In the past few years, it’s been hard to avoid stories about large corporations mitigating their tax bills by shifting profits into jurisdictions with low tax rates, or otherwise taking advantage of international tax laws that have not kept pace with modern business practices. A conservative estimate on the Organisation of Economic Co-operation and Development (OECD) website puts the potential global corporate income tax revenues lost as a result of the current system at anywhere from 4 – 10%, i.e. USD 100 to 240 billion annually (source).
In 2013, the governments of the G20 and the OECD launched the Base Erosion and Profit Shifting (BEPS) project to modernise the international tax rules. After years of attempts to create unity among international regimes and ensure tax happens where the economic activity takes place, it appears some progress is being made. The latest update to this project is the BEPS action plan: 15 recommendations on how governments can make changes to tackle international tax gaps.
In the world of project finance, it’s been easy to keep these stories on the back burner, but the publication of the 15 Action Plans has caused project finance professionals to sit up and take notice. There are some changes that have potentially massive implications for how these deals are planned and priced.
Action Plan Four: Interest deductibility
The most important change for the project finance sector is Action Plan #4, which covers interest deductibility. It’s been known for some time interest deductibility arbitrage would be addressed – but the specific mechanisms weren’t known. As the recommendations have been clarified, it’s now down to individual countries to decide how to apply them specifically.
The aim behind the action plan is to limit the amount of tax relief available on interest. The plan discusses a fixed ratio rule and a possible group ratio rule. Using the fixed ratio rule, interest up to 10 – 30% of earnings before interest, tax, depreciation and amortisation (EBITDA) would be eligible for tax relief, and as you would imagine, the market is very keen for it to be 30.
The UK government recently announced a consultation as it plans to introduce the new rules into domestic law. It’s fair to say that this will be an active consultation, as many interested parties will attempt to secure rules which are as favourable as possible for their particular sector. The UK has generally been extremely generous compared to its European peers in allowing tax relief to be taken on interest. This means that the BEPS rules could introduce some significant changes to existing projects. It could even send some large projects into default.
Addressing the plan: Three considerations
Given the timelines of most major project finance deals, existing projects will hope that the interest rate and deductibility assumptions on which the project was financed and planned will remain, so that the project can remain solvent. However, the government has indicated that it would expect grandfathering of existing loans to apply “only in exceptional circumstances”, so the application of the new rules to existing projects could have a major negative impact on many companies in the project finance sector, and challenges could also appear as these deals attempt to secure refinancing. The definition of the ‘public benefit’ exclusion (see below) will therefore be crucial.
The public benefit project exclusion
The possibility for an exclusion from the new rules based on the (still nebulous) concept of ‘public benefit’ will certainly appeal to much of the industry. There are several classes of infrastructure that we would expect to be included in any exclusion, such as schools, hospitals, street lighting and roads. There are others, however, whose status isn’t as clear: renewable energy, university accommodation, certain social housing. These can be expected to lobby heavily to secure their status as public benefit projects, though it remains to be seen what the criteria will be.
At present the proposal is only to include third party interest in the exclusion, but the public private partnership (PPP) and private finance initiative (PFI) industries will certainly be hoping that the definition will include all arm’s length debt, not just third party.
Group Ratio Rule
This is an optional treatment suggested by the OECD, and it is up to individual countries to decide whether to offer it. The UK government is considering doing so. It could be introduced as a replacement for the fixed ratio rule for groups which are highly leveraged for commercial reasons. The group ratio would likely be the ratio of net third party interest to EBITDA in the GAAP accounts for the worldwide group as a whole. This may allow some groups that have a higher level of external gearing to deduct more interest than the fixed ratio rule would allow for an individual project company.
Response to the government’s consultation
While there was no mention of the BEPS changes in George Osborne’s autumn statement, the item is clearly on the government’s agenda in advance of the budget. On January 6th the government announced its updated consultation, inviting feedback from the industry on the proposed changes.
As Operis is heavily involved in consultation on major project finance deals, we have already been asked to run sensitivities on this issue across a range of projects and scenarios. We have also contributed to the consultation by way of the CIOT and PPP Forum, particularly in the area of how the public benefit exclusion should be applied. One suggestion is that projects accounting under IFRIC 12 would be a good starting point, with the list then expanded to take into account other specific classes of public benefit entity.
The clock is ticking
Once more details of the change become clear, the conversation will quickly turn to timings. Given the closing date on the consultation of 14th January, it’s likely that there will be a statement in the March budget. While many terms remain to be ironed out, Action Plan 4, regarding interest deductibility is likely to be one of the first to be implemented, with draft legislation expected in the year to come.
As ever, change can create uncertainty in the market. While there is some anxiety in the market about the implication of these changes, for the most part there are encouraging signs that a workable solution can be found. I would encourage anyone working in project finance, or involved in the administration of longstanding projects to educate themselves on the subject via the OECD or HM Treasury website.
If you have any questions about the upcoming 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.