OECD proposals will have 'significant impact' on UK real estate sector, says expert

Real estate tax expert John Christian of Pinsent Masons, the law firm behind Out-Law.com, was commenting on the final report on limiting base erosion involving interest and other financial payments which was published by the OECD on 5 October. The OECD considered restrictions on interest deductibility as part of its 15-point action plan to counteract base erosion and profit shifting (BEPS).

In its report, the OECD recommended that countries should introduce into their tax systems an interest/EBITDA limitation on tax deductibility, with countries free to pick a percentage level within a range. The suggested range is from 10% to 30%. EBITDA means a company's earnings before interest, taxes, depreciation and amortisation.

The restriction would apply to all interest, including amounts paid to third parties, with no 'arm’s length' escape route. However, the OECD said that countries could choose to have an additional allowance where interest does not exceed the group ratio. This would mean that a subsidiary with 40% EBITDA interest would not have a disallowance if the group ratio was also at least 40%.

“As with other capital intensive sectors, the real estate investment model uses debt funding for commercial reasons so the effect of restrictions on deductibility will be to increase the effective cost of that debt funding and reduce the net returns for UK tax paying investors," Christian said.

The OECD recommended that countries should also be able to choose to introduce a 'public benefit exemption', to allow certain public infrastructure projects to be exempt from the new rules. Any exemption introduced would have to comply with detailed conditions.

"The implementation of the public benefit exception will be scrutinised closely but this is likely to be limited to certain public infrastructure," Christian said. "It will be interesting to see whether a case can be made for social and affordable housing being within public benefit, though private rented sector housing sounds unlikely."

"There will need to be specific work on how an interest restriction operates in the context of the real estate investment trust (REIT) regime where the profits required to be distributed are based on taxable profits so a restriction on interest deductions may lead to REITs having to distribute a higher proportion of income. Assuming this can be overcome, there may be an increased emphasis on the REIT as an investment vehicle because of its tax exempt position. The effect of the existing cap on interest costs within the REIT regime would have to be compared with the post-tax returns in a post –BEPS taxable vehicle but the outcome may be positive for REITs," he said

REITs are tax efficient property investment companies. They were first developed in the US but were introduced in the UK in 2007.

BEPS refers to the shifting of profits of multinational groups to low tax jurisdictions and the exploitation of mismatches between different tax systems so that little or no tax is paid. Following international recognition that the international tax system needed to be reformed to prevent BEPS, the G20 asked the OECD to recommend possible solutions. In July 2013, the OECD published its 15 point Action Plan.

In addition to the report on interest, twelve other reports were published by the OECD on 5 October. Finance ministers from the G20 countries endorsed the proposals at their meeting in Lima on 8 October.  

The interest proposals do not contain minimum standards which OECD and G20 countries have agreed to adopt. Instead they are "best practices" where countries have agreed a "general policy direction". An explanatory statement issued by the OECD states that countries "are expected to converge over time through the implementation of the agreed common approaches, this enabling further consideration of whether such measures should become minimum standards in the future".

John Christian said: "The UK Government’s response to the BEPS interest recommendations is keenly awaited. Other governments apparently consider that their current regimes are BEPS compliant in relation to interest so a tightening in the UK regime could contribute to investment in UK assets being relatively less attractive.”