UK takes tough line on corporate interest deductibility BEPS rules

The OECD has updated its guidance on Action 4 of its Base Erosion and Profit Shifting (BEPS) project relating to interest deductions, with particular reference to the group ratio rule and the risks posed by the banking and insurance sectors

In a lighter touch approach than expected, the OECD is offering countries some flexibility in implementation but also retaining a consistent approach.

The UK has indicated it will be applying more stringent requirements when its new interest deductibility rules comes into force from April 2017. 

The original report, limiting base erosion involving Interest deductions and other financial payments, set out a common approach to address BEPS involving interest and payments economically equivalent to interest.

This included a 'fixed ratio rule' which limits an entity's net interest deductions to a set percentage of its tax-EBITDA and a 'group ratio rule' to allow an entity to claim higher net interest deductions, based on a relevant financial ratio of its worldwide group.

The report included a detailed outline of a rule based on the net third party interest/EBITDA ratio of a consolidated financial reporting group, and provided that further work would be conducted in 2016 on elements of the design and operation of the rule.

The updated report provides a further layer of technical detail to assist countries in implementing the group ratio rule in line with the common approach. This emphasises the importance of a consistent approach in providing protection for countries and reducing compliance costs for groups, while including some flexibility for a country to take into account particular features of its tax law and policy.

The OECD says that overall, a number of features reduce the risk of BEPS involving interest posed by banking and insurance groups, but differences exist between countries and sectors and in some countries risks remain.

It says each country should identify the risks it faces, distinguishing between those posed by banking groups and those posed by insurance groups. Where no material risks are identified, a country may reasonably exempt banking and/or insurance groups from the fixed ratio rule and group ratio rule without the need for additional tax rules.

Where BEPS risks are identified, a country should introduce rules appropriate to address these risks, taking into account the regulatory regime and tax system in that country. The updated report considers how these rules may be designed, and includes a summary of selected rules currently applied by countries. In all cases, countries should ensure that the interaction of tax and regulatory rules and the possible impact on groups is fully understood.

UK position on interest deductibility

However, there are claims that the UK is likely to opt for a stricter interpretation of the rules than other jurisdictions. Earlier this month the UK government published draft legislation to introduce a new corporate interest restriction to implement Action 4, scheduled to be effective from 1 April 2017. At that time it said that, although most respondents to a consultation on the rules published in May 2016 had suggested that banking and insurance groups should be excluded from the rules, banking and insurance groups would be subject to the fixed ratio rule in the same way as other industry groups.

HMRC has now said the rules will operate on a worldwide group basis to allow groups to manage any restriction across their businesses. They will apply to the net interest expense within the charge to corporation tax, including other similar financing costs. Groups with less than £2m of net interest expense within the scope of corporation tax per annum will not need to apply the rules.

The fixed ratio rule will limit the amount of net interest expense that a worldwide group can deduct against its taxable profits to 30% of its taxable earnings before EBITDA. A modified debt cap within the new rules will ensure the net interest deduction does not exceed the total net interest expense of the worldwide group.

The group ratio rule allows a ‘group ratio’ to be substituted for the 30% figure. The group ratio is based on the net interest expense to EBITDA ratio for the worldwide group based on its consolidated accounts.

Eloise Walker, a tax expert with law firm Pinsent Masons, said: ‘Why is the UK so keen to force banks and insurance companies to jump through pointless hoops each year in relation to this new legislation, when it has not identified credible BEPS risks from these sectors and pushing ahead could damage the industries?’

The OECD points out in its report that in most cases banks will have net interest income, rather than net interest expense. However it states that where a banking group or an entity within the group has net interest expense, the application of the fixed ratio rule is likely to have more of an impact on such a group than on a group operating in a different sector because for banks interest is the main source of operating income so that they are likely to have low or negative EBITDA.

The fixed ratio rule is likely therefore to mean that any bank with net interest expenses will have almost all of the expense disallowed.

In its report, the OECD said: ‘In particular for banks, as interest expense is typically a bank's largest single operating expense, this disallowance could seriously hinder an entity's ability to survive financial shocks.’

Walker said: ‘We will have to wait until we get the further draft Finance Bill legislation in January to see if the UK softens its approach to interest restrictions for banks and insurance companies, in the light of the OECD's latest report. However, it is far from ideal that there are still so many question marks over how the regime will apply, considering it is due to come into force in April.’

OECD’s update to Action 4, limiting base erosion involving interest deductions and other financial payments is here

HMRC’s policy paper Corporation Tax: tax deductibility of corporate interest expense is here

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