Interest deduction restrictions must not put UK banks, insurers at disadvantage, says expert

Matthew Taylor, an insurance tax expert at Pinsent Masons, the law firm behind Out-law.com, was commenting as the Organisation for Economic Co-operation and Development (OECD) published a discussion draft on how proposed restrictions on interest deductibility for companies should apply to banks and insurance companies. The UK government is proposing to implement interest restrictions based on OECD recommendations, with effect from April 2017.

He was commenting as the Organisation for Economic Co-operation and Development (OECD) published a discussion draft on how proposed restrictions on interest deductibility for companies should apply to banks and insurance companies. The UK government is proposing to implement interest restrictions based on OECD recommendations, with effect from April 2017.

Matthew Taylor said: "Particularly in the light of Brexit, it would be heavy-handed to introduce rules more restrictive than the German rules on which the OECD proposals are partly based".

In October 2015, the OECD published its recommendations to prevent international tax avoidance by multinationals through the use of interest deductions. The proposals included a ‘fixed ratio rule’ which limits an entity or local group’s net interest deductions to a set percentage of its tax-EBITDA and a ‘group ratio rule’ to allow an entity to claim higher net interest deductions, based on a relevant financial ratio of its worldwide group.

The OECD report said that countries could choose to exclude entities in banking and insurance groups, and regulated banks and insurance companies in non-financial groups from the scope of the fixed ratio rule and group ratio rule. It said that further work would be conducted in 2016 to identify the risks posed by these groups. The discussion draft issued by the OECD is part of this work.

It said that banks and insurance companies only pose a limited risk of 'base erosion and profit shifting' (BEPS) by using interest deductions to shift profits to low or no tax jurisdictions to avoid tax. However the OECD said that that other entities in the same group as a banking or insurance company, such as holding companies, group service companies and companies engaged in non-regulated financial or non-financial activities, may pose a higher risk.

The document does not propose a single approach to dealing with banks and insurance companies because the BEPS risk they pose in each country will differ. It allows such companies to be excluded from both rules and recommends that countries should introduce specific rules to deal with the actual BEPS risk faced in their jurisdiction. However, the OECD said that the fixed ratio rule and group ratio rule should be applied to other entities within a banking or insurance group.

The OECD sets out five examples of how groups containing banks or insurance companies could be treated. One option considered is to include banks and insurance companies when the fixed ratio rule is applied to a local group, so that net interest expenses in banking or insurance companies can effectively allow a higher interest deduction by non banking or insurance entities in the group.  An option is to exclude the funding and earnings of banking and insurance companies and apply the rule separately to them. Similar options are considered for the group ratio rule.

A consultation document issued by the UK government in May said that the government was considering excluding the tax-interest and tax-EBITDA of banking and insurance companies from the interest restriction calculation, but did not give details as to how this would affect the group ratio rule.

Werner Geisselmeier, a Pinsent Masons German tax expert said that the German fixed ratio rule, on which the OECD proposals are partly based, does not exclude banks and insurance companies in a group if the companies form a fiscal unity within the meaning of the German Corporate Income Tax Act.

Matthew Taylor said: "There is no direct equivalent in the UK of a fiscal unity but the group relief provisions allow the offset of unrelieved interest against the profits of other companies in the group in the same period."

Banks pose a lower BEPS risk because they will usually have net interest income because they will generate profit by charging more interest on the loans they make than they pay on deposits and their debt, the discussion draft said. Insurance companies also usually have interest income which significantly exceeds their interest expenses as they tend to invest premiums in stable income producing assets such as long-term debt instruments, in order to generate income and ensure sufficient liquidity to pay claims as they fall due.

Regulatory capital rules will also usually ensure that banks and insurance companies are capitalised with an appropriate level of equity, providing protection against excessive leverage for tax purposes.

However, the OECD considers that there is a BEPS risk where banks or insurance companies, and entities in a group with a bank or insurance company, use third party or intragroup interest to fund equity investments giving rise to income which is non-taxable or is taxed in a preferential manner. It also considers that there is a BEPS risk where entities in a group with a bank or insurance company incur excessive third party or intragroup interest expenses, which may be set against taxable interest income in the bank or insurance company.

There have been calls for the UK's implementation of the interest deduction rules to be postponed in the light of the Brexit vote, so that the rules do not come into force in April 2017. Arguments for a delay intensified after the OECD published a discussion draft earlier this month on how the group ratio rule should apply which suggested a more favourable treatment for joint ventures than that currently proposed by the UK government.

Matthew Taylor said: "The philosophy behind the proposals is to reduce or remove incentives to shift profits for tax purposes.  At the same time UK policy is also clearly to establish a competitive tax environment.  It would therefore be unfortunate if the UK were to enact proposals more restrictive than those applying in other jurisdictions."