On 28 July 2016 the OECD issued a discussion draft outlining approaches to combating base erosion and profit shifting (BEPS) involving interest in the banking and insurance sectors. This is part of further work following the final report on BEPS action 4 on limiting base erosion involving interest deductions and other financial payments.

That final report issued in September 2015 outlined an approach to dealing with BEPS involving interest and payments economically equivalent to interest. This used a fixed ratio rule to limit net interest deductions to a percentage of earnings before interest, tax, depreciation and amortization and a group ratio rule permitting a higher net interest deduction depending on a relevant financial ratio of the worldwide group.

The report suggested that a different approach would be required in the case of entities in the banking and insurance sectors owing to various factors relevant to these industries. Banks and insurance companies generally have net interest income rather than net interest expense. Interest plays a different role in these sectors and banking and insurance groups are subject to regulatory capital requirements that limit their ability to place debt in certain entities.

As a result of these differences the final report on action 4 allowed countries to exclude from the fixed ratio and group ratio rules all entities in banking and insurance groups and regulated banks and insurance companies in non-financial groups. The final report provided for further work to be conducted to identify suitable approaches to addressing BEPS in the banking and insurance sectors, taking into account the characteristics of these industries.

The use of deposits and short-term debt to make loans is the core business of most banks. Profit arises from the difference in interest rates on the money loaned as compared to interest rate paid on deposits. The interest is therefore an important source of profitability and can be compared to sales revenue and cost of sales in other industries. A bank would normally be highly leveraged with interest as the most significant expense item. There will generally be net interest income, depending on the mix of banking and non-banking activities.

Insurance companies invest premiums in income-producing assets such as long-term debt instruments to generate income to pay claims. Generation of interest income is an important part of the insurance company’s business. As most investments are funded by premiums rather than by debt the insurance companies generally have very low levels of leverage compared to banks. Owing to the income from investments they are generally net interest income recipients.

The latest discussion draft does not alter the conclusions of the final report on BEPS action 4 but looks in more detail at the BEPS risks in banks and insurance companies and the risks posed by entities in a group with a bank or insurance company, including holding companies, group services companies and companies carrying on non-regulated financial or non-financial activities.

A limited BEPS risk has been identified for banks and insurance companies and the discussion draft looks at why this may be the case. Regulatory capital rules require minimum amounts of equity to be held and also limit the level of leverage in a solo-regulated entity. The draft considers the protection provided by regulatory capital rules and the limits to this protection as they vary from country to country. Rather than putting forward a single approach to these risks the discussion draft suggests that countries should introduce rules that address the particular BEPS risks they are facing.

In the case of other entities that are part of a banking or insurance group the draft considers that there is a greater BEPS risk and therefore recommends that countries should consider applying the fixed ratio and group ratio rules to them, subject to certain modifications in some cases. Each country could take into account particular features of its own legal system.

Comments on the discussion draft are invited from interested parties and should be sent in by 8 September 2016.