Government is considering interest deduction restrictions for infrastructure

In a report on 'tackling aggressive tax planning in the global economy' published in March 2014, the UK government set out its priorities for the Organisation for Economic Cooperation and Development (OECD) project for counteracting base erosion and profit shifting (BEPS). This report flagged that changes to the UK's rules on interest deductibility may be required, but that the impact of any changes on the infrastructure and financial services sectors would need to be considered.

BEPS refers to the shifting of profits of multinational groups to low tax jurisdictions and the exploitation of mismatches between different tax systems so that little or no tax is paid.  Following international recognition that the international tax system needs to be reformed to prevent BEPS, the G20 asked the OECD to recommend possible solutions.

In July 2013, the OECD published a 15 point Action Plan and the first formal proposals dealing with seven of the 15 specific actions were published in September 2014.

Action Point 4 of the OECD's action plan is limiting base erosion through interest deductions. The OECD plans to issue a discussion document on this action in mid-December 2014 and it is due to make formal recommendations in September 2015.

The integrated global financial system means that debt finance can be relatively easily raised and moved across tax jurisdictions by a group to facilitate the shifting of profits to low or no tax jurisdictions. The UK tax code includes anti avoidance provisions designed to prevent the exploitation of interest deductions. These include an unallowable purpose rule which prevents tax deductions where a company is party to a loan with a main purpose of tax avoidance. A thin capitalisation rule also applies to restrict deductions where a company has more debt than it either could borrow on an arm’s length basis.

Many countries have also introduced ‘structural’ interest restriction rules that apply to all borrowings on a company or group basis, rather than by reference to particular debt transactions. The UK tax system includes a limited structural interest restriction called the worldwide debt cap which ensures that the interest relief claimed in the UK does not exceed the amount attributable to the group’s total worldwide external debt.

The OECD is exploring the introduction of structural interest restrictions and will make recommendations on best practice for states to introduce domestic rules on interest restrictions to limit base erosion from interest payments. It is understood that the OECD BEPS working group on possible restrictions on interest is considering a limitation on interest relief for infrastructure projects on a fixed financial ratio, such as a fixed percentage of EBITDA or a model, similar to the UK's worldwide debt cap, based on allocating interest payments across the group.

Corporate tax expert Eloise Walker of Pinsent Masons, the law firm behind Out-law.com, said that any structural restrictions on interest deductibility could have a "particularly detrimental effect" for infrastructure projects which tend to be very highly geared, and many of which already suffer tax at much higher rates than the standard 21%, "thanks to the current lack of any proper infrastructure allowances for such capital assets in the UK".

HMRC's March 2014 report recognises that most major infrastructure projects are financed and delivered through special purpose vehicles (SPVs), which have a very high level of debt relative to equity. It states that it is "standard international commercial practice" for most projects are financed by around 80-90% senior debt. It says that "the characteristics of infrastructure projects are such that their financing may be sensitive to changes in the tax treatment of financing costs, in part because of the very long term nature of the projects."

Eloise Walker said that "given the OECD is not due to make recommendations until September 2015, any changes to UK law are unlikely to be imminent. However this is a good opportunity for those in the industry to make the government aware of the problems interest relief restrictions could cause for infrastructure projects".