BEPS Action Plan 4: Limiting base erosion arising from interest deductions
Debt planning and restructuring is a common mechanism to minimize taxable income by increasing deductions among different entities in a multinational group of companies. As interest on debt is generally a deductible expense of the payor and taxed in the hands of the payee, groups may create intercompany loans to place high levels of debt in high-tax countries, generate interest deductions in excess of actual third party interest rates, or fund the generation of tax-exempt income.
The Organisation for Economic Co-operation and Development’s (OECD’s) final report on Action Plan 4 recommends best practices to address base erosion and profit shifting (BEPS) using interest payments and payments that are economically equivalent to interest.
The report first suggests to remove from the scope of the interest limitation rule those entities which pose the lowest risk of BEPS, applying a de minimis monetary threshold of net interest expense.
The next recommendation is to apply a “fixed ratio rule,” which will limit net interest deductions claimed to a fixed percentage of earnings before interest, taxes, depreciation, and amortization (EBITDA). This recognizes that an entity should be able to deduct interest expense up to a specified proportion of EBITDA while ensuring that a portion of an entity’s profit remains subject to tax. Based on previous studies, the report recommends that different jurisdictions set their benchmark fixed ratio within a best practice range or “corridor” between 10%-30%. This corridor aims to provide a reasonable cap on net interest expense while still allowing most companies to deduct third party interest expense. A fixed ratio rule, however, does not consider the fact that groups may be leveraged differently. If a fixed ratio rule is introduced in isolation, entities that are simply more highly leveraged (or with significantly more debt than equity) will be unable to deduct all of their net third party interest expense.
To supplement the fixed ratio rule, the report recommends that countries adopt a “group ratio rule,” which will allow an entity that exceeded the adopted fixed ratio to deduct interest expense up to the net third party interest/EBITDA ratio of its group, if this group ratio is higher. In computing a group’s net third party interest expense/EBITDA ratio, a country may apply an uplift of 10% to the group’s net third party interest expense, reducing the risk that all of the group’s actual net third party interest expense is not taken into account.
In reality, however, an entity’s interest expense and earnings may arise in different periods. Examples are when an entity’s ability to deduct interest changes from year to year due to market conditions, or when an entity has incurred interest expense to fund an investment which will give rise to earnings at a later date. In this case, exclusively applying a fixed ratio rule and a group rule may result in either a permanent disallowance of interest expense, or unused interest capacity. This could create uncertainty, possibly render long-term tax planning difficult, and may be viewed negatively by both tax authorities and taxpayers.
To address these risks, the report recommends allowing disallowed interest expense and unused interest capacity to be utilized in other periods by way of carryforward or carryback provisions. This will support a policy that net interest deductions should be linked to the level of earnings over time. The report provides further recommendations on the limits within which the carryforward or carryback provisions may be exercised.
The rules described so far are general interest limitation rules which impose an overall limit on an entity’s interest deductions. The report suggests that countries also consider providing targeted rules that will restrict interest deductions in specific transactions or arrangements. For instance, a targeted rule may cover a situation where an entity with net interest expense enters into an arrangement to reduce the net interest expense subject to the fixed ratio rule by converting such interest expense into a different form of deductible expense.
Enacting and implementing targeted rules will entail more effort on the part of tax authorities, as this will require authorities to identify the most common BEPS schemes in their jurisdictions. The efficacy of having targeted rules will also depend on a tax authority’s ability to discern when a transaction is being entered into to avoid the general interest limitation rules. Nevertheless, adopting such targeted rules may prove to be the most equitable manner of imposing restrictions on interest deductions.
The report acknowledges that the prescribed recommendations may not be applicable to entities in the banking and insurance sectors. These entities are net lenders by a significant margin and will often have net interest income than net interest expense. While these entities should not be exempted from the best practice approach to tackling BEPS involving interest, recommendations specific to them will still have to be made, with the work hopefully completed by 2016.
These recommendations will initially be reviewed by countries involved in the BEPS project no later than the end of 2020. This review will take into consideration the experiences of jurisdictions which have adopted the suggested best practices, as well as the behavior of multinational groups.
While Section 34 (B) of the National Internal Revenue Code and its implementing issuances currently provide for a limitation on interest expense deductibility both as to amount and source, this rule was enacted to apply to all companies, and not necessarily to combat BEPS. In the meantime, as there is yet no new law adopting the recommendations above, it is important for companies to keep in mind the observations and recommendations regarding interest expense deductibility when planning intercompany transactions.