Ireland’s new interest limitation rule Ireland’s new interest limitation rule Ireland’s new interest limitation rule

Aviation finance is a capital-intensive industry in which it is commercially feasible to borrow significant levels of debt. Similar to infrastructure, these high levels of debt are justified by the reliable cash flows generated by the asset and the security which lenders can take over aircraft. Joe O'Mara, Gareth Bryan and Eamonn Smith of our Aviation Finance team explain.

In this context, any restriction on the tax deductibility of interest costs has the capacity to fundamentally change the way aviation finance is taxed. This is particularly relevant in the current environment where Ireland is facing significantly increased competition from Hong Kong and Singapore as a global centre of excellence for aircraft leasing.

The Finance Bill includes the legislation which will enact the interest limitation rule (ILR) mandated by the EU’s anti-tax avoidance directive (ATAD). All EU Member States are obliged to introduce these rules and many other countries have enacted similar rules (such as the UK, the US, Japan, etc.).

The ILR will cap deductions for “exceeding borrowing costs” at 30% of a corporate taxpayer’s EBITDA as measured under tax principles. As with all EU directives, detailed implementation of measures is determined locally so there can be important differences between Member States.

Ireland’s transposition of the ILR into domestic law comes following a detailed consultation by the Irish Revenue Commissioners and Department of Finance (DoF) with taxpayers and stakeholders on the shape of the ILR regime. In particular, there has been very active engagement between Irish Revenue, the DoF and the Irish aviation finance sector, both in terms of consideration and discussions with KPMG in relation to our Aviation Finance ILR submissions and through bilateral discussions with Aircraft Leasing Ireland (ALI).

Ireland has fully complied with the minimum standards set out in ATAD and has, for the most part, adopted the various exemptions and reliefs permitted by ATAD. The legislation contained in the Finance Bill is, in general, pragmatic in its approach, which is to be welcomed given the potentially material impact of the rules on Irish taxpayers.

The ILR applies both to interest and amounts economically equivalent to interest. Specifically, the ILR will apply to a company’s “exceeding borrowing costs” (i.e. its interest and equivalent borrowing costs as reduced by its interest and equivalent income). Therefore, a financing company which borrows and lends (at a profit) generally would not have exceeding borrowing costs and so, in practice, would not be subject to the ILR.

The key question from a leasing perspective is therefore how will the ILR apply to a business that has the nature of a financing business but whose income has the legal form of operating lease rentals.

Importantly from an aviation finance perspective and in acknowledgment of the points put forward on behalf of the aviation finance industry in our two KPMG Aviation Finance ILR submissions and the submissions made by ALI, the Finance Bill sets out that the concept of “interest equivalent” will include both: (i) the finance element of finance lease payments / income, and (ii) a portion of operating lease income for certain lessors carrying on a trade of leasing.

From a finance lease perspective, the amount of interest equivalent will be a portion of the finance lease payment / income equal to the ratio of the total amounts expected to be included in the company’s income statement over the full term of the lease to the total (gross) expected payments over the term of the lease. This fraction will be fixed at the commencement of the lease and applied to each year’s actual expense/income; however, if the lease is amended, the ratio will be recalculated and applied prospectively.

For operating lease lessors carrying on a leasing trade, the Finance Bill provides that a slice of their operating lease income and expense will be treated as equivalent to interest. This treatment reflects the facts that professional lessors are, in practice, providing asset finance to their customers (albeit while retaining residual value risk). Due to the different accounting treatments that apply to lessees and lessors under operating lease agreements, the calculation of the interest portion is different for lease expenses and lease income.

The fraction of each year’s operating lease income will be computed by calculating the amount by which the total expected lease income over the term of the lease exceeds the expected decrease in value of the asset in the company’s accounts (i.e. expected aggerate depreciation). The ratio of this amount to the total expected lease income over the term of the lease will be the fraction applied to each year’s rental income to determine the interest income equivalent component.

