Release of BEPS Action 4 discussion draft on interest deductibility in the banking and insurance sectors
On 28 July 2016, the Organisation for Economic Co-operation and Development (“OECD”) issued a discussion draft which deals with approaches to tackle base erosion and profit shifting (“BEPS”) involving interest in the banking and insurance sectors (“the discussion draft”).
The common approach to tackling BEPS involving interest
In October 2015, the OECD published the final Action 4 report (“the Report” or “the Action 4 Report”), Limiting Base Erosion Involving Interest Deductions and Other Financial Payments, which sets out a best practice approach for countries to prevent erosion of the tax base through the use of interest expense. Action 4 is focused on the use of third-party, related party and intragroup debt to obtain excessive deductions or to finance the production of exempt or deferred income.
The Report recommends an approach based on a fixed ratio rule, with a potential range of ratios to take into account that not all countries are in an equivalent position. The fixed ratio approach can be supplemented by a worldwide group ratio rule, as well as certain targeted rules.
The Report also recognized that the fixed ratio and the worldwide group ratio rules are unlikely to be effective in addressing BEPS involving interest in the banking and insurance sectors, because of the specific features of those industries. These include the following:
- Entities engaged in banking or insurance business will typically have net interest income rather than net interest expense;
- The nature of interest is fundamentally different than for most other businesses, where interest income is linked to a treasury function;
- Banking and insurance groups are subject to regulatory capital requirements that restrict the ability of groups to place debt in certain entities.
Discussion draft on the banking and insurance sectors
The discussion draft does not change any of the conclusions agreed in the Report, but provides a more detailed consideration of the BEPS risks posed by regulated banks and insurance companies, whereas entities such as captive insurers and group treasury companies remain subject to the general approach set out in the Action 4 Report. It is worth noting that the discussion draft focuses on the technical treatment of the Action 4 Report’s recommendations and in this respect does not refer to the arm’s length nature of the proposed treatment.
For banks and insurance companies, a limited BEPS risk has been identified and the discussion draft explores why this might be the case, the protection provided by regulatory capital rules, and the limits to this protection which differ between countries. Given the differences in risk faced by countries, the discussion draft does not propose a single approach but provides that countries should introduce rules to deal with the actual BEPS risks they face. A country may therefore still choose to apply a fixed ratio rule to banks and insurers, although in this case the report also highlights the following potential problems that this can create for such businesses:
- In cases where a bank or insurance company finds itself in a net interest expense position as a result of poor market conditions, the fixed ratio rule is likely to result in a disallowance of most or all of this net expense, which could seriously hinder an entity’s ability to survive financial shocks.
- When permitted, the option to carry forward disallowed interest expenses would be limited for bank and insurance companies as they will generally have a low or negative EBITDA, even when they are highly profitable in terms of their level of net interest income.
For other entities in a banking or insurance group, the discussion draft identifies a greater BEPS risk and recommends that countries consider applying the fixed ratio rule and the worldwide group ratio rule to these entities, with modification in certain cases. In each case, flexibility is provided for a country to take into account particular features of its tax law and policy.
The discussion draft illustrates the various approaches proposed by the following examples:
- Application of the fixed ratio rule to the net interest position of all the entities of a local group, including regulated banks and insurance companies;
- Application of the fixed ratio rule to the net interest position of the entities of a local group but excluding regulated banks and insurance companies;
- Application of the fixed ratio rule to the net interest position of the entities of a local group, including the net interest expense from specific debt funding activities (e.g. regulatory capital instruments);
- Application of the fixed ratio rule to the net interest position of the entities of a local group but excluding the net interest expense from specific debt funding activities (e.g. regulatory capital instruments);
- Application of the fixed ratio rule, alongside the worldwide group ratio rule, to the net interest position of the entities of a group resident in different countries. This highlights the possibility of differentiated treatment, as in the example discussed, the position of banks and insurance companies is not taken into account in applying the fixed ratio rule but is taken into account in applying the worldwide group ratio rule.
Finally, it is worth noting that the final report on approaches to address BEPS involving interest in the banking and insurance sectors will include a summary of the rules currently applied by countries which are intended to provide protection against BEPS involving interest in the banking and insurance sectors.
Next steps
The options included in this discussion draft do not represent the consensus view of the Committee on Fiscal Affairs or its subsidiary bodies, but are intended to provide stakeholders with substantive options for analysis and comment. In this respect, interested parties are invited to submit comments, including responses to the specific questions identified in the discussion draft, by 8 September 2016.
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