CFM97745 - Interest restriction: property and REITs: disallowance allocated to residual business exceeding its net tax-interest expense: example

TIOPA10/S452(6) to (10)

Example 1

A UK REIT group has a CIR disallowance of £100 million.

Within the group, company A, a UK resident company, has net tax-interest expense of £10 million in respect of its PRB, all of which derived from loan relationships to which it is a party for the purposes of its PRB. It also has £0.5 million of net tax-interest expense relating to loans in respect of its residual business.

Applying S452(2), company A is treated as if it comprised two companies, the PRB company and the residual business company.

It is assumed for the purposes of the example that, if the group allocates a CIR disallowance of more than £7 million to the PRB of company A, it would be unable to legally distribute 90% of its exempted PRB profits, as adjusted for the CIR disallowance. Accordingly S452(5)(b) applies, limiting the maximum allocation of disallowance to PRB company to that amount, see CFM97730.

The reporting company for the worldwide group seeks to allocate a CIR disallowance of £9 million to company A and to allocate the largest amount permitted to the PRB company.

The following steps are undertaken to calculate the maximum amount of CIR disallowance that can be allocated to the residual business of company A. This will, in turn, determine the amount of CIR disallowance that can be allocated to company A by the reporting company.

Step 1: Calculate the total REIT expenses

Calculate the amount of disallowance that can be allocated to the PRB and that can be allocated to the residual business (ignoring step 5).

The maximum amount that could be allocated to the PRB is its net tax-interest expense of £10 million. The maximum amount that could be allocated to the actual residual business is its net tax-interest expense of £0.5 million. The total REIT expense is therefore £10.5 million (being £10 million plus £0.5 million).

Step 2: Ascertain the actual disallowed amount

Assume that the actual CIR disallowance allocated to the PRB is £7 million, which is the maximum amount possible.

Step 3: Calculate the remaining total REIT expenses

The remaining total REIT expenses after the actual disallowed amount allocated to the PRB is £3.5 million, that is £10.5 million from step 1 minus £7 million from step 2.

Step 4: Determine if this exceeds the net tax-interest expense of residual business

The remaining total REIT expenses of £3.5 million exceeds the net tax-interest expense of the residual business of £0.5 million. The amount of the excess is £3 million.

Step 5

The amount of excess calculated in the previous step, £3m, is now brought into account by the residual business company as both deemed tax-interest expense and deemed tax-interest income. These amounts must have the same nature as underlying items of tax-interest expense of the PRB and must therefore be non-trading loan relationships credits and debits.

As a result (before the actual interest disallowance is taken into account) company A will have:

  • Actual tax-interest expense of £0.5m;
  • Created tax-interest expense of £3m; and
  • Created tax-interest income of £3m

Although the computational mechanics create this income and expense of the residual business company (and hence outside of the REIT exemption for the purposes of the REIT rules), they relate in nature to the actual interest expense of the property rental business.

Company A can be allocated up to £3.5 million of CIR disallowance against its residual business. Accordingly, of the total allocated CIR disallowance of £9m, £7m can be set off against the PRB company. Assuming that £7m is so allocated, £2m of the disallowance is allocated to the residual business company.

As a result, the exempted profits of the PRB company, calculated in accordance with CTA10/S599 are its profits after deducting tax-interest expense of £3m (the actual £10m interest expense less the £7m CIR disallowance allocated to the PRB).

Turning to the residual business company the tax-interest position is as follows:

  • The deemed tax interest income is £3m.
  • The deduction for tax-interest expense, after the CIR allocation of £2m is £1.5m (comprising actual interest expense of £0.5m plus created tax-interest expense £3m arising less the £2m CIR disallowance allocated to the residual business).
  • The net tax-interest income is £1.5m (£3m tax-interest income less £1.5m tax-interest expense), is not exempted from CT under the REIT rules, and is subject to UK CT.
  • In summary, the overall CIR disallowance is £9m, of which £7m has been allocated to PRB and £2m to deemed residual business. This compares with the actual net interest expense of £10.5m.

Nature of tax-interest income and expense amounts

As regards the nature of the amounts to be brought into account, the nature of the expense must be the same as that of actual expenses of the PRB company and the nature of the income must be same as that of the expense - S452(9), (10). Nature here refers to the categories in S377 (see CFM98660 and the example below).

Most commonly the expense amounts will be loan relationships or possibly derivative contracts debits. S452(4) requires CTA10/S534 and 599 to be disapplied in calculating amounts under the CIR, with the effect that for this purpose, the amounts will be treated as non-trading loan relationships debits (see CFM97715). Thus the tax-interest income brought into account would be a non-trading loan relationships credit taken into account in computing a non-trading profit taxed under CTA09/S299.

Variation on Example 1, disallowed finance lease expense

In the example above, all of the tax-interest expense of the company and of the deemed residual business company comprised non-trading loan relationships amounts, it follows that the deemed tax-interest expense and income amounts of the residual business company must comprise non-trading loan relationships debits and credits, respectively.

On the other hand, if the tax-interest expense of the PRB had included finance lease expense of £2.4m, the balance of £7.6m being loan relationships debits, it would be possible for up to £2.4m of the tax-interest amounts to comprise finance lease expense or income.

In an election under S377(3), the £2m disallowed could have been identified as finance lease expense falling within the fifth category in S377(2) see CFM98660. In consequence (assuming that there were no loan relationships credits netted off in computing tax-interest expense) the residual business tax-interest amounts after application of the CIR would be:

  • Created finance lease expense £2.4m less disallowed £2m = £0.4m
  • Actual loan relationships debits £0.5m, none disallowed
  • Created loan relationships debits £0.6m, none disallowed
  • Created finance lease credits £2.4m
  • Created loan relationships credits £0.6m

The net result would be:

  • A net non-trading loan relationships deficit of £0.5m (£0.5m actual debit, matching created debits and credits £0.6m, disallowance nil);
  • Net property business profit outside the scope of the REIT exemption £2m (created finance lease income £2.4m, matching created expense of £2.4m of which £2.0m is disallowed).

So, as in the original example, the net disallowance allocated to the residual business company is £2m. What is different is that the taxable amount is now not a non-trading loan relationships credit within CTA09/PT5 and instead falls to be treated as property business profits with CTA09/PT4. The overall result of the process is to take £2m of property income outside the ambit of the REIT exemption.