12 February 2016

The future of interest deductibility in Europe

As we reported in Private Equity Comment last year, proposals issued by the Organisation for Economic Co-operation and Development (OECD) could lead to restrictions on the deductibility of interest payments by private equity portfolio companies, and may cause particular concerns for highly geared sectors such as infrastructure and real estate.

The OECD's final report, published last October, included rules to prevent multi-national organisations from financing entities located in high tax jurisdictions with high interest loans from group entities based in low tax jurisdictions. Loans with excessive interest reduce a group's overall tax burden if the interest payments can be deducted from profits, and the OECD therefore recommended that governments should limit an entity's net interest deductions to a fixed ratio (of between 10% and 30%) of its EBITDA. It also envisaged that an entity would be permitted to deduct net interest expenses up to a 'group ratio' (the level of the net interest / EBITDA ratio of its worldwide group) where that was higher than the fixed ratio. The OECD suggested that there should only be limited transitional 'grandfathering' provisions, so their proposals could affect existing investments, and recommended a limited 'public benefit' exemption for certain public interest projects.

In January 2016 the European Commission responded to the OECD proposals with a draft Anti Tax Avoidance Directive, which proposed, as a minimum, that borrowing costs would be deductible up to the higher of 30% of EBITDA or €1m. In the event that these rules are adopted, EU member states would be obliged to implement the Commission's Directive, though they would be able to choose a threshold lower (and therefore more restrictive) than 30%.

Rules restricting interest deductibility have already been implemented in Germany, France and Italy. On Wednesday this week the German Federal Tax Court (Bundesfinanzhof) issued a decision in which it questions the German rule, and the German Federal Constitutional Court (Bundesverfassungsgericht) must now decide whether constitutional law has been breached – the outcome of this decision may influence the approach of other European policymakers.

The UK, meanwhile, has been consulting on its own implementation of the OECD report, and it is anticipated that concrete proposals will be published at the time of the UK Budget on 16 March. Last month, the BVCA made representations to the UK government listing its concerns about the potentially adverse effect of the new rules.

The BVCA suggested that 'transfer pricing' rules are the most sensible method of determining interest deductibility, as this approach takes account of the borrowing capacity of a business, rather than using an arbitrary fixed ratio. They also expressed concern that limiting interest deductibility could significantly affect business cash flows and forecasts (particularly where deductions relate to third-party debt or have been agreed in advance with the tax authority), potentially causing breaches of financial covenants under banking documents and a concomitant decrease in UK investment. This means that the length of any grandfathering provisions will be of paramount importance to the private equity industry (the BVCA suggests that the implementation of any rule is deferred until April 2018, and that grandfathering lasts for two to three years). The BVCA also argued that the UK's fixed ratio should be set at 30% (in keeping with other European jurisdictions such as Germany) and should be reviewed as the global economic environment changes and interest rates increase.

Very importantly, the BVCA stressed in its response that a fund's portfolio companies should not be considered as part of the same group for the purposes of a fixed or group ratio rule, as portfolio companies operate in separate sectors, are often financed on an independent basis, and will likely be at different stages of development, so that determining a single company's interest costs by reference to the economic performance of the whole fund would be arbitrary and administratively unworkable. Furthermore, as this initiative was originally focused on multi-national organisations, a threshold should be introduced to minimise compliance costs for small companies, and the BVCA suggests that all groups should be able to deduct up to £2m (€2.6m) of net UK interest expenses.

Some of the BVCA's suggestions accord with the OECD's conclusions and so it seems quite likely that they will be reflected in the UK Government's proposals in March, and perhaps also in the proposals expected to be issued by other European national governments. However, those European private equity portfolio companies who are not yet subject to restrictions on interest deductions are likely to have to deal with them soon.

A Guide to Doing Business in China

We explore the key issues being considered by clients looking to unlock investment opportunities in the People’s Republic of China.

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