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Limiting base erosion involving interest deductions and other financial payments

The OECD recommended approach is to limit interest deductions based on a fixed percentage of between 10% and 30% of EBITDA. HM Treasury responded this week by issuing their consultation document outlining 18 questions for consideration.

Further work will be undertaken by the OECD during 2016 on group ratio rules, the application of action 4 to companies in the banking and insurance sectors and the use of additional targeted rules.

The key objective of action 4 was to identify coherent and consistent solutions to address BEPS using interest and payments economically equivalent to interest. The work is not complete but the final report has identified a best practice approach and framework as summarised in the table below:

The main rules

Fixed ratio rule:

Allows an entity to deduct net interest expense up to a benchmark net interest/EBITDA ratio. Relevant factors help a country set its benchmark ratio within a corridor of 10%-30%

Optional group ratio rule:

Allows an entity to deduct net interest expense up to its group’s net interest/EBITDA ratio where this is higher than the benchmark fixed ratio

Supplemental rules

Optional de minimis monetary threshold to remove low risk entities

Optional carry forward of disallowed interest/unused interest capacity and/or carry back of disallowed interest

Targeted rules to support general interest limitation rules and address specific risks

Further work

Specific rules to address issues raised by the banking and insurance sectors

Fixed ratio rule – the basic test

The OECD's recommendation is for interest deductions to be limited to a fixed percentage of EBITDA, effectively overriding the arm's-length principle.

Countries are recommended to set their fixed ratio at between 10% and 30%, referred to as the “corridor”. There is a tightly targeted relaxation for public sector asset investment structures, which are usually very highly geared structures. This may be an intended concession to the UK PFI/PPP industry, however the conditions suggest the relaxation of the general rule will be applicable in only very specific circumstances.

The guidance provides information for tax legislators detailing the factors that may be taken into consideration when determining where a country should position itself within the 10% to 30% corridor, these include:

•       whether interest capacity can be carried back/forward;

•       local interest rates;

•       whether the fixed ratio is to be implemented alongside a group ratio rule; and

•       whether tax rules exist to tackle a number, but not all, of the risks included with Action 4 and thus mitigate the overall risk of BEPS.

Group ratio rule – optional

The OECD suggests that a group ratio rule may be introduced as a separate additional provision, or as a compliment to the fixed ratio rule. This will allow an entity to deduct net interest expense up to its group’s net interest/EBITDA ratio, where this is higher than the benchmark fixed ratio. It is of note that a country may apply an uplift to a group’s net third party interest expense of up to 10%.

The group rule is aimed at compensating for the “blunt” operation of the fixed ratio rule and allows for sectors or industries that are traditionally highly leveraged to obtain a higher deduction.

The OECD discusess a number of significant issues with formulating a best-practice policy including the definition of a group, the inclusion (or otherwise) of loss-making companies in the ratio calculation and the most appropriate measure of net interest and of EBITDA.

The OECD has indicated further work on the definition and application of a group ratio rule will be undertaken in 2016. The OECD indicated that a country may apply a different group rule or no group rule at all.

De minimis threshold to remove low risk entities – optional

The OECD recognises that certain entities may be sufficiently low risk and that excluding them from a fixed ratio rule and group ratio rule would be appropriate. Excluding such entities from the fixed ratio rule and group ratio rule means that tax authorities can focus on entities which pose material risk of BEPS, reducing compliance costs for other entities.

The guidance proposes the use of a net interest expense measure as the basis for a de minimis threshold given that it should be relatively simple to apply.

It is worth noting that the use of a de minimis threshold is considered optional by the OECD, but if applied, should be accompanied by anti-fragmentation or similar anti-abuse rules.

However, given that a number of countries currently include a de minimis threshold, such as Germany, which has a conditional threshold of €3m net interest before applying interest restriction rules, one can only be hopeful that this pragmatic and measured option will be widely adopted in legislation.

Carry-forward of disallowed interest/unused interest capacity and/or carry back of disallowed interest – optional

The report allows countries to choose whether entities are able to benefit from any of the following reliefs:

•       To carry forward disallowed interest expense only;

•       To carry forward disallowed interest expense and unused interest capacity; and

•       To carry forward and carry back disallowed interest expense.

Where a country allows an entity to carry forward unused interest capacity, this may be limited to the amount by which an entity’s net interest expense is below that permitted under the fixed ratio rule to prevent future BEPS behaviour.

As with the application of a de minimis threshold, this is a welcome relaxation of the basic fixed ratio rule although potentially adds a degree of complexity to local tax filings and administration.

Targeted rules to support general interest limitation rules and address specific risks

The OECD recommends countries introduce targeted rules as an effective solution to mitigating BEPS risks that are not adequately covered by the basic rules. Eight specific situations are listed in the report covering payments to related parties or in connection with structured arrangements.

Related parties are considered to include individuals and entities where a significant relationship exists and/or they are acting together. The acting together rules are similar to UK legislation and accordingly, appear directed at restricting interest deductions in private equity and venture capital backed structures.

Targeted rules are intended to complement the fixed ratio and group ratio rules.

Specific rules to address issues raised by the banking and insurance sectors


Further work will be conducted in 2016 to identify recommendations to deal with the potential BEPS risks arising in the banking and insurance sectors due to the inherent complexity of these sectors and the stringent regulatory environment in which they operate.

Key dates
As part of the consultation process, HMRC has stated that if new restrictions are introduced in the UK it is unlikely this would be before April 1 2017. It is no longer certain that existing financing arrangements will be “grandfathered” by any amendments and businesses should be prepared for changes to levels of allowable interest from this date.

HM Treasury consultation document

HM Treasury issued its consultation document relating to BEPS Action 4 on 22 October 2015. The consultation covers all key points raised by the BEPS publication and seeks to garner responses on 18 specific questions.

This consultation is open until January 14 2016 and the government will consider responses in the development of a future business tax roadmap.

Further information and a copy of the full document can be found on the following website:

www.gov.uk/government/consultations/tax-deductibility-of-corporate-interest-expense

What next?
We recommend that groups consider the impact of the fixed ratio rule on their interest deductions and assess whether refinancing or restructuring of the debt arrangements is appropriate. Groups should start modelling the likely impact as soon as practicable.


By Wendy Nicholls, Nick Marshall and Elizabeth Hughes, of Grant Thornton UK

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