The real estate industry is in focus in the context of the Government’s current tax initiatives. The most recent proposal from the Government regarding a limitation on deduction of interest expenses, which has now been sent out for consultation with the last date for a reply on the 26 September, will imply a very dramatic increase in taxes for the real estate industry.
Previously in Tax matters, we reported on the Government’s consultation process regarding its memorandum, New tax rules for the corporate sector, in which the most notable component is a proposal for new rules to limit deductibility of net interest expenses. We have also reported on the real estate packaging proposal and how this has been received by the industry.
In this article, we are focusing on the new proposal for limitations on deductibility of interest expenses and how this proposal is expected to impact the real estate industry.
The proposal contains general limitation rules regarding both external and internal interest expenses in order to comply with the EU Directive’s requirements for such new regulations, but the proposal also implies that the current rules on limitation of deduction of intra-group interest expenses are retained, however, with, according to the proposal, a more limited scope of application. The Government also proposes a prohibition on deduction of interest in certain hybrid situations, something that we will not address in any detail in this report.
To the degree negative net interest remains after application of the special rule for intra-group interest expenses, a further limitation rule is proposed. In the main proposal in the Government’s memorandum, it is proposed that deduction be limited to 35 percent of taxable EBIT, that is, earnings before financial items and tax, after tax adjustments. As an alternative, there is also a proposal in the memorandum for deduction to be limited to 25 percent of taxable EBITDA, that is, earnings before financial items, taxes and depreciation, after tax adjustments. Typically, this implies that the basis for determining tax deductible interest expenses is higher if EBITDA is applied as this measures earnings before depreciation. Internationally, it is common that similar types of deduction rules are based on EBITDA.
In terms of the method applied, the two alternatives differ as regards how the basis for the deduction is determined.. The EBIT method implies that the basis would be calculated on result after deduction of previous year’s tax losses and the tax allocation reserve. The EBITDA method is also calculated on the result after previous year’s tax losses but before any provisions to the tax allocation reserve which means that the interest deduction will reduce the basis for calculating the tax allocation reserve. In both alternatives, received or distributed group contributions should be taken into account when calculating the basis.
A threshold rule is also introduced. Negative net interest can be deducted up to an amount of SEK 100,000, per group. The remaining negative net interest can be rolled forward and deducted within six years. In certain changes in ownership, the right to utilize such remaining negative net interest is lost. A possibility for companies having positive net interest to deduct another group company’s unutilized negative net interest against their own positive net interest will also be introduced.
Furthermore, the proposal includes the introduction of a so-called primary deduction of2 percent per year during the first five years after the completion of the construction of rental property, in the form of an accelerated depreciation.
In addition, the Government proposes that the right to deduct previous years’ tax losses will be temporarily limited. Legal entities will only be allowed to deduct previous years’ tax losses with an amount corresponding to 50 percent of a calculated taxable profit (two years if the EBIT model is introduced and three years if the EBITDA model is introduced).
In addition to the previous proposal regarding taxation of packaged real estate, we now have a proposal to limit deductions for interest expenses which will drastically increase the tax pressure within the real estate industry.
As the proposal appears, today, it is uncertain as to the degree to which the current rules on deduction of intra-group interest expenses will actually be narrowed in scope, should the proposal be adopted. The Government also states that the restrictions will not impact state finances (the effect is stated at SEK 0, 00 billion). Our assessment is that there is a substantial risk that deductions for internal interest expenses will not be granted to a greater extent than is currently the case. Should the Government maintain that the afore-mentioned rules are to remain, the proposal should in our view need to be clarified in order to avoid a continued uncertainty as to in which situations a deduction can, actually, be granted.
As regards the choice of method for the general limitation of interest deductions, the Government notes that a method based on EBITDA provides a more generous deduction, which should benefit all companies. The proposal based on EBIT will be less advantageous for companies with significant depreciations, as these will decrease the basis for deduction. A method based on EBIT will, therefore, be less advantageous for those industries requiring larger investments in capital assets compared with, for example, a services company. For real estate companies and energy companies, who are referred to as those companies typically seen to incur the highest increase in taxes as a result of the proposals, the EBITDA method would be preferable.
To a certain degree, it is unclear how the actual basis for determining the deductible net interest expenses should be calculated when both tax losses carry forward and provisions to the tax allocation reserve is included, particularly when you have also consider the temporary limitation on the right to utilize tax losses carry forward which is proposed to apply during the first years after the new rules would come into effect. What is also notable is that the proposal seems to mean that the order of priority of when to calculate the above-mentioned items in the tax calculation is to be changed compared with how it is today. In the EBIT model, the intention would now appear to be that the company is to first calculate the amount of the tax losses carry forward that can be deducted, whereby it has to consider the proposed temporary limitation on tax losses carry forward and, thereafter, it has to calculate the allowed provision to the tax allocation reserve and, then, finally, it has to calculate the capacity for interest expense deduction. In the EBITDA model, the tax allocation reserve is proposed to be calculated as the last item. It is not clear whether the wording of the proposed text is intended to imply this order of priority in the calculation, and the proposal should be reviewed to avoid difficulties in its practical application.
Furthermore, it is our assessment that it will be difficult for enterprises in the real estate industry to get a deduction in subsequent years for rolled forward negative net interest. This is due to the fact that the typical real estate company has long-term financing and a stable level of interest expenses during a long period of time. In order to be able to also get a deduction for rolled forward interest expenses, it will be a requirement that the loans are being amortized, or that the taxable income increases significantly or that some other, similar factor applies if the company is to reach a sufficiently large basis to be able to deduct the combined interest expenses. It can also be mentioned that the proposed amount as a threshold amount of SEK 100,000 per group is very low when seen in an international comparison (the corresponding amount in the EU Directive is EUR 3 million). It could hardly be the intention that even smaller companies with a low level of borrowing should be hit by such complicated rules.
The currently proposed rules will complicate the yearly profit equalization for all groups. This is due to the fact that companies will now also have to consider the interest expense deductions and the allocation of net interest when determining the profit equalization via group contributions. This will place new demands on the tax function and will imply a large degree of annual investigative work to be undertaken by the real estate companies.
We will revert with further commentary regarding the Government’s proposals as regards, amongst other things, the practical aspects of the proposals.
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