Deducing BEPS Action 4: Interest deductions and other financial payments

Entities within scope: The recommended approach should apply to all entities in a multinational group

While we should compliment those at the OECD generally on the work they have put into the BEPS project, it is interesting to note that the project has not sought to suggest a more harmonised international definition of 'debt' or 'equity' for tax purposes. While this would be a complicated exercise, it is in one sense the purest way – from a legislative perspective – to ensure that interest or similar amounts cannot be used to erode the tax base of one jurisdiction without taxable or other appropriate recognition in another. It could also, for example, provide a better solution to some of the issues outlined in Action 2 (Hybrid Mismatch Arrangements). It is also worth remembering that double non-taxation is not always a result of the deliberate exploitation of tax asymmetries. In other words, sometimes that is what is supposed to happen.

Assuming the OECD's final position is that any possible solution to the debt/equity conundrum could not be implemented on an international basis, it is essential that any proposals to limit base erosion through the use of arrangements which pay interest or equivalent amounts are proportionate to the perceived mischief that they are intended to address.

A number of jurisdictions already have legislation to deal with deductibility of interest (and similar) payments. As noted in the public discussion draft of December 2014, some of these are based on accounting rules or other methods of recognition or calculation and in all cases there will be statute or case law which outlines what is interest and thereby creates a legal basis for what amounts could potentially be deductible. Most of the other rules (primarily anti-avoidance provisions) will seek to limit deductibility based on specific circumstances (for example, insolvency, hybrid debt) or based on perceived motives of the taxpayer.

However, if the effect of any recommendations from Action 4 is that taxpayers are subject to further rules which do not complement or indeed clarify existing domestic and cross-border rules relating to interest deductibility, then the process will not represent progress on the current position (and any further complexity would likely create further opportunity for tax arbitrage, which clearly the OECD wishes to avoid).

On October 5 2015, the OECD Secretariat published 13 papers and an Explanatory Statement outlining consensus actions under the BEPS project. The outputs of each of the BEPS Actions are intended to create a coordinated approach to the taxation of international transactions and arrangements. These can include domestic law recommendations and international principles under the OECD model tax treaty and transfer pricing guidelines and are broadly classified as either 'minimum standard', 'best practice' or 'recommendations' for adoption. With various work streams still ongoing, the OECD has published a final report on Action 4 which sets out a best practice approach for countries. Interestingly, it does not deal with transfer pricing aspects of financial transactions, which remains an ongoing work stream.

While a detailed outline of the content of the Action 4 final report is beyond the scope of this article, taxpayers should, as a 'minimum standard' – to use an OECD output term – be aware of the following summary proposals:

The recommended approach is based on a fixed ratio rule (FRR) limiting an entity's net interest deductions to a percentage of its EBITDA, to ensure that net interest deductions are directly linked to the taxable income generated by economic activities and encourage groups to adopt funding structures whereby the net interest expense of an entity is linked to the overall net interest expense of the group.

The report also considers earnings-based and asset-based measures and concludes that an earnings-based rule is most appropriate for a FRR. EBITDA is preferred but EBIT could be used if other elements of the rule are consistent with the report's recommendations. Both EBITDA and EBIT should exclude non-taxable income (for example, branch profits or exempt dividend income, adjusted to the extent these would be taxable but for the availability of foreign tax credits).

The report recommends selecting a percentage in the 10%-30% range (or possibly more than one percentage, depending on the size of the entity's group (based on group consolidated revenue or group assets)) after taking into account a number of factors, including: (i) whether the FRR will be applied in isolation or in combination with a group ratio rule (see further below); (ii) whether the FRR will permit the carry-forward of unused interest capacity or the carry-back of disallowed interest expense; (iii) whether other targeted rules will apply to specifically address the BEPS risks targeted by Action 4; and (iv) whether the country has high interest rates compared with other countries. The recommended percentage range may be revised following an initial review of the best practice, to be completed by the end of 2020.

The report recommends supplementing the FRR with a group ratio rule (GRR) allowing the FRR limit to be exceeded, as certain groups are highly leveraged for non-tax reasons; however, a GRR is considered optional and, if a country chooses to adopt one, it need not take the suggested form (although it should compare a relevant financial ratio to that of the wider group). Use of a GRR should enable the FRR percentage to be kept low.

