One of the 15 BEPS action points was the use by multi-national groups of interest and other financing expense as a means of diverting profits. Following initial consultation the Government has confirmed that it will introduce a new structural fixed ratio rule in line with the OECD’s recommendations. The key points that have emerged (mostly as generally anticipated) are as follows.
(1) The rules will have effect from 1 April 2017.
(2) The rules will comprise principally a new “Fixed Ratio Rule” which will limit a group’s UK corporation tax deductions for interest and other financing costs to 30% of its taxable EBITDA (30% being at the generous end of the 10 to 30% corridor suggested by the OECD).
(3) The UK will adopt the “optional extra” offered by the OECD of a “Group Ratio Rule” under which a UK company (or sub-group) will be allowed to deduct additional financing costs (over and above that permitted by the Fixed Ratio Rule) up to an amount equal to its share (based on EBITDA) of the group’s net third party financing costs. This is designed to alleviate the impact of the new rule for groups with (commercially driven) high levels of third party debt.
(4) There will be a ‘de minimis’ group threshold of £2 million of UK financing costs. This is so that only larger groups are targeted (where the scope for BEPS is greater) thereby minimising the compliance burden for smaller groups. This is an improvement on the originally proposed £1 million threshold.
(5) There will be an exemption or other relaxation of the rules to ensure that it does not impede the raising of private finance for certain public infrastructure works (where there is no material BEPS risk).
(6) There will be further consultation in relation to the detail of the rules, in particular, to address the impact of the rules where earnings are volatile. It seems it is yet to be decided whether this will be achieved through a system of carry forward or carry back of disallowed interest (to years with higher EBITDA), carry forward of interest capacity or some form of averaging.
(7) The existing UK worldwide debt cap (WWDC) rules will cease and, to the extent necessary, will be re-stated within the new set of rules so that a group’s UK interest deductions cannot exceed the worldwide net third party financing cost expense (as currently achieved through the WWDC).
It remains to be seen whether the opportunity will be taken to review and simplify the numerous other UK rules and regimes affecting interest deductibility (eg. transfer pricing, loan relationship TAARs, anti-hybrid rules and the deemed distribution rules).
These new rules represents a radical change to the UK’s rules on interest expense deductibility, comprising as it does a stand alone structural restriction (in contrast to the restrictions currently in place which (with the exception of the WWDC) are transactional in nature).
The Fixed Ratio Rule, even when tempered by the Group Ratio Rule, is indiscriminating in its application and (unlike the UK’s and most other transfer pricing and thin capitalisation regimes) will pay little or no heed to arm’s length commercial principles. Two companies will be treated the same way even though they may be in wholly disparate sectors, have very different looking balance sheets and would be viewed very differently by third party lenders. This all feels potentially quite distortive.