OECD sets out options for restricting tax deductions for interest

The OECD made the suggestion in a discussion draft issued as part of its base erosion and profit shifting (BEPS) project. BEPS refers to the shifting of profits of multinational groups to low tax jurisdictions and the exploitation of mismatches between different tax systems so that little or no tax is paid.  Following international recognition that the international tax system needs to be reformed to prevent BEPS, the G20 asked the OECD to recommend possible solutions.

In July 2013, the OECD published a 15 point Action Plan and the first formal proposals dealing with seven of the 15 specific actions were published in September 2014. Action Point 4 of the OECD's action plan is limiting base erosion through interest deductions.

Heather Self, a tax expert at Pinsent Masons, the law firm behind Out-law.com said that Action 4 is one of the key actions on BEPS as it "goes to the heart of tax systems, focusing on the tax treatment of interest".

Deductible payments such as interest can give rise to 'double non-taxation'. Excessive intra group interest deductions can be used by multinational groups to reduce taxable profits in operating companies, even in cases where the group as a whole has little or no external debt. The OECD is also concerned that groups can use debt finance to produce tax exempt or deferred income, thereby claiming a deduction for interest expense while the related income is brought into tax later or not at all.

Self said "The document identifies that debt and equity are generally treated differently for tax purposes, and makes the leap towards saying that this causes BEPS. There will be a natural bias towards locating debt in higher tax jurisdictions, but this is a natural consequence of tax competition and not necessarily a sign that BEPS is taking place".

The discussion draft considers the types of provisions that countries currently use to prevent excessive interest deductions. These include rules which limit the level of interest expense or debt in an entity with reference to a fixed ratio, rules which compare the level of debt in an entity by reference to the group’s overall position and targeted anti-avoidance rules which disallow interest expense on specific transactions.  However, the OECD said that existing approaches have had limited success.

The document considers the countries which already have fixed ratio rules. These include Germany, Greece, Italy, Norway, Portugal and Spain with a limit of 30% of taxable EBITDA and France with 25%. However the document says that anecdotal evidence indicates that those ratios may be too high to be effective in preventing BEPS and it says that research has indicated that most multinationals have a net interest expense to EBITDA ratio below 10%.  

The discussion paper considers ways that fixed ratio rules, group-wide rules and targeted rules could be implemented. It suggests that any new rules should apply to payments between group companies, connected and related parties but countries should not have to implement restrictions applying to payments to standalone, third party entities. It also considers whether countries should be able to introduce a threshold or exception to exclude small entities from the new rules.

The document considers the pros and cons of group wide rules and fixed ratio rules and the different ways in which they could be implemented. It also suggests that if ratio rules and interest allocation rules are insufficient on their own to tackle BEPS, the two types of rule could be combined. The paper suggests two different ways of doing this.

"There is a real risk the cure could be worse than the problem," said Self. "The outline proposals will involve onerous compliance burdens and in many cases will lead to double tax.  This is not an acceptable outcome for a project which should be focused on preventing avoidance structures – the proposals should concentrate on abusive structures and not seek to impose a global regime for dealing with interest expense."

There have been concerns that because of their highly geared and long-term nature, infrastructure projects could be adversely affected by any BEPS proposals in relation to interest. 

The document recognises that banks, insurance companies and the infrastructure sector will have particular issues with any proposals for limiting interest deductions.

In relation to infrastructure, the discussion paper says: "if the final design of any rules for an effective response to base erosion and profit shifting does not provide an appropriate solution for this particular sector, special provisions may need to be considered. Any special provisions that are introduced would need to be targeted to ensure that they address the specific needs of the sector and do not create arbitrage opportunities or a possible competitive advantage for certain groups."

Comments on the proposals and responses to the specific questions raised are requested by 6 February 2015.

On the same day the OECD published a discussion draft on dispute resolution procedures for international tax disputes.