BEPS Action 4
BEPS Action 4 makes recommendations on best practices in the design of rules to address base erosion and profit shifting (BEPS) using interest and other economically equivalent payments. The recommendation made in 2015 is to align interest deductions with taxable economic activity.
The focus of Action 4 is on the use of debt to achieve excessive interest deductions or to finance the production of exempt or deferred income. It concerns all types of debt, like third party, related party and intragroup debt. With this wider focus on debt in general and not just on intragroup debt this action is additional to the recommendations that are outlined in BEPS Actions 8-10 on transfer pricing.
In order to tackle the issues related to the use of debt Action 4 is targeted at all forms of interest and payments equivalent to interest. This prevents that rules are avoided by structuring debt in a another legal form.
Examples of payments equivalent to interest are payments under profit participating loans, finance cost elements of finance lease payments, capitalized interest or the amortization thereof, guarantee fees with respect to financing arrangements and fees related to the borrowing of funds.
Deemed (interest) deductions are not treated as being (equivalent to) interest for the purpose of BEPS Action 4.
BEPS occurs when one entity or country in a group bears an excessive proportion of the group’s total net third party interest or where a group uses intragroup interest expense to shift taxable income from high tax to low tax countries. When payments are made to a lender outside a country, either direct or indirect, BEPS can also take place.
Approaches trying to tackle BEPS that were already in place before the work on Action 4 was done are:
- Arm’s length tests, which compare the level of interest or debt in an entity with the position that would have existed had the entity been dealing with third parties.
- Withholding tax on interest payments, which are used to allocate taxing rights to the source jurisdiction.
- Rules which disallow a specified percentage of the interest expense of an entity, irrespective of the nature of the payment or to whom it is made.
- Rules which limit the level of interest expense or debt in an entity with reference to a fixed ratio, such as debt/equity, interest/earnings or interest/total assets.
- Rules which limit the level of interest expense or debt in an entity with reference to the group’s overall position.
- Targeted anti-avoidance rules which disallow interest expense on specific transactions.
Single or combination of these kinds of rules have been used by various tax jurisdictions.
Arm’s length testing on the level of interest or debt is considered to be resource intensive for both taxpayers and tax administrations. It is also not considered effective in preventing BEPS. Arm’s length testing is considered more useful on the pricing of interest income and expense.
Also withholding taxes are not considered a suitable tool for tackling BEPS risks. This is due to the fact that often the rates are reduced under bilateral tax treaties, in the EU the application of withholding taxes between member states is extremely difficult due to the Interest and Royalty Directive and some countries do not apply withholding tax to interest payments due to policy reasons. All in all the use of withholding taxes is not considered an effective measure to tackle BEPS.
Disallowing tax deductability of a percentage of all interest paid by an entity has the effect that for all entities the cost of debt increases. It does not matter if an entity has low leverage or it is highly leveraged. It does not target BEPS involving interest. At most it reduces attractiveness of debt financing over equity financing.
The above three approaches are not considered best practice approaches for the reasons provided. BEPS Action 4 states that countries can still implement or maintain one or more of these approaches alongside the recommended best practice for local tax policy goals.
The best practice approach that is recommended by BEPS Action 4 is a combination of the approaches listed under 4, 5 and 6 above.
It states best practice as implementing a fixed ratio rule with an optional group ratio rule. In any case the chosen ratio rule should be complemented with targeted rules. It is believed the combination of these provide effective protection for countries against BEPS. A targeted rule can always be implemented if a situation is not covered under a ratio rule, so we can conclude that indeed countries are effectively protected against BEPS if they implement the recommendations from BEPS Action4.
Further to this there are options provided like a minimum monetary threshold to remove low risk entities, carry forward of disallowed interest/unused interest capacity and/or carry back of disallowed interest and specific rules to address issues raised by the banking and insurance sectors.
The best practice approach as recommended is:
Countries may elect to implement a minimum threshold based on a monetary value of net interest expense. All interest expense below the threshold can then be deducted without limitation. Countries are advised to implement the threshold on a group basis, which means to include all entities of a group residing in a country to prevent fragmentation.
Fixed Ratio Rule
The center of the best practice approach is the fixed ratio rule. This rule limits an entity’s net interest deductions to a fixed percentage of its profit. EBITDA based on tax numbers is the recommended measure for profit. A direct link between interest deductions and economic activity is established with this rule.
Countries are recommended to set the fixed ratio benchmark between 10% to 30%. This corridor is to be revised after a review of the best practice which is scheduled for 2020. Furthermore countries can opt for EBIT or asset values as the measure of profit in certain cases.
Applying the benchmark ratio to the EBITDA based on tax numbers yields the maximum allowed interest deduction under the fixed ratio rule for an entity. Any net interest expense above this is then disallowed.
The OECD has realized that the fixed ratio rule is a rather blunt tool. It does provide countries with a level of protection against BEPS but it does not take into account the specifics of different sectors requiring different leverage amounts. If entities that are leveraged above the set ratio then this may even lead to double taxation. To prevent this it is recommended to add a group ratio rule when implementing the fixed ratio rule.
Group Ratio Rule
A group ratio rule allows entities that exceed the benchmark of the fixed ratio rule because of high leverage of the group they belong to, to deduct interest expense up to the net third party interest/EBITDA ratio of its group, where this is higher. Combining the fixed ratio rule with the group ratio rule compensates entities for the blunt operation of the fixed ratio rule.
With this combination countries are able to opt for a relatively lower fixed ratio to prevent BEPS for most entities. At the same time those entities that are part of a highly leverage group are not negatively affected due to the implementation of the group ratio rule.