The calculation used to determine the fraction of each year’s operating lease expense to be treated as an interest expense is similar except that, instead of using the expected decrease in value of the asset in the company’s accounts (which would not be possible as the asset would not be on the lessee’s balance sheet), the value of the right of use asset recorded in the company’s accounts at the commencement of the lease is used instead.

Both of the above fractions will be fixed at the commencement of the lease. Importantly, this deemed interest treatment only applies for the purposes of the ILR calculation and does not re-characterise the lease income / expense as interest for other purposes.

The ILR will apply to the Irish “interest group” of lessors with operations in Ireland. 

Companies may elect to join an “interest group” with other companies that are within the charge to corporation tax or are Irish tax resident and which are part of the same “worldwide group” (being a group whose members whose results are included in an accounting consolidation prepared under IFRS, or GAAP of Australia, Canada, China, Hong Kong, Ireland, India, Japan, New Zealand, South Korea, Singapore or the USA). Formation of a group will result in the ILR calculations being done at a group level. This has the benefit of allowing for pooling of interest / interest equivalents and spare capacity between group members.

The ILR calculations of an interest group are to comprise all of the results of the members. We understand that this will give taxpayers the choice to either aggregate the various components of the ILR calculations for each member or to apply a consolidation approach (which will, in effect, result in intra-group transactions being eliminated and, consequently, disregarded). 

If a leasing company has exceeding borrowing costs in excess of 30% of EBITDA (after taking into account the portion of operating lease rentals to be treated as interest), in principle that excess net interest should be treated as non-deductible for Irish tax purposes. However, there are a number of relieving measures provided for in the Finance Bill that may help alleviate the impact of the interest restriction. These include:

• Carry forward - Restricted interest should be available for carry forward to be deducted in future years where the taxpayer has sufficient capacity to claim the deduction (this would be the case where the company has not exceeded its 30% threshold in that year). This will be subject to certain limitations for companies in a tax loss position.
• Unused capacity - When exceeding borrowing costs are below the 30% threshold, the unused amount is carried forward for up to 60 months as “limitation spare capacity” and can be used in future periods where exceeding borrowing costs exceed 30% of EBITDA.
  
• €3m de minimis - Full exemption from the ILR is available where an Irish taxpayer group’s exceeding borrowing costs do not exceed €3 million. However, once this de minimis threshold is breached, the entire amount of the exceeding borrowing costs is subject to restriction (not just the amounts in excess of the limit).
  
• Legacy debt - The legislation includes an exemption in respect of "legacy debt". To qualify the terms must have been agreed before 17 June 2016. If the principal was not drawn down by that date, it will only qualify if there is a legal obligation on the lender to advance and the borrower to drawn down that amount upon the occurrence of pre-determined deliverable or project phase (set out in the original agreement but excluding a borrower call for drawdown). Where the exemption applies, the amount of interest on the legacy debt is excluded from the EBITDA calculation.
• Worldwide group exceptions - The Finance Bill provides for certain group-based exceptions that may provide certain taxpayer groups additional relief from the ILR. These include (i) a full exemption from the ILR were the relevant taxpayer’s ratio of equity-to-assets is within 2% of or greater than that of the worldwide group, and (ii) an increased deductibility threshold above 30% of EBITDA where the ratio of external interest expense of the worldwide group is greater than 30% of EBITDA.

These worldwide group exceptions will require careful consideration from a leasing perspective as the comparison to be made between Irish group and worldwide group should be done with respect to information prepared consistently for accounting purposes. This may therefore require computation of local Irish accounting results under the accounting principles adopted at a worldwide group level.

While the other strands of ATAD (most of which have already been implemented) affect many groups, the ILR has the capacity to have a significant impact on a capital-intensive industry such as aviation finance, given the widespread use of debt finance to fund aviation assets.

Careful consideration must be given to its impact and matters such as whether to form a local interest group and the ability to access the various exemptions and reliefs. 

To discuss the ILR further, please contact Joe O'Mara, Gareth Bryan or Eamonn Smith of our Aviation Finance team. We'd be delighted to hear from you.