Interest restriction: overview: OECD Action 4
Action 4 of the Organisation for Economic Cooperation and Development (OECD) Base Erosion and Profit Shifting (BEPS) Project addressed “Limiting Base Erosion Involving Interest Deductions and Other Financial Payments”. The BEPS project was a major and wide ranging initiative by the OECD and G20 countries to limit tax base erosion and the shifting of profits in such a way that they would bear little or no taxation.
The first output from this initiative was the publication of the report “Addressing Base Erosion and Profit Shifting” in February 2013. This was followed by a 15-point Action Plan, adopted in September 2013. One of those actions concerned hybrid mismatches and the UK brought into effect legislation to address these issues in the Hybrid and Other Mismatches legislation (TIOPA10/PART6A), applicable from 1 January 2017.
The OECD report on Action 4 was published in interim form in 2014 and in final form in October 2015. Further technical work was conducted on specific areas during 2016 and an updated report was issued in December 2016.
By 2016, the focus of the BEPS project had shifted to implementation. The BEPS package as a whole is designed to be implemented via changes in domestic law and practices, and via treaty provisions. Action 4 requires enactment in domestic law. The report put forward extensive best practice recommendations.
The Executive Summary of the Action 4 Report begins as follows:
“It is an empirical matter of fact that money is mobile and fungible. Thus, multinational groups may achieve favourable tax results by adjusting the amount of debt in a group entity. The influence of tax rules on the location of debt within multinational groups has been established in a number of academic studies and it is well known that groups can easily multiply the level of debt at the level of individual group entities via intragroup financing. Financial instruments can also be used to make payments which are economically equivalent to interest but have a different legal form, therefore escaping restrictions on the deductibility of interest. Base Erosion and Profit Shifting (BEPS) risks in this area may arise in three basic scenarios:
- Groups placing higher levels of third party debt in high tax countries.
- Groups using intragroup loans to generate interest deductions in excess of the group’s actual third party interest expense.
- Groups using third party or intragroup financing to fund the generation of tax exempt income.”
This clearly sets out the issues covered by the report.
The best-practice recommendations in the report include a number of specific elements, some of which are necessary to implement with the recommended approach and some of which are optional. The key components are:
- a “fixed-ratio” rule that limits deductions for interest and payments economically equivalent to interest to a fixed percentage of earnings before interest, taxes, depreciation and amortisation (EBITDA); and
- an optional group ratio that would allow a higher ratio of financing expense to EBITDA where groups are highly leveraged with third party debt for non-tax reasons.
Certain other features are allowed to reduce the impact of the provisions on entities that pose less BEPS risk. These include the following.
- A de minimis threshold: a level of interest expense below which the provisions would not apply.
- An exclusion for interest paid to third party lenders on loans used to fund public benefit projects, subject to conditions. In these circumstances, although an entity might be highly leveraged, the BEPS risk is considered to be reduced due to the nature of the projects and the close link to the public sector.
- The carry-forward of disallowed interest expense and/or unused interest capacity (where an entity’s actual net interest deductions are below the maximum permitted) for use in future years. This would have a smoothing effect, reducing the impact of earnings and interest rate volatility.
The report also contemplates targeted rules to prevent circumvention of the measure and address specific risks.
As a best practice approach, the report does not prescribe in detail exactly how its recommendations should be implemented as legislation in each jurisdiction. However, it is anticipated that a co-ordinated implementation of the recommended approach would successfully impact on the ability of multinational groups to use debt to achieve base erosion or to shift profit. The implementation, operation and impact of the approach will be monitored over time.