The ease of locating debt in virtually any jurisdiction because of the fungibility of money and flexibility of financial instruments, means that the use of deductible interest and similar financial payments to reduce the tax base in high tax jurisdictions is a particularly widespread issue. As a result, the OECD's recommendations to prevent BEPS in this area are wide in scope and will be relevant to a great number of companies.
It is notable that the UK issued a consultation paper on the implementation of these recommendations almost immediately and, although the consultation questions are framed in very broad terms at this stage, it is clear that the UK's regime for taxing interest will change significantly.
OECD recommendations
As widely anticipated, the recommended approach is a fixed ratio rule which will limit the deductibility of an entity's net interest and financing costs to a percentage of EBITDA. The recommended corridor is ten to 30 per cent. Countries choosing to implement the best practice recommendation will generally be free to fix the percentage applicable in their jurisdiction within this corridor and to supplement the basic rule in a number of different ways. In particular, countries may consider:
- a de minimis threshold, which would exclude entities from the fixed ratio rule if their net interest expense were below a certain level;
- a group ratio test, which would allow an entity whose net interest costs were above a country's fixed ratio rule to deduct a percentage of net interest costs up to the level of the net interest to EBITDA ratio of the worldwide group (if higher);
- specific exclusions for the banking and insurance sectors and certain public benefit projects;
- the carry forward of disallowed interest or unutilised interest capacity and the carry back of disallowed interest;
- targeted rules, which would apply, among other things, to related party debt and arrangements designed to minimise the effects of the fixed ratio rule; and
- transitional/grandfathering rules, recognising that an immediate introduction could involve a significant cost for some entities.
In light of the number of options open to individual countries, including the ability to set the fixed ratio rule between ten and 30 per cent, it is unlikely that the best practice recommendation will be implemented uniformly across the globe. What is more, it means that a great degree of uncertainty remains as to how individual countries will implement the recommended approach and what, therefore, the practical implications will be.
A fixed ratio rule of 30 per cent, for example, may not in many cases be game changing and mirrors the position in a number of European jurisdictions already. The effects at ten per cent could be much more significant. Similarly, if a group test is adopted which allows an entity to deduct net interest costs up to the level of the group's net interest to EBITDA ratio, the effects of any fixed ratio rule may be reduced even further, subject to any targeted rules around related party debt, which will be particularly relevant to the private equity and venture capital industry. Related party, for these purposes, will be primarily determined by reference to 25 per cent plus holdings or effective control.
UK implementation
The UK Government has responded to this report particularly quickly and has already published a consultation on the implementation of this best practice recommendation. While supportive of the OECD approach, however, the Government gives little indication of where it believes this consultation should end up on the more detailed issues.
Instead, the consultation paper comprises a discussion of the issues raised by the various recommendations, together with a request for stakeholder views on each point. Perhaps most obviously, the paper reveals no preference for any particular percentage within the ten to 30 per cent corridor for the fixed ratio test, nor is there any hint as to whether a group ratio test is favoured.
Grandfathering of existing arrangements is expected by the government to be available "only in exceptional circumstances".
Next steps
The UK consultation is open for comments until 14 January next year and responses will be considered in the development of a future business tax roadmap, which is expected to be published next April.
The document states that any new rules would not come into force until at least 1 April 2017 and, given that the Government is waiting on further work by the OECD before concluding how to deal with the banking and insurance sectors, it may be even later before these sectors will have clarity on changes affecting them.
New interest deductibility rules following the OECD's recommended approach could significantly affect the deductibility of interest costs, particularly in respect of financing transactions where leverage plays an important part. Determining the percentage of EBITDA, the scope of any group ratio test and any targeted rules and the format of any transitional provisions will therefore be crucial.
Please click on the links below for the other articles in the November 2015 tax newsletter:
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