Interest Limitation Rules (ILR)
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. While the default rate of the fixed ratio is set at 30%, a taxpayer may in certain circumstances deduct an amount in excess of 30% of tax-adjusted EBITDA under the “group ratio” rule.
As with all EU directives, the ATAD is binding as to the results it aims to achieve, but Member States are free to choose the form and method of achieving those results. In that regard, the ATAD ILR contains a number of optional provisions, meaning a considered implementation of the ATAD was crucial, so that any optionality was exercised in a manner that was consistent with Ireland’s established international tax policy. There were a series of public consultations. The iterative approach to the consultation process that was adopted is to be warmly welcomed. PwC played a very constructive and central role in shaping the new rules, and was in close and regular contact with the Department of Finance and with Revenue throughout the consultation process.
The Bill provides that the new interest restriction provisions will operate alongside existing comprehensive rules that restrict the deductibility of interest expenses. The introduction of the new interest restriction rules provided the legislature with an opportunity to consolidate and simplify existing Irish rules surrounding interest deductions. However, this opportunity has been missed. Taxpayers therefore face an increasingly complex set of rules and a greater administrative burden.
The restriction is applied by reference to “EBITDA”, which in turn relies on the definition of “relevant profits”. The legislation provides that “relevant profits” is the amount on which corporation tax finally falls to be borne, disregarding any losses carried forward or back. “Relevant profits” are adjusted proportionally where there is income and gains taxable at different rates. Franked investment income is excluded from the tax-adjusted EBITDA amount.
A key definition within the new ILR rules is “interest equivalent”, as a restriction applies only if interest equivalent expense exceeds interest equivalent income. The definition is key, both from an income and expense side. “Interest equivalent” has been defined quite widely so as to include, not just interest on all forms of debt, but also all other economic equivalents including financial instruments such as derivatives. It is unlikely that a corporate group would not have some of these which would need to be restricted.
As expected, and as provided for by ATAD, Ireland provides for the application of ILR using a “group approach” i.e., calculating the interest restriction at the level of a local group of companies (an “interest group”). Membership is elective.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. This approach is to be welcomed and should ensure that the profits of all group members that are exposed to Irish tax are included.
The draft provisions provide for an equity-escape carve-out from the interest limitation rules. The legislation focuses on the ratio of equity to total assets. If the ratio of equity to total assets of the interest group 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.
As alluded to above, an element of relief is also provided for under the 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.
The draft legislation provides that the restrictions do not apply to loans concluded before 17 June 2016 (before the terms of the ILR were agreed). This exemption for legacy debt has been framed more narrowly than anticipated, with strict conditions applying, particularly in relation to pre-existing loan facilities. Grandfathering may be lost where the loan is modified. However, the draft legislation provides that any amendments to legacy debt will only result in a limitation on the “interest equivalent in respect of legacy debt” to the extent that they increase the interest payable on such legacy debt (with the interest limitation rules applying only to the increase itself). Care should be taken when considering amending/modifying the terms of legacy debt.
The draft legislation provides for a number of exemptions. One of these exemptions relates to situations where a taxpayer’s net borrowing costs do not exceed €3 million. The risk of base erosion is considered low in such a situation. The de minimis threshold applies to the “interest group” as a whole, the scope of which was discussed above. The manner in which the de minimis threshold is applied accommodates taxpayers that have profits taxable at different rates.
The legislation helpfully provides for relief for amounts disallowed as an interest deduction. These amounts can be carried forward and deducted in future years. The legislation also provides for relief where there is “interest spare capacity” or “limitation spare capacity”. “Interest spare capacity” arises where taxable interest equivalent exceeds deductible interest equivalent. “Limitation spare capacity” arises where exceeding borrowing costs is less than the allowable amount (i.e. 30% of tax-adjusted EBITDA or the group ratio % of tax-adjusted EBITDA). Both amounts form “total spare capacity”, and must be used within a period of 60 months from the end of the accounting period in which it arose.
The wide-ranging nature of the carve-out for long term infrastructure projects is to be welcomed. The carve-out covers a wide array of assets in areas such as energy infrastructure, transport infrastructure, environmental infrastructure and health infrastructure. There is no requirement for State or public ownership of the infrastructure.
The implications of the rules for specific sectors is discussed in more detail and can be found in their respective sections, financial services and large corporates. Please get in contact with us if you would like to discuss these rules in more detail.
