IFM22200 - Real Estate Investment Trust : Conditions and Tests: interest cover test (profit: financing cost ratio): CTA2010/S543

The UK-REIT legislation sets a limit on the amount of interest a UK-REIT can pay in connection with its property rental business (PRB). If too much interest is paid, a tax charge is imposed on the residual business of the REIT – see IFM22205. The limit is expressed in terms of the ratio of profits to financing costs (often referred to as an interest cover test) and is 1.25.

HMRC may waive a tax charge where the profit: financing cost ratio is breached in respect of an accounting period in which, during the accounting period, the company was in severe financial difficulties due to unexpected circumstances and as a result could not have avoided the breach (CTA2010/S543(7)). Should a REIT find itself in such a position it is recommended that it contact HMRC in the first instance.

The purpose of setting a limit is to ensure UK-REITs are not highly geared, and also to reduce the scope for using profits of the PRB to meet interest payments instead of paying property income distributions to shareholders. Although transfer-pricing rules will operate as normal for a UK-REIT, these give little protection if one end of the transaction is in a tax-exempt environment.

The limit and the consequence of breaching it are set in CTA2010/S543. It is measured by reference to the rental profits and financing costs of each accounting period.

The ratio is Property Profits (PP) : Property Financing costs (PFC).

Property Profits

These are the amount of profits of:

· In the case of a group REIT the sum of the profits of the PRB of group members that arise in the period as shown in the financial statement prepared under CTA2010/S532(2)(b).

· In the case of a company REIT the amount of profits of the company’s PRB that arise in the period as calculated under CTA2010/S599.

· In both cases profits are profits before the offset of capital allowances, losses from a previous accounting period and financing costs under section CTA2010/S599(3).

Financing Costs (CTA2010/S543(3))

These are the financing costs of:

· In the case of a group REIT the amount of the financing costs incurred in respect of the PRB of members of the group (excluding financing costs owed by one member of the group to another) for the period as set out in the financial statement under CTA2010/S532(2)(a). Financing costs under CTA2010/S532(2)(a) includes worldwide costs. However the statement must show the financing costs referable to the UK PRB separately (SI2006/2865 Regs 5 and 6). It is the financing costs referable to the UK PRB (financing costs external (SI2006/2865 Reg 6)) that are included in the profit : financing cost ratio. Although, following the rewrite of the rules to CTA2010, this is not specifically set out in legislation, HMRC’s position remains that the ratio should continue to be applied on this basis.

· In the case of a company REIT the amount of the financing costs incurred in the period in respect of the company’s PRB.

Financing costs, defined at CTA2010/S544(3)–(5), means the cost of debt finance and covers:

· interest on loans and related costs with the exception of exchange losses;

· debits or credits arising on derivative contracts in relation to debt finance;

· finance costs arising under finance leases; and

· other costs that under generally accepted accounting practice are considered to arise from a financing transaction.

Matters to be taken into account include:

· interest payable on borrowing,

· amortisation of discounts relating to borrowing,

· amortisation of premiums relating to borrowing,

· the financing expense implicit in payments made under finance leases,

· alternative finance return (defined in CTA2009/S511 to S513),

· periodic payments or receipts so far as they—

· are from any derivative contract or other arrangement entered into as a hedge of risk in connection with borrowing, and

· are attributable to the hedge,

· amortisation of discounts and premiums relating to a derivative contract or other arrangement within the bullet point above.

The financial statement under CTA2010/S532(2)(a) must specify profits calculated in accordance with international accounting standards. This means that the finance costs do not include capitalised interest but will include amounts taken to the income statement on disposal or practical completion of the property.

Joint ventures

The profits and financing costs of the joint venture are taken into account in deciding whether the interest cover test is met – see IFM30030.