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HMRC internal manual

Guidance on Real Estate Investment Trusts

Conditions and Tests: interest cover test: consequences of breaching the limit

Section 115 FA 2006 sets a limit of 1.25 on the ratio of rental profits (before interest other financial charges and capital allowances) to interest. Definitions of the terms can be found at GREIT02200. If the limit is breached, a tax charge by reference to the excess interest is imposed on C (residual) (regulations 12 and 13 SI 2006/2864).

The excess interest is treated as income chargeable to tax as other income. The income arises to C (residual) (and not to C (tax-exempt), which was the business that incurred the excess interest) in the same accounting period as that for which the limit was breached.

The income is chargeable at the main CT rate. No loss, deficit, expense or allowances that might otherwise be offset against an amount chargeable as other income, can be used to reduce the amount of income brought into charge (regulations 12(4) and 13(4) SI 2006/2864). In common with other places in the UK-REIT rules that prohibit reduction of income by losses, deficits etc, the prohibition here extends to prevent the offset of management expenses or charges that are normally given as a deduction from total profits rather than as a deduction in reaching the profits from any particular source of income or gains.

Example

The Schedule A profits of C (tax-exempt) are 95, after deduction of 5 capital allowances. For the accounting period, interest payable in respect of C (tax-exempt)’s business was 90.

The ‘profits’ of C (tax-exempt) (are as measured by section 120 FA 2006) are 95 - 90 = 5. The top line of the fraction would be 100 = 5 + 5 + 90, and the ratio would be 100/90 = 1.11, which breaches the 1.25 limit (a breach is when the fraction is below 1.25).

To work out the income that is chargeable on C (residual), the first step is to work out the amount of interest that would just meet the 1.25 limit. A bit of algebra tells us that if 1.25 = (P+FC)/FC then FC = 80% of P where P is profits before capital allowances and financing costs have been deducted and FC is the interest cost that just meets the limit. Therefore the interest expense that just meets the limit in this example is 80.

The other chargeable income of C (residual) would therefore be 10 (= 90 - 80).

Group REITs

A similar charge arises to the residual part of the principal company of a Group REIT if the group breaches the 1.25 limit as modified for Group REITs - see GREIT12150.