The suggested form of GRR would allow an entity with net interest expense above a country's fixed ratio to deduct interest up to the level of the net third-party interest/EBITDA ratio of its worldwide group and would also allow an uplift of up to 10% to the group's net third-party interest expense. Special provisions are suggested to address issues arising from loss-making entities/groups, as are targeted rules to prevent exploitation of the GRR via payments to related parties. Where a GRR is used, only net interest expense which takes an entity's net interest/EBITDA ratio above the higher of the fixed ratio and the group ratio would be disallowed.

The recommended approach also permits supplementary measures to reduce the impact of the FRR and/or GRR where the risk of BEPS is lower. Such measures might include: (i) a de minimis threshold carving out entities with a low level of net interest expense (ideally based on net interest expense of the local group); (ii) an exclusion for interest paid to third-party lenders on loans used to fund public benefit projects; and (iii) the carry-forward of disallowed interest expense and/or unused interest capacity. The report also recommends using targeted anti-avoidance rules (including anti-fragmentation rules where any rule is to be applied on an individual entity basis). The recommended approach does not include a fixed debt-to-equity ratio or an arm's-length test but acknowledges that these can play a role within an overall tax policy to limit interest deductions.

The report suggests that the recommended approach should apply to all entities in a multinational group (that is, a group operating in multiple jurisdictions, including through a permanent establishment), although countries may also apply this to domestic groups and/or standalone entities. An entity will be part of a group if it is directly or indirectly controlled by a company or controls one or more other entities. Where a GRR is used, an alternative approach is to assess whether an entity is included on a line-by-line basis in the consolidated financial statements of any company (or would be if such statements were prepared in accordance with accounting standards accepted in the relevant jurisdiction). The Action 4 final report suggests that jurisdictions impose thresholds to exclude "low risk entities" from the scope of the ratio rules.

Where a group has multiple entities in a country, that country may apply the rules on a per-entity basis or to the overall position of the local group.

The rules should apply to all forms of interest and payments equivalent to interest, to ensure that they cannot be bypassed by structuring financing in a different legal form. Payments economically equivalent to interest should be identified based on economic substance but will include payments linked to financing which are determined by applying a fixed or variable percentage to an actual or notional principal over time. The rules should also apply to other financing expenses, for example, arrangement or guarantee fees.

The report suggests optional measures to address volatility and indicates that averaging of EBITDA across, say, a three year period, could be used (although this could be difficult for GRR purposes if the group structure has changed). If adopted, averaging should apply to all entities in a local group to prevent arbitrage.

The preferred approach to address volatility, however, is to allow the carry-forward and/or carry-back of disallowed interest and unused interest capacity, enabling an entity's net interest deductions to be linked to its level of earnings over time (for example, enabling interest expense on long-term investments to be claimed when they eventually become profitable). This would not apply to interest expense disallowed under targeted anti-avoidance rules and countries may also consider imposing time and/or value limits (by reducing the value of carry-forwards over time, having a monetary or percentage cap, resetting carry-forwards to zero on, for example, change of ownership and economic activity, among others).

Further work is to be conducted on certain issues, including the operation of the GRR (encompassing the impact of losses, too) and specific rules to address BEPS risks in the banking and insurance sectors (since entities in these sectors typically receive net interest income and interest income is sufficiently significant that EBITDA may not be a suitable measure of activity) and special rules for certain infrastructure arrangements. This work is expected to be completed during 2016.

The OECD has stated that interest restrictions should be 'best practice', which means that Action 4 is unlikely to be adopted by all countries participating in the BEPS project (and indeed beyond that). This is further compounded by the fact that there are various options offered to countries implementing Action 4. Therefore, it will be interesting to watch the domestic reactions to this, particularly with countries which already have similar rules or, like the UK, a wealth of existing anti-avoidance legislation in the debt area. It should also be noted that implementation within the EU may need to be considered in the light of EU treaty obligations, and the likely complexity means that jurisdictions would be well-advised to allow appropriate transition periods.

As noted above, transfer pricing rules for financial transactions will be developed in due course. It also important to note that any restrictions under hybrid mismatch arrangements (Action 2) are intended to apply in priority to Action 4. To a certain extent, this is also true of the recognition of income under CFC rules (Action 3), although this is less clear given that CFC income may be included in EBITDA. These points of interaction should be monitored carefully, as should the further work on specific sectors like infrastructure and financial services. One gets the feeling that there is a long way to go before we have any certainty, especially when you consider that 'best practice' will be subject to an initial review in 2020. It should also be noted that on October 22 2015, HMRC published a consultation on the UK implementation of the Action 4 final report and this seeks input on various matters, including which of the available policy choices the UK should follow.