Out-Law Analysis | 22 Jan 2016 | 10:03 am | 5 min. read
Infrastructure projects are capital intensive and often have a high level of 'gearing', meaning that debt levels tend to be relatively high in comparison to the project's equity capital. Deals are usually priced on the basis that deductions will be available for interest expenses.
Now, the Organisation for Economic Cooperation and Development (OECD) has recommended limiting the tax deductions available to companies for interest payments, as part of its ongoing reform of the international tax rules aimed at preventing so-called base erosion and profit shifting (BEPS). This is intended to address its concern that multinational corporate groups can use interest payments to reduce their taxable profits in companies in high tax jurisdictions, even in cases where the group as a whole has little or no external debt.
Despite the potential damage to the competitiveness of the UK tax system, the UK government has indicated that it proposes to introduce the proposed restrictions and has issued a consultation document seeking views on how the OECD recommendations should be implemented in the UK.
Until the UK finalises its approach, developers and project sponsors face a period of uncertainty as to what their impact will be on project cash flows. Those entering into new projects and those with existing projects will need to factor in the impact the possible changes may have. In particular, companies will want to stress test their cash flow projections, and may want to seek flexibility in their banking covenants so that any potential impact of the new rules can be mitigated.
Interest deductions and infrastructure finance
In a typical major infrastructure project, the financing costs are treated as part of the cost of earning the profits which makes them, broadly speaking, deductible for tax purposes. So if the book profit is, say, 20, after charging interest costs of 80 the taxable profit would be 20 as well - not 100. If the tax rules change, so that the taxable profit becomes, say, 70, there will be an extra tax bill which was almost certainly not part of the project's expected cash flow forecasts.
In comparison with some other countries, the UK currently has a generous regime for providing tax deductions for interest expenses. There are anti-avoidance provisions, but these are mainly aimed at payments to connected parties. Interest deductions can usually be obtained relatively easily for highly geared transactions on arm's length terms with third party lenders.
Put simply, reduced tax deductions mean higher tax liabilities - with a resulting impact on the cash flows for the project and the level of returns for investors. In extreme cases, the proposals could even affect the viability of some projects. There is a particular risk that any unexpected tax costs could cause lending covenants to be breached, with potentially serious consequences.
What has the OECD proposed?
The OECD is recommending that interest deductions should not be permitted to the extent that net interest exceeds a percentage of earnings before interest, taxes, depreciation and amortisation (EBITDA). In implementing the proposals, individual countries would be free to select a percentage between 10% and 30%, with an optional relaxation if the overall external leverage of the group is higher. These new rules would apply even if there was no tax avoidance motive, any lending was purely on arm's length terms and even if the transactions and parties were based in the same jurisdiction.
The OECD's concern is that countries have been losing out on tax receipts due to excessive interest costs – the 'base erosion' part of the BEPS project. Excessive intra-group interest deductions can be used by multinational groups to reduce taxable profits in group companies based in high tax jurisdictions, even in cases where the group as a whole has little or no external debt. The OECD is also concerned that groups can use debt finance to produce tax exempt or deferred income; thereby claiming a deduction for interest expenses in one company while the related income is brought into tax in another – which is usually located in another jurisdiction – either later, or not at all.
The OECD recommendations allow countries to include in their rules a public benefit exemption from the general fixed ratio restrictions, subject to detailed recommended conditions. These include that a public sector body or public benefit entity has obliged the operator to provide goods or services in which there is a general public benefit; and that the loans were obtained from third parties on non-recourse terms. In this scenario, the lender would only have security over the assets or income streams of the project, with no guarantees from other group companies.
What should the UK do?
Although the OECD proposals on interest deductions are expressed as merely recommendations, the UK government has been a strong and vocal supporter of the BEPS project. A consultation document, issued in October, indicated that the government was intending to implement the recommendations and asked for views on the best way to do this. The consultation period closed on 14 January 2016 and the Pinsent Masons response to the consultation included our concerns about the impact of the proposals on the infrastructure sector.
For the infrastructure sector, the design of any public benefit exemption in UK law is key. It seems relatively clear that many PFI projects could fall within this exemption - and the Treasury clearly has a vested interest in ensuring these projects remain viable and therefore do not effectively come back onto the government's books. However, the OECD's recommended exemption is narrow, and would only apply to interest on third party debt. The use of shareholder debt is common in many UK projects and could face interest restrictions.
It is not at all clear that infrastructure projects generally would fall within the exemption envisaged by the OECD. Even where such projects are highly-leveraged, we consider that they do not necessarily present a risk to the UK tax base. Given the Government's initiatives in relation to developing UK housing stock and urban regeneration, we consider that the public benefit exclusion should also be capable of being applied to regeneration projects (including entities jointly owned by the public and private sectors) and to housing including student accommodation. If the price of such projects goes up due to tax changes, it will be even more difficult to deliver the infrastructure projects set out in the National Infrastructure Plan.
We hope that the UK government will ensure that the public benefit exemption is wide enough to ensure that investment in commercial infrastructure and energy projects and real estate regeneration projects is not harmed. In our opinion the UK public benefit exclusion should therefore comply with the underlying purpose of the BEPS project rather than necessarily reflecting the detailed recommendations set out in the OECD's report.
The OECD recommended the introduction of suitable transitional rules, especially for 'grandfathered' third party debt, so that existing debt would not be affected by the new restrictions. This is particularly important for infrastructure projects, which often have a total life of 10 years or more We consider that the implementation of suitable grandfathering should be an essential feature of any new rule limiting interest deductions in the UK, and we expressed concern that in the consultation the government suggested that grandfathering should only be available in "exceptional circumstances".
We can expect to hear more about the Treasury's concrete proposals in the Chancellor's Budget on 16 March 2016, although it is unlikely that any changes would take effect before April 2017 at the earliest. But the proposals could affect projects which are already underway, so companies need to start understanding and planning for the new rules now.