As with the fixed ratio rules countries have the flexibility to implement different group ratio rules, including those using asset based ratios. However any such rule should only permit an entity to exceed the benchmark fixed ratio where it is able to demonstrate that the relevant financial ratio is in line with that of its group.
The deductible amount of interest expense for an entity is obtained as follows:
These calculations are rather straightforward if both group and entity have positive EBITDA. In situations where one of the two has negative EBITDA there need to be some additional steps.
Group positive EBITDA / Entity negative EBITDA
The Group’s consolidated EBITDA is reduced by the impact of loss-giving entities. The net third party interest/EBITDA ratio of the group is increased due to this situation. There are fears that this situation leads to entities within the group that are EBITDA-positive to increase their interest deductions due to the higher group ratio.
The recommendation in this situation is that an upper limit is applied to the net interest expense of the entity which is equal to the net third party interest expense of the entire group. There is recognition that this limit is not entirely effective as the total of the individual entity limits can exceed the consolidated total net third party interest expense of the group. It should prevent an individual entity receiving a very high level of interest capacity that could be used for BEPS.
The application of an upper limit is explained with below example. A group consisting of 3 subsidiaries have the below EBITDA and net interest:
Due to the upper limit being in place the interest capacity of each of the subsidiaries is limited to 12. The deductible interest expenses is at maximum 12 which limits Company A to a deductible interest of 12 instead of 20. The remainder of 8 is the disallowed interest expense which may be carried forward if the applicable rule permits.
Company B can deduct its full net interest of 2. The remainder of 10 is the unused interest capacity which may be carried forward, but again, only if the applicable rule permits.
Company C has an interest capacity of 0, due to the negative EBITDA of the company. There is no deduction and no carry forward is available.
Group negative EBITDA / Entity positive EBITDA
The recommended best practice in this situation is that an entity with positive EBITDA receives interest capacity equal to the lower of the entity’s net actual interest expense and the net third party interest expense of the group.
The same group of 3 subsidiaries now has realized below EBITDA and net interest over the period:
In this example the interest capacity for Company A is limited to the net interest of the group, which is 12. Company A in this example has a deductible interest expense limited to 12. The disallowed interest expense to be carried forward – if allowed under the applicable rules – is 8.
For Company B however the interest capacity is limited to the net interest expense, which is 2. This is due to the negative EBITDA of the group as opposed to the previous example. The deductible interest expense also is 2. In this situation Company B has fully used its interest capacity and as such there is nothing left to carry forward.
Company C, due to its negative EBITDA has an interest capacity of 0 like in previous example.
The main difference between the two examples is the group’s EBITDA being positive in the first example and negative in the second. In group EBITDA positive situations positive EBITDA entities in the group potentially have a carry forward of unused interest capacity. In negative group EBITDA situations this is not the case.
Alternatively an approach can be implemented to exclude loss-making entities from the calculation of a group’s EBITDA. However the drawbacks of such an approach are that it is difficult to obtain information on individual entities from consolidated group statements which makes this approach highly cumbersome and inaccurate for both taxpayers and tax administrations.
Carry forward of disallowed interest/unused interest capacity and/or carry back of disallowed interest
Volatility in earnings impacts the ability of an entity to deduct interest expenses. Earnings and interest expense are not always linked in the same tax period. This leads to issues where entities cannot deduct interest expenses incurred in other periods than in which earnings are realized as a result of timing mismatch.
To compensate for this volatility in earnings countries can implement permissions for carry forward or carry back of net interest expense and unused interest capacity.
Targeted rules to support general interest limitation rules and address specific risks
A country can implement targeted rules alongside general limitation rules like the fixed ratio rule and the group ratio rule. These targeted rules include any provisions which aim to restrict interest deductions on payments made under specific transactions or arrangements. These rules are very specific and therefor require that tax administrations must actively recognize situations in which they are applicable. Consequently targeted rules may increase complexity for both taxpayers and tax administrations, certainly if multiple targeted rules are applicable.
The best practice approach of BEPS Action 4 is to use the fixed ratio rule and group ratio rules. In addition targeted rules or specific provisions within the general rules to prevent the avoidance of these general rules should be implemented.
Specific rules to address issues raised by the banking and insurance sectors
Fixed ratio rules and group ratio rules are expected to have little to no effect on groups in the banking and insurance business. This is due to the fact that most groups in these sectors are net lenders and as such have net third party interest income. Also because of this characteristic EBITDA is not as good a measure for earnings as it is in other sectors. Another reason is that financial statements of banks and insurers differ from those of groups in other sectors, which would impact the operation of a group ratio rule.
For these reasons the general rules are not deemed to be effective for banks and insurers and therefor the recommendation to countries is to implement specific targeted rules for these sectors. The companies should only be those that are under regulatory control, which means that treasury companies, captive insurance companies etcetera should not be included in the scope of these targeted rules. These kind of companies should be in the normal scope of the fixed ratio rule and the group ratio rule.
Effects of BEPS Action 4
Through using fixed and group ratio rules BEPS Action 4 aims to make it difficult for groups to shift interest expenses into high tax jurisdictions to lower its taxable base. These general rules are rather straightforward to implement by countries. This makes it highly likely a lot of countries will elect to implement these recommendations. The effect will be that multinational groups will have an incentive to more closely match net interest expense with where profits are made.
A lot of impact comes from the implementation - or not - of provisions to allow for carry forwards and carry backs of unused interest capacity. If these are implemented then the rule sets are most likely effective. But if these provisions are not implemented double taxation may be the result which goes against the aim of BEPS in general.