The OECD’s final report on base erosion and profit shifting (BEPS) Action 4 (Interest deductions and other financial payments) published last year noted that banks and insurers were potential “special cases”, because of the regulatory constraints imposed on them and the fact that in many (although certainly not all) cases they would be net interest recipients. The OECD therefore indicated that more thought would be needed in this area, and have now released a discussion draft representing the results of their additional consideration.
The view taken in the discussion draft is that the BEPS risks posed by banks and insurers will be different in different jurisdictions and groups, and on this basis it repeatedly holds back from mandating particular approaches, preferring simply to highlight potential issues and describe the possible range of approaches. Although there is a certain logic to rejecting a “one size fits all” approach, this will inevitably increase uncertainty and the risk of inconsistent approaches in different jurisdictions. It will be interesting to see how the EU chooses to take this forward in the context of the recently agreed anti-tax avoidance directive.
With regard to the excessive leverage of banking and insurance entities, the role of regulation in limiting this is acknowledged. Nonetheless, the report does not accept that this means there will never be a risk of excessive interest deductions in such entities. Individual countries are therefore encouraged to reach their own conclusions on whether to apply the general interest restriction rules or some modified form of these to either banking and insurance entities in general or some particular subset of these (excluding captive insurers and group treasury companies which are explicitly excluded from the discussion draft).
Where countries do decide to exempt banking and insurance entities from the basic interest restriction rules, the draft assumes this will be done on an entity-by-entity basis and encourages such an approach to prevent, for example, excessive deductions in other group entities being effectively sheltered by the net interest income in a bank or insurer. This entity level exemption potentially opens the door to different risks, and the report particularly notes concerns about banks/insurers claiming deductions on debt used to fund investments generating non-taxable income, although it is noted that regulatory/commercial constraints should make this comparatively unusual.
Another problem with simply exempting banking and insurance entities is how to deal with other group entities incurring interest costs on funding used to support the activities of regulated entities. Absent any additional rules, there is a risk that groups pushing the funding down as equity would suffer a restriction whereas those pushing it down as debt would not. The report therefore leaves it open to individual countries to introduce a supplementary exemption for this kind of interest cost– although there is little guidance given on how to deal with the practical problems arising. The ongoing UK consultation also envisages an entity level exemption for banking and insurance entities but does not explicitly address the question of this kind of supplementary exemption.
Another lacuna in the UK consultation was the question of how the group ratio rule should be applied if an exemption is given to banking and insurance entities. The OECD, in keeping with the rest of the discussion draft, holds back from giving any firm recommendation on this, but does offer a range of options, including:
Responses to the discussion draft have been requested by 8 September.