Sarah Howarth, Senior Manager in the Tax team at Price Bailey, and Mark Ellis, Corporate Finance Assistant Manager, discuss the impact of interest rates on our clients in our two-part video series. With interest rates having reached an all-time high, we dissect exactly how both individuals and businesses may be impacted and what action is necessary.
The first video (The impact of rising interest rates on the current business landscape) provides an overview of interest rates in the current business landscape, as well as the emerging impacts of rising interest rates on small businesses that are now affected by the Corporate Interest Restriction (CIR) regime. While part 2 (Tax considerations in relation to rising interest rates) covers how best to prepare for tax authority reviews and understanding the tax implications of interest repayment issues.
If you should have any questions following discussion in these videos or wish to find out more information on any of the topics raised, use the form below to contact one of our experts.
The impact of rising interest rates on the current business landscape
Our first video in this 2 part series explores interest rates and their implications on both personal finances and the broader business landscape. The past few years have been turbulent, with the pandemic leading to a surge in consumer spending and, as a result, economic overheating. We explore how the Bank of England has responded with significant interest rate hikes, going from a record low of 0.25% in the 2010s to a striking 5.25% currently, and what this means for those remortgaging or managing business debts, as well as those with fixed rates.
The second half of the video discusses tax ramifications, specifically the Corporate Interest Restriction (CIR) regime introduced in 2017. Initially targeting multinationals, the regime has started to impact smaller businesses as the rising interest rates push them over the £2m threshold for UK interest expenses. Discussing CIR calculations and disallowed interest deductions, Sarah and Mark stress the importance of businesses examining their forecasts to recognise if they will exceed the £2m threshold.
Transcript for part 1:
00:00 – Sarah Howarth
So, Mark, interest rates are quite topical at the moment. It feels like every other week I'm talking to a friend. They're remortgaging and they are stunned at how much more it's costing them under their new deal. What's kind of been going on in the market in the last couple of years?
00:13 – Mark Ellis
Yeah, so we've had quite turbulent economic times really. We obviously had the pandemic and from the fallout of that we've now got a period of high inflation. So the interest rates are one of the main tools that the Bank of England can use to sort of impact how an economy either cools down or overheats. Through the 2010s there were historic lows really, when there wasn't a lot of economic growth and to try and spur that on, interest rates were quite low to spur that spending activity and as we've come through the pandemic period, there's been quite a surge in consumer spending and that's caused an overheating economy. There's supply issues as well, but interest rates have been increased around 14 times- 14 different steps from lows of 0.25% up to what they currently are at 5.25%, and that is quite a staggering increase given how long they're low for, and that has a lot of impacts on business as well, not just general consumers.
01:18 – Sarah Howarth
So what does that kind of mean for cost of debt for businesses?
01:23 – Mark Ellis
Well, it really depends on how you finance your business. If you're on fixed rates, then you're in a lucky period; could potentially be quite lucky where over the past couple of years you might have seen base rates increasing. But your fixed interest rates stay the same. Those that are a bit more unlucky might have a floating rate and it might just become a lot more expensive to service that debt. Interest rates have increased, therefore your monthly payments if that's how you're paying have gone up as well, and that is not necessarily an issue if you've got the cash flow to fund it. Where it does become an issue is if those interest payments are eating away at whatever profit or cash flow you've got left in the business. But I suppose what I want to know about Sarah is what are the tax impacts of this? Is there anything that sort of our client base needs to be concerned about or aware of?
02:11 – Sarah Howarth
So I think, from a tax point of view, the main thing I wanted to mention was Corporate Interest Restriction. So this was a regime brought in in 2017, part of a raft of international measures to try to discourage multinationals primarily from over leveraging the UK. So what the Corporate Interest regime attempts to do is to allow interest deductions only for the proportion of UK debt that is kind of in proportion to the economic returns in the UK, or proportionate to the overall group borrowing. So when the rules were first introduced, there was a two million diminus. So any group with UK interest expense less than two million didn't have to worry and for a long time, as you said, the rates have been low and that's kind of exempted most small businesses. However, what we see now interest rates are increasing and that's really starting to flow through now, as fixed rate deals come to an end perhaps, and we're seeing businesses exceed that two million interest expense. That's an aggregate number, so if you've got several UK entities in a group added together, you can see how you might quite quickly actually exceed two million.
