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Interest deductions: the new war on base erosion

The G20 and OECD's Base Erosion and Profit Shifting (BEPS) project has rarely been out of the headlines during 2014. At the heart of the BEPS project is the assumption international tax rules make it possible for profits to be taxed in countries that are different from where the underlying economic activity takes place.

The debate has focused on intangibles, the new guidance on transfer pricing documentation, hybrid mismatch arrangements and the digital economy. Those discussions have, perhaps for the first time, reached a broad audience of stakeholders as demonstrated by the detailed responses made to the OECD by international tax practitioners, business representative groups, civil society organisations, trade unions, academics and individual businesses.

Some of the 2014 actions will now be addressed in 2015 and as the end of the year approaches, there is an increasing focus on the BEPS actions for 2015.

This article looks at what is to come for BEPS in 2015 and in particular looks at Action 4 (Limit base erosion via interest deductions and other financial payments), which could be every bit as ambitious and challenging as the 2014 actions have proved to be.

BEPS in 2015

Given the length of time that BEPS has been in progress it is sometimes hard to remember how much there is still to do. Table 1 below summarises the expected actions and outputs from the BEPS project in 2015. In total, eight of the 15 actions will have their first outputs to be delivered in 2015. In addition, Action 5 (harmful tax practices) has to complete the work it started in 2014, Action 8 (intangibles) has to deliver changes to the Transfer Pricing Guidelines and Action 15 has to develop a multilateral instrument in 2015.

Table 1 – Summary of 2015 BEPS actions

ActionDescriptionExpected Output2015 Deadline
3 – Strengthen CFC RulesDevelop recommendations regarding the design of controlled foreign company rules. Recommendations regarding the design of domestic rulesSeptember 15
4 – Limit base erosion via interest deductions and other financial paymentsDevelop recommendations regarding best practices in the design of rules to prevent base erosion through the use of interest expense. Recommendations regarding the design of domestic rules

Changes to the Transfer Pricing Guidelines
September 2015

December 2015
7 – Prevent the artificial avoidance of PE statusDevelop changes to the definition of PE to prevent the artificial avoidance of PE status in relation to BEPS, including through the use of commissionaire arrangements and the specific activity exemptions.Changes to the Model Tax ConventionSeptember 15
9 – Assure that transfer pricing outcomes are in line with value creation: risks and capitalDevelop rules to prevent BEPS by transferring risks among, or allocating excessive capital to, group members. This will involve adopting transfer pricing rules or special measures to ensure that inappropriate returns will not accrue to an entity solely because it has contractually assumed risks or has provided capital. Changes to the Transfer Pricing Guidelines and possibly to the Model Tax ConventionSeptember 15
10 – Assure that transfer pricing outcomes are in line with value creation: other high-risk transactionsDevelop rules to prevent BEPS by engaging in transactions which would not, or would only very rarely, occur between third parties.Changes to the Transfer Pricing Guidelines and possibly to the Model Tax ConventionSeptember 15
11 – Establish methodologies to collect and analyse data on BEPS and the actions to addressDevelop recommendations regarding indicators of the scale and economic impact of BEPS and ensure that tools are available to monitor and evaluate the effectiveness and economic impact of the actions taken to address BEPS on an ongoing basis. Recommendations regarding data to be collected and methodologies to analyse themSeptember 15
12 – Require taxpayers to disclose their aggressive tax planning arrangementsDevelop recommendations regarding the design of mandatory disclosure rules for aggressive or abusive transactions, arrangements, or structures, taking into consideration the administrative costs for tax administrations and businesses and drawing on experiences of the increasing number of countries that have such rules. Recommendations regarding the design of domestic rulesSeptember 15
14 – Make dispute resolution mechanisms more effectiveDevelop solutions to address obstacles that prevent countries from solving treaty related disputes under MAP.Changes to the Model Tax ConventionSeptember 15
Source: Action Plan on Base Erosion and Profit Shifting OECD 2013

Limit base erosion via interest deductions (Action 4)

Amid all the actions to be undertaken in 2015, one stands out for us – Action 4, which focuses on limiting base erosion via interest deductions and similar deductible payments (for example, financial and performance guarantees, derivatives and payments to captive insurers and other insurance arrangements).

