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Q&A: Deductibility of corporate interest expense - October 2015 consultation

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Following the OECD’s final recommendations on tackling base erosion and profit shifting (BEPS), the UK government is now consulting on changes to its rules on the deductibility of corporate interest. The likely changes include the introduction of a fixed ratio rule, and would represent a major change to UK law.


What issues were the OECD proposals seeking to address?

Action 4 seeks to address three scenarios in which the OECD consider that BEPS concerns may arise. They are:

  • where groups place high levels of debt from third party borrowings in high tax jurisdictions;
  • the use of intragroup financing to increase the level of deductible expense to amounts in excess of the financing cost of a group’s third party borrowings;
  • the use of group or third party financing to fund the creation of tax exempt income.

What are the OECD proposals?

In summary, the final report on Action 4 recommends a structural restriction on relief for financing costs (not dissimilar from the interest barrier approach used in Germany). There are two key elements.

  • First, the final report recommends that countries restrict relief for financing costs of companies by reference to a fixed ratio of the company’s taxable earnings before interest, tax, depreciation and amortization (EBITDA). The proposed ratio would limit relief for a company’s net financing costs to an amount equal to between 10% and 30% of taxable EBITDA. The level of the restriction (i.e. between 10% and 30%) might vary depending on the circumstances of the country concerned.
  • Second, the final report suggests an optional group ratio rule, which is designed to mitigate the effect of the fixed ratio rule on highly-leveraged groups. Under the group ratio rule, a company would be allowed to deduct additional financing costs (in excess of the deductions permitted by the fixed ratio rule) up to an amount equal to the company’s share of the net third party financing costs of the group. The company’s share of net third party financing costs would be determined by reference to the company’s share of the EBITDA of the group.

For these purposes, financing costs would extend not only to interest but also to payments that are economically equivalent to interest such as profit-participating returns, discounts, alternative and Islamic finance returns, related foreign exchange gains and losses, and financing fees.

The ratios apply to ‘net’ financing costs. So the fixed ratio would be calculated by reference to financing costs after deduction of financing income. The result should be a restriction on tax relief for financing costs against income other than financing income.

The EBITDA-based group ratio rule can be replaced by other group ratio rules such as an ‘equity escape’ rule (used in the German interest barrier rule) which compares the ratio of the company’s equity and net assets to that of its group. However, even in this form, the group ratio rule does carry downsides in that it appears to favour more highly-leveraged groups over those which are predominantly equity-funded. This is a design flaw that it shares with our own worldwide debt cap. The consultation paper recognizes this issue but does not put forward any solution. It simply notes that the OECD proposes to do further work on the detail of the group ratio rule during 2016.

Potential impact

How might the proposed rules apply to corporate groups?

The use of a rule applying to net financing costs means that – although there would still be an incentive for groups to ensure that borrowing costs are ultimately borne in a jurisdiction in which non-financing earnings arise – the rule should not restrict the ability of larger groups to raise third party debt centrally and on-lend to group companies established in other jurisdictions.

At a more practical level, the final report permits some flexibility as to how the rules should apply to groups. The UK consultation paper suggests that the UK might apply the fixed ratio rule not to individual group companies resident in the UK, but by reference to the aggregate position of UK resident companies within a wider group. If so, the resulting grouping rules may look similar to those which currently apply for the purposes of the worldwide debt cap.

If the UK were to adopt this approach, it would also be necessary to include rules to allocate any resulting disallowance between members of the group. Once again, there is a model in the form of the current debt cap rules.

How might the rules allow for volatility in the earnings of companies?

One of the problems with a restriction that is defined by reference to EBITDA is how to deal with volatility in earnings which affects a company’s ability to deduct interest expense. The final report considers various options including the use of averaging, rules to permit the carry forward or carry back of disallowed interest expense and rules to allow the carry forward of excess interest capacity.

The consultation paper implies that HMRC’s preferred option is to permit the carry forward of disallowed interest expense. It expresses concerns that allowing the carry forward of unused capacity could result in companies building up excess capacity, which in turn might encourage tax-driven transactions to exploit that capacity.

How would any new rules interact with other restrictions on tax relief for financing costs?

The UK already has a myriad of rules which restrict tax relief for financing costs including:

  • the transfer pricing rules;
  • anti-avoidance rules within the loan relationship and the derivative contracts regimes;
  • the distribution rules;
  • the anti-hybrid rules; and
  • the worldwide debt cap.

