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IFM22200 | Real Estate Investment Trust : Conditions and Tests: interest cover test (profit: financing cost ratio): CTA2010/S543-S544

From HM Revenue & Customs · Investment Funds Manual

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 interest and certain other financing costs of a REIT exceed a specified limit, 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.

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 operate for UK-REITs (including small and medium enterprises, CTA 2010/S542(2)) , 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 ratio of Property Profits (PP): Property Financing costs (PFC) for each accounting period.

Property Profits (CTA2010/S544)

These are the amount of profits of:

  • In the case of a group REIT: the sum of the profits of the PRB in the UK of group members that arise in the period as shown in the financial statement prepared under CTA2010/S532(2)(b), see IFM22360.

  • In the case of a company REIT: the amount of the profits of the company’s PRB that arise in the period.

  • In both cases profits are profits as calculated in accordance with CTA2010/S599 but, in accordance with CTA2010/S544(2), before the offset of capital allowances, losses from a previous accounting period and financing costs under section CTA2010/S599(3).

Property Financing Costs (CTA2010/S544(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 group’s PRB in the United Kingdom (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).

For this purpose the group’s property rental business in the United Kingdom (“UK PRB”) consists of the PRB of UK members of the group (i.e. both UK and overseas PRB) and the UK PRB of non-UK members (CTA2010/S544(3A).

Financing costs under CTA2010/S532(2)(a) include worldwide costs (both UK and overseas property business of all members of the group). However the statement must also 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 (SI2006/2865 Reg 6)) that are included in the profit: financing cost ratio.

· 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), means the cost of debt finance. The amounts to be taken into account are set out at CTA2010/S544(5)-(5B) and are:

  • 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 (including certain right-of-use leases recognised in accounts made under old UK GAAP (see BLM51025), 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.

For accounting periods ending on or after 1 April 2023, financing costs do not include any expense for which a deduction would not be allowed in calculating PRB profits in accordance with CTA2010/S599 (see IFM24005), other than an expense which is disallowed only as a result of the application of the corporate interest restriction (CIR) (see CFM97710).

For example, REIT A has paid interest of £10 million although an HMRC enquiry results in a transfer pricing adjustment reducing this to £9 million. The financing costs for the profit: financing-cost ratio would therefore be £9 million as the figure will be adjusted for the £1 million where no deduction was allowed.

REIT B has also paid interest of £10 million and calculated a CIR disallowance of £1 million which is allocated to the PRB, reducing the finance costs used for calculating the PRB in accordance with CTA2010/S599 to £9 million. The CIR disallowance does not affect the finance costs for the profit: financing-cost ratio and these would remain at £10 million. Any charge arising under CTA2010/S543(4) will be calculated first and then taken into account in the calculations for CIR (TIOPA2010/S452(4A)). It is not necessary to recalculate that S543(4) charge when a CIR disallowance is subsequently allocated. See CFM97710 for further information on the interaction between the profit: financing-cost ratio and CIR.

The financial statement under CTA2010/S532(2)(a) must specify profits and expenses calculated in accordance with international accounting standards. This means that the finance costs do not include capitalised interest but will include amounts later taken to the income statement.

Joint ventures

Where a joint venture notice is in place in relation to a joint venture company or joint venture group, the profits and financing costs of the joint venture are taken into account in deciding whether the interest cover test is met. This is because the REIT legislation applies to the joint venture company or members of the joint venture group as though they were members of a REIT group – see IFM30030.