So the consequences of that for the taxpayer there are a few. First of all, it's quite a big compliance burden. The CIR calculation is quite complicated. It's quite data hungry. As I said, it's a group calculation, so if you've got different UK companies with different FD's which operate quite autonomously, just getting that data can be quite difficult. You then got the potential of an interest disallowance, so that means there's going to be a proportion of interest expense that you can't deduct for the purposes of calculating your tax bill. So if, for example, say we've got three million of interest expense we can only deduct two million, that's 250k of extra tax you're going to have to pay, which for businesses in these economic times that could be quite significant.
04:06 – Mark Ellis
Yeah, yeah, and I think, just doing the maths very quickly At 5.25% base rate, that's still businesses with around £39-40 million worth of debt on the books. So there are very, very large businesses. But how can your team help to work through those compliance issues?
04:27 – Sarah Howarth
So I think the main thing we would ask is just for businesses to try and think ahead, to look at their forecasts, just to understand if that £2 million is likely to be exceeded. The reason for kind of being proactive on this is that there are various elections within the corporate interest restriction regime which might allow for an overall more favourable outcome a lower interest restriction or none at all but the majority of those need to be made before the end of the year to which the charge relates. So really kind of being ahead of the curve on this could pay real dividends. I think the other thing to mention really is accounting, so if there is an interest restriction, potentially that's only a timing difference for accounts purposes- so quite often our audit colleagues will ask can we recognise this as a deferred tax asset? Again, we can help businesses do some modelling, looking at future profits, interest expense, to see if we might be able to claim the benefit of that disallowance in later years.
05:27 – Mark Ellis
Sure, and is it something that's affecting more of our client base?
05:31 – Sarah Howarth
Yeah, definitely, and I think just it's not that well known, so it sometimes comes as a surprise and hasn't been factored into cash flow forecasts and what have you, which is obviously not ideal.
05:44 – Mark Ellis
No, certainly not, and I think that's an overriding theme of. As interest rates increase, we should be mindful of the interest rates in general. It is as I said at the start of this sort of conversation it's going to be biting more and more into your cash flow and it might come to a point where certain bank covenants if that's who your lender is it might even be applicable to other sort of third party debt. But bank covenants might come into play, so interest coverage might become a bit of a worry, and so forecasting, or at least having an understanding of how the interest rates are moving, how that impacts your balance sheet and your capital structure, it's going to be pertinent, along with these tax issues as well, that might come out of the woodwork. As you say, it's quite a niche area for some clients that might not have been thought about before.
06:36 – Sarah Howarth
Agreed and I think in terms of kind of timing as well, any client within the quarterly instalment payment regime where you're having to make payments of tax within the year. They need to be particularly alert to these things, especially if it's going to be material.
Tax considerations in relation to rising interest rates
Continuing our discussion surrounding the difficulties businesses are facing during this period of economic uncertainty, Sarah and Mark explore how quickly a business can fall into serious difficulty. Banks will be monitoring interest coverage and leverage, so month-by-month monitoring and ensuring that the appropriate resources are in place to withstand periods of economic uncertainty is crucial.
Their discussion then turns to the complexities of related party debt and transfer pricing rules. We explain how these transactions must be priced at arm's length for tax purposes and the tax deductibility of interest from related party loans. We also touch upon the intricacies of guarantee fees and the requirements for benchmark studies that justify the arm's-length nature of these transactions.
We understand the challenges of navigating the financial management of a business, especially in an international context. This video offers an insight into preparing for tax authority reviews and understanding the tax implications of interest repayment issues.
Transcript for part 2:
00:00 – Sarah Howarth
So Mark as in previous tough economic times. I guess we've seen some big high street names go bust recently, as well as, I'm sure, countless small businesses. What kind of things are banks looking out for as providers of debt, and how quickly can things go south?
00:15 – Mark Ellis
So things can go south for a business very, very quickly, particularly when there's a huge economic shock such as COVID-19 pandemic, but in general it only takes the loss of a big customer if you've got a high degree of customer reliance. But in respect of what banks are looking for, they'll have a whole host of things that they'll monitor on a fairly continual basis, and these are things like interest coverage. So they'll look at the amount of interest being paid in comparison to the profits being generated. It might consider leverage, might consider all the financing that they've got and how the bank's debt is secured against various assets in the business or maybe in personal guarantees.
00:58
So when the red flag starts to show, I think it's very much having a look on a month by month basis. And are you seeing a declining trend in the business in terms of profitability, cash flow, are there genuine worries about being able to pay the staff, for example? That's a pretty clear sign. But beyond that you will start to see a general slip and most businesses, if they manage well, should have resources on hand to withstand a couple of months at least, ideally a fair few more, of bad economic times. But I suppose that that's with a third party looking over your shoulder. What are the things to consider when you've got related party debt there?
