Assignment Module 3 - BEPS project Action 4 (0)

BEPS project Action 4: Interest deductions and other financial payments
Maris Leemets
10.08. 2016
Peer Assignment in Module 3
The OECD with its Base Erosion and Profit Shifting (BEPS) project is working towards proposing politically feasible and multilaterally acceptable ways to minimize the corporate tax base erosion and profit shifting activities since 2013. Out of its 15 main lines of work under BEPS project (called Actions) I will concentrate on Action 4 which aims at proposing new rules for preventing the manipulation of interest expense related tax deductions of corporates. The underlying problem is that multinational groups can easily create and relocate debt in their group according to the most preferential tax treatment available which in some cases results in no or even negative corporate tax payments from those companies .
For BEPS project to be transparent and inclusive, a broad- based public involvement has been carried out by the OECD. The discussion draft to prepare the final report and received comments to the discussion draft were both published, in 2014 and early 2015, respectively. On October 5th, 2015 the Final Report on Limiting Base Erosion Involving Interest Deductions and Other Financial Payments was presented analyzing several best practices and recommending new rules for limiting the level of interest expenses allowed for tax deductions.
The recommended approach by the OECD is to limit the entity’s net interest expenses, and payments economically equivalent to interest, to a percentage of entity’s earnings before interest, taxes , depreciation and amortization ( EBITDA ). The net interest expense/EBITDA ratio should be fixed in a corridor of 10-30%. This approach aims at two objectives – uses net interest expense to calculate the amount of tax deductible (to maintain freedom for a corporate to decide where in the group it is most effective to borrow), and by using EBITDA assures that the group has actual business earnings in that particular entity/ country . This fixed ratio rule is advised to be supplemented with the group ratio rule to allow a more flexible approach to groups having high debt in a particular entity/country for non-tax reasons but low interest expenses in other group entities; and additional targeted/ specific rules as necessary to manage volatility of interest expenses, achieve additional tax policy objectives or lower other risks. The fixed ratio rule, as a minimum, should apply to all entities in multinational groups.
In reaching its recommended best practice approach – the fixed ratio rule - the OECD has put great work into comparative analyses of different metrics, definitions, existing practices and risks. In the Final Report it explains thoroughly how it arrived at fixed ratio rule as the most promising but still relatively non- complex metrics. First , many countries already use the general interest or debt limitation rule for the purpose of limiting the tax deductibility of interest expenses, therefore there already was experience to learn from. In analyzing the different routes – interest expense versus debt as a base, the OECD proposes the former because it would be less complicated to control . Second, the OECD analyses different metrics to measure the economic activity and proposes using earnings (EBITDA, or EBIT – earnings before interest and taxes - if the country prefers the latter ), but discusses also the benefits of using asset values as the base. It concludes that in many cases determining the market value of land , buildings, and e.g. intellectual property may become too complicated to arrive at reasonable results across different companies in different sectors, therefore preferring the earnings. There are some shortcomings to use earnings as a measure of economic activity – for example in case of a loss- making entity – but there are ways to overcome this by using targeted rules to carry forward (or back ) the disallowed or unused interest expense. The definition of earnings is also to exclude income which is subject to favorable tax treatment (i.e dividend income in many countries) to limit its ability to fund tax exempt or tax deferred income.
The main drawback of the OECD’s proposed fixed ratio rule is the flexibility of the term “fixed”. It is in accordance with the reality that countries are not in the position to agree to a benchmark value of a fixed ratio that would apply in every country to every type of entity. The proposed corridor from 10% to 30% has good arguments, but with exceptions and transition times allowed and some earnings or interest expenses excluded, this will create confusion among corporates and tax administers alike. It is important to ensure that no new ways to avoid the rules are created. In the long term that process would take us to the world of less base erosion and profit shifting but still with different fixed ratios, different group ratios (if any), targeted rules on top of these ratios to address earnings volatility or loss-making years of corporates. Furthermore, countries can not be forced to aim for lower fixed ratios if their economic policy is geared towards attracting international investments, and in reverse case, if not following all of the proposed options, some new forms of double taxation may arise .
As indicated in the 2015 Final Report, two additional papers have been prepared since then: Discussion Drafts on Group Ratio Rule and on Banking and Insurance Sectors. These two lines of work had been identified for a separate analysis.
For group ratio rule, the definition of a group needs to be followed consistently across tax administrations of different jurisdictions. Also, as it is needed to determine the group’s net third party interest/EBITDA ratio and thereafter apply the group’s ratio to an entity’s EBITDA, these may not be so straightforward to calculate. Therefore, applying the group ratio rule effectively raises a number of issues regarding the accounting rules followed, treatment of loss-making entities in the group, or the availability of consolidated financial reports. The comments to the discussion draft are expected by August 16, 2016.
For banking and insurance companies - being net interest income receivers as their business model - the proposed fixed and group ratio rules will not be effective. OECD recognizes that these entities and groups are in most cases well regulated and therefore have lower BEPS risks. The banking and insurance groups are restricted to place debt in certain entities in their group by international regulatory capital requirements . However, the groups may have different regulated or non-regulated, financial or non-financial entities in their structure, aggravating the opportunities for BEPS, for example in their branch and financial instrument-related operations. The fixed ratio rule and the group ratio rule should be used for these entities not controlled by financial regulations. However, for banking and insurance entities in the groups, the July 2016 discussion draft recommends no single approach but provides that countries should introduce their own rules to tackle the actual BEPS risks they face . Unfortunately, this will add to the complexity of interest expense deductibility rules the companies face and tax administrators need to take into account . The comments to this discussion draft are expected by September 8th, 201t6.
In summary, the OECD has done a thorough preparation to address the challenges under Action 4 of their BEPS project. Some lines of work are still in the discussion phase but a proposal for a fixed ratio rule supplemented with group ratio rule to limit allowed tax deductions to a fixed net interest expense/EBITDA ratio is a promising way forward. Even with its drawbacks and potential for countries to opt out from applying these new rules to their full effect, the possibilities for multinationals to minimize payable taxes can be restricted. Furthermore, the work on transfer pricing aspects of financial transactions is undertaken during 2016 and 2017 , closing another window of tax avoiding opportunity. Still, the BEPS project will be tested by its implementation, and first results can only be measured in 2020 when the effectiveness of Actions will be reviewed.