IFM22205 | Real Estate Investment Trust : Conditions and Tests: interest cover test: consequences of breaching the limit: CTA2010/S543

CTA2010/S543 sets a limit of 1.25 on the ratio of rental profits (before interest other financial charges and capital allowances) to finance costs. Definitions of the terms can be found at IFM22200. If the limit is breached, a tax charge by reference to the excess finance costs is imposed on the residual business unless the circumstances are those where HMRC may waive the charge – see IFM22200. The tax charge is capped to an amount equal to 20% of the property rental profits for the accounting period.

The excess finance costs is treated as income chargeable to tax as other income. The income arises to the residual business and not the property rental business, which was the business that incurred the excess interest in the same accounting period as that for which the limit was breached. For a group REIT the tax charge is imposed on the residual part of the principal company of the group.

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 CTA2010/S543(6). 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

For the accounting period, the profits of the property rental business are 100 (as measured by CTA2010/S599) and the finance costs payable in respect of the property rental business are 90.

Financing cost ratio = PP/PFC, where PP is property profits and PFC is property finance costs. The ratio is 1.11 (100/90), and will therefore breach the limit as it is below 1.25.

To work out the income that is chargeable on the residual business, the first step is to work out the amount of finance costs that would be required in order to just meet the 1.25 limit.

To calculate the amount of PFC required to just meet the 1.25 limit, PFC = PP/1.25, in this case it is 80 (100/1.25).

The income chargeable is the lower of the excess finance costs and 20% of the property profits. Excess finance costs = 10 (90-80) and 20% of property profits = 20 (20% of 100), therefore the other chargeable income on the residual business would be 10.