The global nature of financial systems means that debt finance is easily raised and moved around international groups in a way that people and physical assets cannot be. According to the BEPS action plan, that creates an opportunity for base erosion and the UK government appears to agree. For example, HM Treasury and HM Revenue and Customs noted in March 2014, that "the UK looks forward to the output from the BEPS work on limiting the use of interest deductibility as a means for shifting profits, especially the identification of best practice". In short, there is a perception by many tax authorities that excessive debt finance has been used to gear up businesses with the sole intention of claiming interest deductions in higher tax countries.

As an aside, it is interesting to note that part of the BEPS Action 3 (strengthen CFC rules) remit, is to prevent over-capitalisation of companies (particularly in low-tax territories) to avoid the excessive allocation of profits to those businesses. Just like the temperature of the porridge in the story of Goldilocks and the Three Bears, a group's capitalisation policy has to be 'just right'.

Rules to limit interest deductions already in place

Excessive debt gearing (often referred to as thin capitalisation) is not a new area of tax authority focus. Many countries already have rules to counteract such outcomes, either through structural limitations (such as those provided through earning-stripping rules or safe harbour ratios) or regulations that seek to allocate interest deductions in line with the paying company's contribution to the group's business or external debt profile. Other countries rely on existing transfer pricing rules to require taxpayers to apply the arm's-length standard to all inter-company transactions, including interest. In some countries, such as the UK, a combination of these approaches are applied to limit interest deductions.

Despite these available measures, there are some calls for special measures or the right to re-characterise transactions, to address the level of debt and interest in certain group financing transactions because the arm's-length principle is perceived to break down in such cases.

Clearly where there are different ways of identifying an acceptable level of interest deduction between countries (and the rules do not necessarily mirror how the recipient of the income is taxed), there is the risk of double taxation for taxpayers. It is to be hoped that the BEPS programme in 2015 will recognise that their work must address this inconsistency in approach as well as the risk of base erosion and double non-taxation.

Leveraged businesses

Whilst the work on Action 4 may impact a wide range of industries, sectors that have traditionally been highly leveraged - such as the financial sector, private equity industry or infrastructure businesses - will be watching the outputs closely.

For example, the financial sector (including banks and insurers) are subject to detailed regulatory requirements that mean prescribed levels of capital have to be maintained. This, combined with the fact that debt is the trading stock of these businesses, means that the financial sector will want to scrutinise any proposals in this area in great detail.

Furthermore, the private equity sector, whose investments in target companies are often characterised by high levels of subordinated debt, will be pleased there are no sudden changes in tax policy arising from the work on Action 4 that does not allow the sector time to reorganise their investments.

The infrastructure sector, which has relied on its steady levels of predictable earnings, typically from government backed organisations, to secure high levels of debt relative to their capital base, will also be concerned that BEPS 2015 does not ignore the specific nature of their industry in the attempt to close out Action 4.


It is important to see the work on Action 4 of the BEPS in the context of the work that is going to happen on Action 3 (CFC) and Action 2 (hybrids).

The BEPS project is at half-time but it does not feel like it is halfway through its work and there are still a significant number of difficult matters to address in 2015.

One of those 2015 work streams is Action 4 (Limit base erosion via interest deductions and other financial payments). The flexibility to move debt finance around an international group makes it a target by tax authorities to limit base erosion. However, the OECD's work should also address the sometimes inconsistent approach taken by different tax authorities to limit interest deductions, which can lead to double taxation. Furthermore, economically important sectors such as the private equity industry, infrastructure and financial services will be watching the outputs of Action 4 closely because there is a risk that, in an attempt to close Action 4 on time, the specific needs of these sectors are ignored.

The views expressed in this article are authors' personal viewpoint and may or may not reflect the views of Grant Thornton UK LLP

By Liz Hughes, Grant Thornton UK LLP,, +44 (0)207 728 3214

Liz Hughes is a Director in Grant Thornton UK LLP's transfer pricing practice, who has a particular interest in the pricing of debt and thin capitalisation matters; and

Oriana Panidha, Grant Thornton UK LLP,, +44 (0) 207 728 2378

Oriana Panidha is an Assistant Manager in Grant Thornton's UK LLP's transfer pricing practice

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