulated Limited Partnerships and Common Contractual Funds.
A reverse hybrid mismatch outcome will arise where some or all of the profits or gains of a reverse hybrid entity that are attributable to a participator are subject to neither Irish nor foreign tax. The application of the rules is predicated on sufficient "association" (per the Irish anti-hybrid definition) between investors in the transparent vehicles and a required aggregated holding by those associated investors in excess of 50%.
Where the reverse hybrid rules apply, the Finance Bill provides for a neutralising mechanism whereby the income of the reverse hybrid entity will be subject to Irish corporation tax, "as if the business carried on in the State by the entity was carried on by a company resident in the State". It should be noted that no mismatch outcome will arise where the investor in the hybrid entity;
- is exempt from tax under the laws of the territory in which it is established,
- is established in a territory, that does not impose a foreign tax, or
- is established in a territory that does not impose a tax on profits or gains receivable in that territory from sources outside that territory.
This is particularly welcome in the context of ILPs whose limited partners meet the above criteria.
A broader exemption has also been introduced for "collective investment vehicles", as defined by Finance Bill 2021. However, in order to avail of the exemption, the transparent entity itself must be considered 'widely held' and holding a 'diversified portfolio of assets'. Due to the prevalence of single investor, private equity structures that utilise limited partnerships, this exemption may be limited in its broader applicability to the Alternative Funds industry.
The PwC Alternative Investments team has been heavily involved in the consultation process in relation to these measures and the extensive stakeholder engagement has led to sensible and pragmatic legislation that meets the minimum standards of ATAD. That said, the rules are extremely complex and given the potentially significant effect of the Finance Bill, many clients are undertaking impact assessments to determine the application of the rules and any necessary mitigating actions. If you have not already done so, we would strongly recommend that an impact assessment of your Irish structures is completed as soon as possible.