01:42 – Sarah Howarth
So whenever we're looking at kind of related party transactions, we're thinking about the transfer pricing rules. So transfer pricing is kind of an international tax concept which says that wherever you have related party transactions, whether they are trading or funding in nature, for tax purposes they must be priced on an arm's length basis or adjustments made if they are not. So I suppose to speak to a couple of points that are relevant here, perhaps if we've got a situation where a third party lender is no longer prepared to provide debt and we're looking to replace that with related party debt, interest will only be deductible for our borrower from a tax perspective to the extent it is arm's length. So is the amount being provided by the related party at an arm's length interest rate? And is the quantum arm's length? So is it equivalent to what a third party would have provided?
02:35
And I suppose the point there is that the third party is no longer prepared to lend on that basis. So we should expect some level of interest restriction because the parent or group member is providing funding over and above what a third party would have supported. The other thing to touch on briefly is guarantee fees. So we might have a situation where a bank is only prepared to continue to lend if a parent or other group entity provides a guarantee, so provides additional security. Obviously, in a third party situation you would expect to pay for that guarantee and the transfer pricing rules says that that must be imputed. So if, for example, a UK company is providing a guarantee to say a French subsidiary, we would expect to get an arm's length return for that and have documentation to support that that is arm's length, perhaps supported by benchmarking.
03:31 – Mark Ellis
Sure, and how are these benchmark studies done? Are they done by an advisor? Can it be done internally?
03:41 – Sarah Howarth
Really depends on the size and sophistication of the business. It's certainly something we can assist with. Benchmarks are generally generated from huge databases of either agreements or financial information, which you then filter down to get appropriate comparables. The main thing that's going to be important obviously, given huge changes we've seen in the last couple of years is that we're pulling recent comparables. They're going to be very different to what was possibly available three, four years ago.
04:11 – Mark Ellis
And is this something that is to be kept on file for future review, or is it something that can actually be agreed with HMRC?
04:20 – Sarah Howarth
So good question, and it kind of depends. HMRC and also certain other tax authorities around the world will have kind of advanced assurance facilities, but generally things need to be of a certain quantum for it to be worth their while. Otherwise, in the UK it's simply a case of holding the documentation on file and having it available for inspection if requested. Other territories will require that it's submitted annually. So for any business operating internationally it's really important to know what the requirements are in your local jurisdictions.
04:53 – Mark Ellis
And are there any tax consequences of none or late repayment of interest?
05:00 – Sarah Howarth
So I think what we'll sometimes see, and I guess it can happen in third party situations as well, is that interest will switch from being paid to being accrued and it might be rolled up for three or four years until there's the cash flow there to support actual payment. So for the most part, interest is deductible on an accrual basis, but with a couple of important exceptions, being when the lender is a shareholder. So the parent or one of several shareholders, and that parent is resident in a kind of tax haven type territory. So in those specific circumstances interest is only going to be deductible when it is actually paid. So that's quite important for businesses to be aware of, because if you're assuming you're going to get a deduction of maybe half a million each year and actually you're not you're just going to get a deduction of 2 million four years down the line when you actually pay that interest. That's going to make quite a big difference to your tax charge and your cash flow.
05:58 – Mark Ellis
I suppose the final point, Sarah, is what should our clients or potential clients be considering from a tax perspective on transfer pricing if they're looking to reorganise their debt?
06:10 – Sarah Howarth
So again, I think, just trying to think ahead be proactive. The main issue is going to be a potential disallowance of interest expense, the impact that's going to have on your tax charge and your cash flow. So just trying to think that through sooner rather than later, and certainly before you kind of get into the point where you need to prepare your tax note for your accounts. You know commerciality comes first. The funding is needed to allow the business to operate. That's fine. Tax tail mustn't wag the dog. But just understanding how that flows through into the numbers for the current year and future years is really important.
06:46 – Mark Ellis
And is it always helpful to try and seek third party debt at the time of real crisis? And those finances from a third party, just a bolster that evidence that you're going to put an end to your tax note.
06:56 – Sarah Howarth
I mean, I think you have to do what's right for the business, whether that's related party debt or third party debt. But of course, if there has been an application for third party debt which has been successful and you've just chosen not to proceed with that, that's going to be really helpful on your kind of defensive documentation. If you do decide to proceed with related party debt, making sure you've got adequate documentation on your file to show that that is arm's length will be crucial to support the filing position for the tax return.
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