Reverse Hybrid Provisions
The first and most substantial part of the anti-hybrid rules was introduced in Finance Act 2019, and entered into effect on 1 January 2020 as required by ATAD. These rules dealt with the main categories of hybrid mismatch outcomes such as “deduction without inclusion” mismatch outcomes, “double deduction” mismatch outcomes, “permanent establishment” mismatch outcomes and “imported” mismatches. As a consequence, Irish companies are required to review and consider each tax-deductible payment made in the context of each of these independent tests to determine whether a mismatch outcome has arisen, which would need to be neutralised under the anti-hybrid legislation. The Bill also includes a number of technical amendments to these rules.
ATAD also required the implementation of anti-hybrid rules targeting reverse hybrid mismatches into EU Member States’ law by no later than 1 January 2022. Reverse hybrid mismatches can arise where an entity, referred to as a reverse hybrid entity, is treated as tax transparent in the territory in which it is established but is treated as a separate taxable person by some, or all, of its investors such that some, or all, of its income goes untaxed.
Accordingly, the Bill proposes new Irish legislation, effective for tax periods commencing on or after 1 January 2022, targeting reverse hybrid mismatches with the rules applicable to Irish transparent entities, impacting popular Irish transparent structures such as Irish limited partnerships (both regulated and unregulated) and Common Contractual Funds.
The Bill provides that an Irish entity will be considered a reverse hybrid entity, where for Irish tax purposes, its profits or gains are seen as arising or accruing to the “relevant participators” in the hybrid entity (broadly defined as those holding, directly or indirectly, the rights to at least 50% of the profits of the entity), while, in return, the entity is seen as being a taxable person in its own right by the “relevant participators''.
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 relevant participator are subject to neither Irish nor foreign tax. As noted above, the application of the rules is predicated on sufficient “association” between investors in these vehicles and a required aggregated holding by those associated investors in excess of 50%.
Where the reverse hybrid rules apply, such that a reverse hybrid mismatch arises, the 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”. The Bill also includes provisions to ensure that the Irish tax charged takes account of the relevant treaty as appropriate where the relevant participator is resident in a tax treaty jurisdiction, as required under Recital 11 of the Directive, which provides that “any adjustments that are required to be made under this Directive should in principle not affect the allocation of taxing rights between jurisdictions laid down under a double taxation treaty.”
As the purpose of the reverse anti-hybrid rules is to bring cross-border transactions in line with domestic transactions, thus removing any hybrid element without affecting the general features of a jurisdictions tax system ot the tax-exempt status of an entity, and accordingly, the legislation provides that the rules will not apply where the “relevant participator(s)”, i.e. the investor, in the hybrid entity is an entity that:
(a) is exempt from tax under the laws of the territory in which it is established,
(b) is established in a territory, that does not impose a foreign tax, or
(c) is established in a territory that does not impose a tax on profits or gains receivable in that territory from sources outside that territory.
From a financial services perspective, the introduction of an exemption for “collective investment vehicles” is welcome. The exemption has been drafted to apply to both common contractual funds (“CCFs”) and limited partnerships that are managed by a regulated fund manager. In order to avail of the exemption, the collective investment vehicles must be considered ‘widely held’ while holding a ‘diversified portfolio of assets’ which are both defined terms in the Bill. Both of these conditions must be considered on a case-by-case basis and could give rise to anomalies. Helpfully, the Bill provides allowances for entities both commencing activity and ceasing operations.
Where the collective investment vehicle exemption is not applicable and the reverse hybrid rules do apply, the Bill allows for the appropriation or cancellation of units to meet the amount of tax arising. There are some technical clarifications that would be welcomed as we move to Committee stage.
Anti-Hybrid Legislation - Technical Amendments
Finance Bill 2021 further includes a number of amendments to the existing anti-hybrid legislation. The definition of an “entity” under section 835Z TCA 1997 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 a financial services perspective, the broadening 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.
Section 835AA TCA 1997, which relates to associated companies, now includes a definition for “consolidated group for financial accounting purposes”, which provides that a group will consist of “(i) a parent entity, and (ii) all other entities, other than non-consolidating entities, which are included in the same consolidated financial statements.” A parent entity is defined as “an entity that prepares, or would prepare, consolidated financial statements under generally accepted accounting practice.”
These amended definitions are also relevant for the interest limitation rules.
A further update has been made to the deeming provisions under section 835AB TCA 1997, with the section now available to payments made between “an individual and a permanent establishment of that individual”, and “two or more permanent establishments of an individual”.
We are here to help you
Our teams have been heavily involved in the consultation process in relation to these measures and they have significant practical experience and valuable perspectives in relation to the operation of the new rules. We will continue to engage with the Department of Finance and with Revenue during the course of the legislative process of the Bill and ultimately with Revenue on the development of comprehensive guidance notes. Please get in touch with us for further insights.