On December 22, 2016 the OECD released an update of its Report on BEPS Action 4 - Limiting Base Erosion Involving Interest Deductions and Other Financial Payments of which the first edition was released on October 5, 2016. The updated version which was released on December 22, 2016 includes further guidance on two areas:
· the design and operation of the group ratio rule; and
· approaches to deal with risks posed by the banking and insurance sectors.
Further guidance on the design and operation of the group ratio rule
The further guidance on the design and operation of the group ratio rule can be found in Part II of the updated version of the report “Elements of the design and operation of the group ratio rule”, which starts on Page 117.
Part II of the updated report contains the outcomes of further work on specific elements of the group ratio rule, conducted following the release of the 2015 Report and completed in 2016. According to the OECD this does not change anything recommended in Part I, but includes additional detail to assist countries in implementing the rule. Part II focuses on three topics:
· the calculation of net third party interest expense
· the calculation of group EBITDA
· approaches to deal with the impact of entities with negative EBITDA on the operation of the rule.
If a country introduces a group ratio rule, the tax authority in that country is responsible for administering the rule in accordance with its country’s tax rules, including auditing the application of the rule by entities in the country. Where the tax authority reaches a conclusion as to the outcome of the rule in that country for a particular entity, this should not in any way impact the operation of group ratio rules in other countries where entities in the same group are located.
Part II considers specific elements of the design and operation of the group ratio rule described in Chapter 7. It does not change anything specifically recommended in Part I and does not deal with any other elements of the common approach. As specified in Chapter 11, the design and content of the common approach will be reviewed by countries involved in the BEPS Project by no later than the end of 2020, which will include consideration of the experience of countries, the impact on the behaviour of groups and any additional available data.
In Part II of the updated report a.o. the following topics are being discussed:
· Calculating net third party interest expense
o Approach 1 (the use unadjusted figures from the face of a group’s consolidated income statement)
o Approach 2 (The use of the interest income and expense figures in a group’s consolidated income statement as the starting point for calculating net third party interest expense. However, unlike under Approach 1, these figures are then adjusted to include or exclude items in accordance with whether they fall within the definition of interest and payments economically equivalent to interest in Chapter 2)
o Approach 3 (Approach 3 to calculating a group’s net third party interest expense is a variant on Approach 2 and so should give the same result. However, rather than making adjustments to the interest figures in a group’s consolidated financial statements, Approach 3 requires an entity to identify all of the group’s items of income or expense which fall within the definition of interest and payments economically equivalent to interest in Chapter 2, and then measure these items based on how they are treated in the consolidated financial statements for the group)
o Comparison of the three approaches
o Adjustments to a group’s net third party interest expense
· Calculating group EBITDA
o Items to be included in the adjustment for interest income and expense
o Items to be included in the adjustment for depreciation and amortisation
o The treatment of dividend income and a group’s share of the earnings of an associate or JVE
o The treatment of fair value gains and losses
o The treatment of non-recurring items
· Addressing the impact of entities with negative EBITDA on the operation of the group ratio rule
o The treatment of entities where a group has positive group EBITDA
o The treatment of entities where a group has zero or negative group EBITDA
Further guidance on approaches to deal with risks posed by the banking and insurance sectors
The further guidance on approaches to deal with risks posed by the banking and insurance sectors can be found in Part III of the updated version of the report “Approaches to address BEPS involving interest in the banking and insurance sectors”, which starts on Page 169.
According to the OECD, the common approach contained in the Part I is suitable for addressing BEPS involving interest in the majority of groups. However, there are a number of factors identified in Chapter 10 which mean that a different approach may be appropriate when dealing with entities in the banking and insurance sectors.
· Banks and insurance companies rely on interest income to ensure their profitability and liquidity and for banks interest is also usually the biggest single item of operating expense.
· Banking and insurance groups are subject to strict regulatory capital rules which limit their ability to place excessive levels of debt in certain entities.
· Banks and insurance companies are key providers of debt finance, either as lenders or investors in corporate bonds, and so typically have net interest income rather than net interest expense.
In light of this, Chapter 10 concludes that, while countries should have an approach to deal with BEPS involving interest where it arises, a country may exclude entities in banking and insurance groups, and regulated banks and insurance companies in non-financial groups, from the scope of the fixed ratio rule and group ratio rule. Chapter 10 also highlights that further work would be conducted, to be completed in 2016, to identify appropriate approaches to address BEPS risks in these entities, taking into account the risks posed, the role interest plays in banking and insurance businesses, and restrictions already imposed by capital regulation. In particular it was noted that any approaches adopted should not conflict with or reduce the effectiveness of regulatory capital rules intended to reduce the risk of a future financial crisis. Part III contains the outcomes of this further work, which focused on the BEPS risks involving interest that countries see posed by banking and insurance groups and how these risks may be addressed.
In Part III of the updated report a.o. the following topics are being discussed:
· BEPS risks involving interest posed by entities in the banking and insurance sectors
o The interest profile of banking and insurance groups
o The impact of regulatory capital rules on leverage in a bank or insurance company for tax purposes
o The impact of regulatory capital rules on the ability of banks and insurance companies to use interest to fund non-taxable income
o The impact of regulatory capital rules on entities in a group with a bank or insurance company
· Approaches to address BEPS involving interest in the banking and insurance sectors
o Risks areas identified during the work on Action 4
o General interest limitation rules
o Rules to address the use of interest to fund non-taxable income
o Targeted rules to address specific risks
o Transitional rules
Annex III to the update report contains a.o.:
· An overview of capital regulation in the banking and insurance sectors
· Selected rules applied by countries to address BEPS involving interest in the banking and insurance sectors
Click here to be forwarded to the website of the OECD from which one can download the 2016 update of the OECD Report on BEPS Action 4.
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