The Organisation for Economic Co-operation and Development (“OECD”) has finally concluded a two year project to tackle international base erosion and profit shifting (“BEPS”), issuing final reports on 5 October 2015. A new phase of the project is now commencing, that of working out how jurisdictions will implement the recommendations.
The actions to reform international tax rules include measures to limit base erosion through interest deductions. Such erosion is viewed as arising when multinational groups allocate their third party debt to high tax countries or highly leverage their operating companies in high tax territories using intra-group debt.
The report on Action 4 of the OECD’s project (“OECD Report”) makes recommendations for ways in which interest reliefs in respect of financing arrangements should be limited to prevent BEPS. In particular, it recommends the introduction of a fixed ratio rule to limit interest reliefs to a fixed net interest to EBITDA ratio of 10% to 30%, subject to an optional group ratio rule which allows interest relief up to a net interest:EBITDA ratio of the group. Additional targeted and optional elements could also be introduced including a de minimis threshold and exclusions for certain third party funding. All of these recommendations would require countries which do not already operate such an interest limitation rule to make changes to their domestic tax rules.
Should these recommendations be introduced in countries such as the UK, they would have a significant impact on the ability of multinationals to benefit from tax reliefs for financing costs in the UK and could also significantly impact on the real estate and private equity industries. In its report “Tackling Aggressive Tax Planning in the Global Economy” in March 2014, the UK Government noted that a limited version of the group ratio method has been adopted by the UK, in the form of the worldwide debt cap applicable to large companies. The Government had cautioned that restricting deductibility of interest would have a significant impact on many businesses and the design of the rules would need to recognise the impact on specific sectors (including those that have legitimately high leverage ratios) and take into account the constraints of EU law.
The UK Government now believes that the OECD recommendations represent an appropriate response to BEPS and is seeking views in its consultation published on 22 October 2015 (“the Consultation”) as to how best to respond to the recommendations.
The Government considers that in order to meet the OECD recommendations, the UK would need to introduce a new general rule for restricting interest which would be a major change to the UK’s regime. This could be subject to a de minimis threshold or exemption for small and medium sized enterprises (“SME”) and to grandfathering for existing third party debt arrangements. Any new interest restriction would apply after the usual thin capitalisation and other anti-avoidance (including anti-hybrid) rules but would replace or adapt the existing worldwide debt cap rules.
The Consultation can be found here. The UK Government is seeking views from interested stakeholders by 14 January 2016 and, given the far reaching potential impact of the proposals, we would recommend that enterprises consider the implications of the proposals and provide comments. The results from the consultation will be considered in developing a business tax roadmap, although any changes are unlikely to be introduced before 1 April 2017.
Details of the Consultation
The Government is seeking views as to whether a general interest restriction rule should be introduced, whether it should be limited to multinationals (i.e. any group with entities in more than one country) and what interest (and amounts equivalent to interest) should be covered by such a rule.
In this context, the Government proposes the introduction of the best practice approach endorsed by the OECD which would involve the following:
- optional: a de minimis monetary threshold (to remove low risk entities);
- fixed ratio rule (to allow an entity or, more likely, a sub-group, to deduct net interest expense up to a net interest/EBITDA ratio of between 10% and 30%. EBITDA for these purposes would be measured using tax principles and would exclude exempt dividend income);
- optional: group ratio rule (to allow an entity to deduct net interest expense up to the group’s net interest/EBITDA ratio, where this is higher than the fixed ratio);
- optional: rules to address volatility of earnings (including carry forward of disallowed interest/unused interest capacity and / or carry back of disallowed interest);
- optional: public benefit project exclusion;
- targeted rules to support general interest limitation rules and address specific risks; and
- specific rules to address issues raised by the banking and insurance sectors.
In this context, the Government is seeking views on the specific application of this approach and views as to how the calculation should operate. The OECD Report envisages restrictions on interest relief applicable at company or local group level, but the Government notes that balancing disallowances in one group company with additional capacity in another company could be complex. Moreover, interest relief restrictions would need to be allocated to individual companies and complexities would arise on the interaction with loss relief and in situations where companies in the group have minority shareholders.
Computational steps could involve:
- calculation of the sum of tax EBITDAs of all UK companies in the sub-group;
- multiply this by the fixed ratio percentage;
- the resulting amount gives the cap for allowable net interest expense for the UK sub-group. The rule would apply to all interest (whether paid to related or unrelated parties);
- any net interest expense of the UK sub-group in excess of the cap (subject to a group ratio rule) would be non-deductible but could be carried forward; and
- allocation of the non-deductible amount to individual companies in the group could be determined mechanically or by allowing taxpayers an element of choice.
The Government is seeking views as to the appropriate percentage for a fixed ratio rule within the range of 10% to 30%.
Optional elements to the general interest restriction rule
Group ratio rule
The Government is seeking views as to whether a group ratio rule should be included in addition to a fixed ratio rule and the form such a rule should take. Such a group rule could be calculated as the ratio of net third party interest expense to EBITDA in the GAAP accounts for the worldwide group as a whole (excluding, therefore, intra-group and related party interest). The OECD Report also allows a group ratio rule to be based instead on asset values (where the company’s tax adjusted equity/total assets ratio is equal to or exceeds that of its group). TheOECD will lead further work on the recommendations for the design and operation of group ratio rules, to be completed in 2016.
De minimis or SME exemption
The Government is seeking views as to the form of any de minimis threshold which could be introduced to minimise compliance burdens together with any exemption for SMEs.
The Government considers the simplest way to introduce a de minimis threshold would be to permit the group to deduct its net UK interest expense up to a fixed amount (for example, £1 million) regardless of the calculated interest cap. A group with a net interest expense above the £1 million threshold would then be entitled to a deduction for net interest equal to the higher of £1 million and the cap calculated according to interest restriction rules. The OECDReport also suggests that SMEs could be exempted from the rules.
Dealing with interest relief restrictions where earnings are volatile
The options for dealing with variable earnings set out in the OECD Report include the averaging of earnings, the use of carry forward and carry back of disallowed interest and the use of carry forward of unused interest capacity. The Government considers that carry forward of disallowed interest expense is the simplest approach. Moreover, as the right to carry forward and carry back unused capacity could encourage business acquisitions solely in order to utilise excess unused capacity, time limits could be introduced or the ability to use such excess capacity restricted in cases where there is a change in ownership of the relevant company.
Targeted exclusion where financing is used for highly geared projects
It is considered that any exclusion from the general interest restriction rule for highly geared projects should be restricted to third party loans linked specifically to projects providing a public benefit where the project lasts at least 10 years, although views are sought on any such exclusion.
The Government is also seeking views on transitional rules which would be necessary to prevent unfair or unintended consequences if a general interest restriction rule was to be introduced (such as situations which could merit grandfathering). The OECD Report says that a country can apply transitional rules which exclude interest on certain existing loans from the scope of the rules whether for a fixed period or indefinitely, although the recommendation is that such transitional rules are restricted to third party loans entered into before the rules were announced.
Views are also sought as to whether a new general interest restriction rule should replace existing rules. It is envisaged that any new interest restriction rule would apply after transfer pricing and anti-avoidance rules (including anti-hybrid rules), but that the new rule would either replace the worldwide debt cap rules or such rules would need to be adapted.