The final report suggests that countries that introduce structural restrictions in line with the recommended approach might continue to use targeted anti-avoidance rules. Although the consultation paper acknowledges that any of the existing rules which become redundant as a result of the introduction of the new regime ‘could’ be repealed, there is no suggestion that legislation to implement the BEPS proposals would be accompanied by a wholesale review of existing restrictions on relief for borrowing costs. The one exception is the worldwide debt cap, where the consultation paper envisages that the new regime may well replace the debt cap or at least lead to substantial changes.

We can only hope that the government and HMRC might seize the opportunity presented by the introduction of any new rules (together with any new anti-hybrid rules based on the recommendation in the final report on Action 2) to rationalize the existing regime. There is surely some scope for doing so. Some parts of the existing distribution code, for example, must be prime candidates for repeal.

Will the new rules apply to all companies, even SMEs or standalone companies which are not members of a group?

The final report acknowledges that BEPS concerns might not be so acute for standalone companies and smaller companies whose levels of borrowing are relatively low.

On the question of standalone companies, the final report allows countries some flexibility as to whether to adopt the recommended approach (principally the fixed ratio rule) or specific rules for standalone companies. The UK consultation paper does not provide a definitive answer, but it notes the EU law concerns and competitiveness risks that might arise if the UK were to implement new rules that are restricted to multinational groups. So the likelihood must be that any UK rules would apply to all companies.

The final report suggests that countries could adopt a de minimis exception to assist companies with low borrowing costs and ease the costs of administration of the new regime. The consultation paper puts forward the possibility of a threshold of £1m of net interest expense which (subject to the operation of other restrictions) would be deductible for all companies. A threshold at this level would, according to the consultation paper, exclude up to 90% of UK resident companies from the regime.

This threshold might be supplemented by an exemption for small and medium-sized enterprises based on the usual EU criteria.

How would these rules apply to banks and insurance companies?

They wouldn’t. A fixed ratio rule calculated by reference to net financing costs would not operate in any meaningful way to banks and insurance companies. The OECD is doing further work on measures to restrict relief for financing costs for groups operating in the banking and insurance sectors.

Looking ahead

Will the UK implement these rules?

In the consultation paper, David Gauke MP, the Financial Secretary to the Treasury, describes the recommended approach set out in the final report as ‘an appropriate response to BEPS issues identified therein’. So it seems quite likely that the government will implement some form of structural restriction on relief for interest expense along the lines set out in the final report. In any event, the UK has been at the forefront of the OECD/G20 project and it would be quite surprising for it not to implement one of the major limbs of its conclusions.

How big a change would this be for the UK?

This would be a major departure for the UK. The retention of general relief for interest expense was a significant element of the settlement reached after the lengthy consultation on the taxation of foreign income of companies that led to the introduction of the debt cap.

The fixed ratio rule applies by reference to ‘taxable’ EBITDA. So in calculating earnings for this purpose, tax exempt income and profits would be excluded. In the UK regime, this would be mean that tax exempt dividend income and gains on the disposal of subsidiaries would not be taken into account (thus reducing the level of interest expense that would be allowed to be deducted).

This is not quite an interest allocation rule, but the overall effect of the fixed ratio rule would be to restrict relief for borrowings costs that are supported by investments in subsidiaries (the returns from which are broadly tax-free) against profits from other taxable businesses. The use of UK holding companies within corporate groups would potentially become less attractive.

What is the likely timetable for introducing any new legislation?

The period for responses to the consultation paper runs until 14 January 2016.

The consultation paper does not set out a firm timetable for the introduction of any new legislation, although it does confirm that it is unlikely that any new rules would be introduced before 1 April 2017. Even that timeframe might be optimistic, if any new legislation is to reflect the further work that the OECD is to do on various aspects of the recommended approach (such as the group ratio rule and rules for the banking and insurance sectors) in the course of 2016.

It is also clear that the precise timetable will depend on a variety of factors – not just domestic issues such as the need to defend the tax base and to allow companies time to adapt to the introduction of the new rules, but also wider issues such as the reaction of other jurisdictions to the final report and their timetables for the introduction of rules based on its recommended approach. We can see here the early signs of the tensions that will affect the implementation of those parts of the OECD/BEPS project which require multilateral action: a desire to be seen to be at the vanguard of the introduction of the new regime to address cross-border tax planning, but a concern not to undermine the international competitiveness of the UK tax system by doing so. 

For the consultation document, see Comments are invited by 14 January 2016.