UK interest deduction restrictions on banks not as OECD recommends, says expert

Tax expert Eloise Walker of Pinsent Masons, the law firm behind Out-law.com, was commenting as the OECD published an update to its 2015 report on Action 4 of its base erosion and profit shifting (BEPS) proposals to combat international tax avoidance by multinationals. The original report recommended that countries introduce a cap on the interest deductions that companies could claim, but said that further work needed to be carried out in relation to how the rules should apply to banks and insurance companies and how a group ratio rule should apply. 

In the updated report the OECD said its work had shown that the manner and extent to which BEPS risks arise from banks and insurance companies in different countries varies and said that "countries should introduce rules to deal with the risks they face". It said that the benefits of applying the interest restriction rules to all companies "must be weighed against the additional compliance and administrative burdens if countries introduce rules to address risks they do not encounter in practice".

Earlier this month the UK government published draft legislation to introduce a new corporate interest restriction to implement the OECD's recommendation on Action 4, which will be effective from 1 April 2017. At that time it said that, although most respondents to a consultation on the rules published in May 2016 had suggested that banking and insurance groups should be excluded from the rules, banking and insurance groups would be subject to the fixed ratio rule in the same way as other industry groups.

In its latest report the OECD said "It is vital that rules to protect countries from BEPS should not weaken the effectiveness of capital regulation in providing protection against default, insolvency and a future financial crisis."

"Therefore, it is suggested that in identifying an approach to deal with a risk it has identified, a country should ensure that rules are suitably targeted, they avoid a disproportionate impact on banking and insurance groups relative to rules applied in other sectors, and the interaction of tax and regulatory rules and the possible impact on groups is fully understood" it said.

Eloise Walker said: "Why is the UK so keen to force banks and insurance companies to jump through pointless hoops each year in relation to this new legislation, when it has not identified credible BEPS risks from these sectors and pushing ahead could damage the industries?"

The UK's new 'fixed ratio' rule will limit tax deductions for interest expenses to 30% of 'tax-EBITDA'. This refers to profits chargeable to corporation tax, excluding interest, tax depreciation such as capital allowances, tax amortisation, relief for losses brought forward or carried back and group relief claimed or surrendered.

The OECD points out in its report that in most cases banks will have net interest income, rather than net interest expense. However it states that where a banking group or an entity within the group has net interest expense, the application of the fixed ratio rule is likely to have more of an impact on such a group than on a group operating in a different sector because for banks  interest is the main source of operating income so that they are likely to have low or negative EBITDA. The fixed ratio rule is likely therefore to mean that any bank with net interest expenses will have almost all of the expense disallowed. "In particular for banks, as interest expense is typically a bank's largest single operating expense, this disallowance could seriously hinder an entity's ability to survive financial shocks" the report said.

Eloise Walker said "We will have to wait until we get the further draft Finance Bill legislation in January to see if the UK softens its approach to interest restrictions for banks and insurance companies, in the light of the OECD's latest report. However, it is far from ideal that there are still so many question marks over how the regime will apply, considering it is due to come into force in April."

In addition to the fixed ratio rule, the OECD recommended an optional 'group ratio rule' to allow an entity to claim higher net interest deductions, based on a relevant financial ratio of its worldwide group. The UK is proposing to implement a group ratio rule as well as the fixed ratio rule.

The OECD's updated report does not change any of the 2015 recommendations in this area, but "provides a further layer of technical detail" to assist countries in implementing the group ratio rule.