In the autumn of 2015, the Organisation for Economic Co-operation and Development (OECD) published its 15 Action Plans to counter Base Erosion and Profit Shifting (BEPS) following a number of years of research and discussion between OECD countries as well as the G20. While the Action Plans provide the framework for targeting the tax strategies used by multinationals engaging in BEPS, it is down to the relevant Governments to implement the necessary legislation with the Action Plans. You can see my analysis on the Actions Plans framework here.
Yesterday’s Budget outlined how the UK Government intends to implement the OECD Action Plans, as well as introduce new rules around interest deductibility which are likely to have a significant impact on the project finance sector. In this blog, I will examine what the new changes in the interest deductibility rules mean for project finance companies.
BEPS within the Business Tax Roadmap
Since first becoming Chancellor, George Osborne has made clear that he wishes to see the UK with a competitive tax environment for businesses while protecting the UK’s tax base. In relation to protecting the tax base, the Chancellor has supported the OECD’s BEPS project and introduced anti avoidance measures, for example, the diverted profits tax which came into effect from 1 April 2015.
The UK Government has issued consultations in respect of Action Plan 4 – interest deductibility and Action Plan 2 – neutralising the effects of Hybrid mismatch arrangements. In addition, legislation was introduced in the 2015 Finance Act to require multinationals to provide Her Majesty’s Revenue and Customs (HMRC) with a country-by-country transfer pricing report in-line with Action Plan 13.
As part of yesterday’s Budget, the Chancellor introduced the Business Tax Roadmap which details the Government’s goals in respect of business taxation during this Parliament with its strategy to achieve those goals.
Within the Roadmap, the Government lays out its intention to introduce legislation in respect of the OECD Action Plans including Action Plan 4 (interest deductibility). In doing this, the UK has positioned itself at the more generous end of the spectrum provided by the OECD proposals as it will adopt the majority of the optional concessions suggested in Action Plan 4 including implementing a public benefit exclusion (although the detail of some of the concessions is still to be released). This approach can be seen as a continuation of the Chancellor’s wish to make the UK competitive from a tax standpoint amongst developed countries. The new interest deductibility rules will come into force from 1 April 2017.
7 things you need to know about the new interest rules in the Roadmap
1. Fixed Ratio Rule
Action Plan 4 recommends a fixed ratio rule of net interest expense to Earnings before interest, taxation, depreciation and amortisation (EBITDA) of between 10% and 30% with excess interest disallowable for corporation tax purposes. As expected, the Roadmap states the UK will limit interest deductibility at the upper level suggested by the OECD of 30% and this will be welcomed by UK companies and groups. However, given the high gearing levels seen within the project finance sector, the new rules are likely to lead to a disallowance of interest for companies within the sector unless one of the concessions provided by the Roadmap can be applied. If not, companies will suffer an additional compliance burden in monitoring the new rules.
2. Group Ratio Rule
The Chancellor has confirmed that the UK will implement a group ratio rule. Under the rule, multinationals will be able to deduct interest up to the net interest expense to EBITDA ratio seen across the worldwide group where this ratio is greater than the 30% fixed ratio rule. The UK Government intends to use a group ratio rule to reflect that some multinationals will naturally have a high level of external gearing due to the sectors that they operate in. This rule therefore may be of use to worldwide groups that focus on infrastructure projects or renewable projects such as solar energy and may provide an alternative avenue to relief from the new interest deductibility rules if the public benefit exclusion is not available.
3. De minimis threshold
The UK will implement a de minimis net UK interest expense threshold of £2m to be applied on a group basis. While this should take many companies and groups outside of the new legislation, the de minimis threshold may be too low to be helpful for project finance companies.
4. Worldwide debt cap
As an interesting addition to the BEPS discussion, the UK Government has confirmed its intention to repeal the existing worldwide debt cap legislation. The old rules will be replaced with new legislation within the new interest deductibility rules such that a group’s net UK interest deduction cannot exceed the global net third party expense of the group.
5. The public benefit project exclusion
As expected, the UK will implement a public benefit exclusion for certain public infrastructure projects whereby the new interest deductibility rules will not apply. The Government has not provided details on which exact types of project will fall within the exclusion and will continue to consult with the private sector on this, but it has stated that the projects qualifying for the exclusion should show no material risk of BEPS.
In addition, the Roadmap does not make clear whether the exclusion will provide relief on just third party debt as the OECD Action Plan suggests or, as the project finance sector has requested, both third party and connected party debt.
6. Adjustments for interest and earnings volatility
The Government has indicated that it will introduce rules to address volatility in interest and earnings. While no detail has been provided, we anticipate that following OECD recommendations this is likely to take the form of legislation enabling companies to carry forward interest that has been treated as non-deductible in one period and allow it to be deducted in future periods where the net interest expense falls below 30% of EBITDA. An additional rule is also likely to allow for excess capacity of EBITDA to be utilised in future periods.
7. Still unknowns
The Roadmap does not discuss the possibility of grandfathering rights for existing projects but the Government has previously stated that it will only accept grandfathering in respect of existing loans in “exceptional circumstances”. It is unclear at this stage how “exceptional circumstances” will be interpreted and, if it is allowed at all, it is likely that grandfathering will need to be agreed with HMRC on a case by case basis. In addition, a further discussion of what constitutes interest income in reaching the net interest expense has not been included in the Roadmap.
A major shift for the UK
The new proposals announced in the Budget represent a major shift in the UK’s approach to interest deductibility with the introduction of rules rather than a principles-based regime. We now know that the fixed ratio rule will be set at 30%, the highest percentage suggested by the OECD and the de minimis threshold is £2m. The project finance sector will be pleased that the UK will implement a group ratio rule, public benefit exclusion and rules to reflect earnings and interest volatility, which will provide some protection.
But the Budget still leaves many unanswered questions and provides a period of uncertainty for bidders on infrastructure projects. It is likely that the true position for the project finance sector will only become apparent once the public benefit exclusion, interest and earnings volatility and grandfathering rules are finalised and there are likely to be further representations made to the Treasury regarding these issues.
If you have any questions about the BEPS changes and would like to speak to someone at Operis about how these can affect you, please don’t hesitate to get in touch.