In October 2015, the OECD released its BEPS Action 4 Report on Limiting Base Erosion Involving Interest Deductions and Other Financial Payments. Chapter 6 of this report deals with a ‘fixed ratio rule’, which is a general rule that would restrict the amount of relief an entity / group can claim for its net interest expense to a fixed percentage of the entity’s / group's taxable earnings before interest, depreciation and amortisation (tax EBITDA) in that country.
EBITDA is a way to evaluate the company’s performance without having to factor in financing decisions, accounting decisions or tax environments. In short, EBITDA is calculated by adding back the non-cash expenses of depreciation and amortisation to a company’s operating income.
In terms of a fixed ratio rule, according to the OECD report, “the premise underlying this rule is that an entity should be able to deduct interest expense up to a specified portion of EBITDA, ensuring that a portion of an entity’s profit remains subject to tax in a country.” The rule can apply to all companies, whether multinational or stand alone.
The benchmark fixed ratio is decided by the in-country government and interest paid to third parties, related parties and group entities is deductible up to this fixed ratio. However, any interest that takes the entity’s ratio above this benchmark is disallowed.
The benchmark fixed ratio applies irrespective of the actual leverage of an entity or group. The OECD recommends separate, targeted rules for the banking and insurance industry, but states that “in general, a country should apply the fixed ratio rule consistently using the same benchmark fixed ratio to groups in all sectors
The OECD report considers the many country-specific factors that may arise and thus recommends different ways to implement a fixed ratio rule e.g.: a country may apply a higher benchmark fixed ratio if it does not permit the carry forward of unused interest capacity or carry back of disallowed interest expense. The report recommends that countries set their benchmark fixed ratio between 10% and 30% in order to suitably tackle base erosion and profit shifting.
The report also provides for benchmark ratios to reflect changing interest rate environments.
South Africa does not currently make use of an OECD Report-type fixed ratio rule, however, we may see effects of this 2015 OECD report in our tax legislation in the future due to the increased international focus on base erosion and profit shifting, which may operate in addition to avoidance and limitation measures currently provided for in the Income Tax Act, such for example s23M and the transfer pricing provisions..