Multinational groups may achieve favourable tax results by adjusting the amount of debt in a group entity. 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.
The use of third party and related party interest is perhaps one of the most simple of the profit-shifting techniques available in international tax planning. The fluidity and fungibility of money makes it a relatively simple exercise to adjust the mix of debt and equity in a controlled entity.
In particular, the deductibility of interest expense can give rise to double non-taxation in both inbound and outbound investment scenarios. The interest payments are deducted against the taxable profits of the operating companies while the interest income is taxed at comparatively low tax rates or not at all at the level of the recipient. This is despite the fact that in some situations the multinational group may have little or no external debt.
The 2015 Action 4 report on Limiting Base Erosion Involving Interest Deductions and Other Financial Payments focused on the use of all types of debt giving rise to excessive interest expense or used to finance the production of exempt or deferred income. In particular, this report established rules that linked an entity’s net interest deductions to its level of economic activity within the jurisdiction, measured using taxable earnings before interest income and expense, depreciation and amortisation (EBITDA). This approach includes three elements: a fixed ratio rule based on a benchmark net interest/EBITDA ratio; a group ratio rule which may allow an entity to deduct more interest expense depending on the relative net interest/EBITDA ratio of the worldwide group; and targeted rules to address specific risks.
As at mid-2019, a number of OECD and Inclusive Framework members have adopted interest limitations rules or are in the process of aligning their domestic legislation with the recommendations of Action 4. From the commencement of 2019, all EU Member States apply an interest cap that restricts a taxpayer’s deductible borrowing costs to generally 30 percent of the taxpayer’s earnings before interest, tax, depreciation and amortisation (EBITDA). Various other countries have also taken steps to limit interest deductibility (e.g., Argentina, India, Malaysia, Norway, South Korea) or are in the process of aligning their domestic legislation with the recommendations of Action 4 (e.g., Japan, Peru, Viet Nam).
The latest edition of Corporate Tax Statistics published in July 2020 collected, for the first time, information on interest limitation rules, which can assist in understanding progress related to the implementation of BEPS Action 4. The data highlights that interest limitation rules can limit base erosion via the use of interest expense to achieve excessive interest deductions or to finance the production of exempt or deferred income. It also shows that information on the presence and design of interest limitation rules is available for 134 Inclusive Framework jurisdictions, of which 67 had interest limitation rules in place in 2019.
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