On 18 December 2014, the OECD published proposed rules for tackling the use of excessive interest payments as a means of shifting profits around a group for tax avoidance purposes. Three main types of rules are considered:
- Fixed allocations of a group's external debt expense between group members
- Fixed ratio rules, restricting deductions for stand-alone companies to a proportion of the company's earnings or net asset values
- Targeted rules, tailored to deal with particular structures and arrangements.
The proposed rules are intended to apply to interest, other financial payments that are economically equivalent to interest and expenses incurred in the raising of finance (such as arrangement and guarantee fees). The focus is on restricting deductions for the net finance expense of the entities concerned (including partnerships and permanent establishments).
Group-wide interest allocation
Two main options are considered for group arrangements. One option would be to cap the expense deductible for each group company, with the cap being set as a proportion of the group's net external debt expense. The cap would be calculated by reference to the earnings or net asset values of the company concerned. In other words, the deductible expense would be set at an amount considered reasonable to service the funding needs of the entity's business.
An alternative basis would be to compare a relevant financial ratio of an individual group company (eg net finance expense to earnings or net finance expense to asset values) with the same ratio for the group as a whole. Interest deductions would then be disallowed where the company ratio exceeds the group ratio.
In either case, companies would be treated as included in the group if their results are to be included in the group's consolidated financial statements using IFRS or specified GAAP rules.
As asset values are considered to be more open to manipulation than earnings, an earnings approach appears to be the favoured option. Various measures of earnings could be used (eg EBITDA, EBIT) but, in all cases, dividend income would be excluded. One downside to this is that volatility of profits year-on-year would reduce certainty over interest deductions. However, rules could be introduced to reduce this volatility, eg using average earnings over a number of years, or allowing disallowed finance expenses or unused capacity to deduct finance expenses to be carried forward.
Fixed ratio rules for stand-alone entities
A fixed ratio approach is considered to be easy to understand and administer but may not be very well targeted: different types of businesses have different funding needs. Therefore, unless different ratios were set for different sectors, some sectors may be unfairly disadvantaged. It is, therefore, possible that such rules might only be applied in exceptional cases.
A combined approach
Two possible options for combining both of the above measures are proposed: in both cases, there is a general rule and a carve-out from that rule in specific circumstances.
Under the first approach, the general rule would allow each group company an allocation of group-wide external net debt expense, but an entity would be carved out from this rule if its own net interest expense was lower than a fixed percentage of its earnings or asset values. This approach would be especially useful in cases where a group as a whole has a very low level of net debt expense but one group member has higher net debts.
Under the second approach, the general rule would be to restrict an entity's finance expense deductions to a fixed ratio test if those expenses exceeded a particular monetary threshold. However, if a large entity's ratio of earnings or assets to finance expense did not exceed that of the group as a whole, it could still claim the full deductions.
Targeted rules
Targeted rules applied in isolation are not considered to be appropriate as a large number of separate rules would be required and would increase complexity and compliance costs. However, targeted rules could be adopted alongside the general rules (above) to address specific risks or identified avoidance activities. The kinds of arrangements that such rules could deal with include:
- Interest payments to connected and related parties
- Artificial debt arrangements designed merely to produce tax deductions with no additional funding actually raised by the borrower
- The routing of funds through intermediary entities to obtain tax benefits
- The use of debt to fund tax-exempt or tax-deferred income.
Dealing with double-taxation
Double-taxation is one of the potential side effects of restricting the deductibility of finance expenses. One way to address this is to re-categorise the disallowed expense as a dividend. However, this raises practical difficulties where payments are made cross-border as it relies on the territory in which the payment is received treating it as non-taxable. A more practical solution may, be to allow disallowed expenses or unused capacity to deduct expenses to be carried forward (with limits on the amount carried forward and the number of years).
The OECD intendeds to present a best practice approach to the G20 Finance Ministers late in 2015 and comments are requested on the proposals by 6 February 2015.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
