Tax Considerations in Financial Statement Audit – UK Real Estate Structures

Preparing for a financial statement audit involves ensuring that all aspects of a company’s tax position are accurately recorded and compliant with relevant laws and accounting standards. Tax is a critical aspect of financial reporting, and errors or misstatements can lead to compliance risks and restatements. 

During the peak audit season, both clients and audit teams face common challenges related to tax reporting in the financial statement close process. This article highlights key considerations for structures with underlying investments in UK commercial real estate. 

Ensuring Audit Readiness: Key Tax Considerations

Lack of preparation and documentation can result in missed deadlines and costly overruns. The year-end financial statement close process and audit provide an opportunity to reassess the impact of the evolving tax landscape and ensure documentation and advice remain up to date. 

While any corporate structure changes should be assessed from a tax perspective in advance, effective communication with client reporting teams is crucial. There may be occasions where transactional changes have not been considered from a financial reporting perspective and additional input from specialists may be required.  

To help client accounting teams update tax disclosures, the following issues should be considered during tax accounting work: 

• Have any changes to the tax profile of the company and/or overlying group occurred during the year or as a subsequent event? Has this impacted the tax reporting and, if so, have these changes been communicated to client accounting teams? 

• Is supporting documentation available, accessible and up to date? (i.e. transfer pricing advice); 

• Are third party providers engaged or required to assist with the full suite of tax reporting required in the financial statement close process including a detailed tax account; and 

• Has a full tax pack been collated to be provided to auditors on request. 

Financing Considerations in Real Estate Structures

Recent audits requiring tax involvement have revealed common themes regarding financing arrangements within real estate structures. These aspects need consideration from both a current and deferred tax perspective: 

• Unpaid related party interest; 

• Impact of the Corporate Interest Restriction (CIR); and 

• Recognition or non-recognition of Deferred Tax Assets (DTAs) arising from these restrictions. 

Unpaid Related Party Interest 

Background  

Before considering the Corporate Interest Restriction, only interest deductible under normal corporation tax rules should be allowed. 

Arm’s length related party debt between a non-UK tax resident company and a non-UK company subject to UK Corporation Tax in respect of UK rental profits, may be subject to restriction under the late paid interest rules and in advance of consideration of the Corporate Interest Restriction. 

For example, if loans are provided by a participator in a close company, late interest rules apply if: 

• Condition A: The interest is not paid within 12 months of the end of the accounting period in which it accrues; and 

• Condition B: Credits representing the full amount of the interest are not brought into account under the loan relationship rules for any accounting period. 

Condition B applies where the creditor is not subject to UK Corporation Tax and does not bring the interest accrued into account from a UK loan relationship perspective. For example, both the debtor and creditor are both Jersey tax resident companies however the debtor holds UK real estate and is therefore subject to UK Corporation Tax, but the Creditor is out of scope of UK Corporation Tax. 

Application 

From a current tax perspective, should conditions A and B apply, the debtor (subject to Corporation Tax on UK rental profits) can only consider the amount of interest paid within 12 months within the loan relationship calculations.  

Consideration from a deferred tax perspective should be required as any interest subsequently paid may be brought into account of the loan relationship rules once the interest has been paid and may result in a future tax deduction.  

Corporation Interest Restriction (“CIR”) 

Background 

The UK Corporate Interest Restriction (CIR) regime, introduced in Finance Act 2017, limits the amount of interest expense that a group can deduct for corporation tax purposes.  

This applies to large groups and aims to prevent excessive interest deductions that reduce taxable profits. In addition to the late-paid interest rules, CIR interacts with other UK legislation, including transfer pricing, hybrid mismatch rules, and thin capitalisation rules.  

CIR applies to groups or standalone companies with: 

• Net tax-interest expense exceeding £2 million per year (de minimis threshold); and 

• Companies within a worldwide group, including UK and non-UK entities.  

Broadly, a group can deduct interest up to the higher of: 

1. Fixed Ratio Rule (FRR): 30% of the group’s tax-EBITDA (earnings before interest, tax, depreciation, and amortisation, adjusted for tax purposes). 

2. Group Ratio Rule (GRR): Based on the worldwide group’s net third-party interest-to-EBITDA ratio. 

3. De minimis threshold: A group can always deduct £2 million of net interest expense, even if FRR/GRR limits are lower.  

Application and challenges 

If net interest exceeds the interest allowance, the excess is disallowed in the current financial period and must be allocated to specific companies. This impacts the current tax position and the loan relationship deduction for the current accounting period. 

Additionally, Large groups (exceeding £2m net interest threshold) must file an Interest Restriction Return (IRR) annually with HMRC. The IRR can be filed by either an Ultimate Parent Entity (UPE) or nominated company. 

From a deferred tax perspective, disallowed interest will be carried forward indefinitely by companies unless they cease their trade or investment activity. In future periods, if the CIR group has an interest allowance higher than its net interest expense for that later period it may ‘reactivate’ interest by allocating an amount of the surplus to companies with brought forward disallowed amounts.  

Unused interest allowance (excess capacity) can be carried forward for up to five years. However, given the current high-interest rate environment, this may be less relevant for current accounting periods. 

For larger groups, challenges arise when different service providers administer the group or when acquisitions and disposals occur. Coordination among relevant parties and advisors is vital to ensure accurate tax accounting information is available to client accounting and audit teams. 

Recognition of DTA’s 

Since the late payment rules and CIR can create timing differences between tax and accounting interest deductions, it may give rise to DTAs if the disallowed interest under either than late paid rules or CIR is expected to be utilised in future periods. 

Recognition of DTA’s should be made to the extent that the asset can unwind under the tax law and recovery is probable. 

Considerations of a company’s ability to recognise DTAs in respect of carried forward late payment interest or CIR disallowances should be: 

• When will the interest actually be paid in order to reverse and obtain tax relief; and 

• When this interest is paid, will there be any additional interest capacity to utilise these carried forward amounts?

Audit evidence, such as forward projections and modelling, should support management’s view on DTA recognition and anticipated unwinding. If large disallowances occur annually due to CIR, available interest capacity in future years may be insufficient to reverse late-paid interest, but this must be assessed case by case. 

From a disclosure perspective, any unrecognised balance should be appropriately disclosed within the financial statements in line with relevant accounting standards.