This paper sets out our comments on the Public Discussion Draft published on 18 December 2014.


  1. The Discussion Draft on interest deductions and other financial payments sets out two main concerns
    • in an inbound scenario, “excess” interest deductions reduce taxable profits in operating companies in high tax jurisdictions, even if a corporate group as a whole has little or no third party borrowings, and income may be recognised by related lender companies in low tax jurisdictions; and
    • in an outbound scenario, companies may borrow to finance the acquisition of investments that produce tax exempt income or deferred income, while claiming deductions for the costs of the finance against other taxable income.
  1. The policy choice that debt finance costs should generally be deductible for tax purposes creates an inevitable bias in favour of debt funding over non-deductible funding, such as shareholder equity finance, as the tax benefit of deductibility typically reduces the net (after-tax) cost of investment. Some countries, for example Belgium, have attempted to address this inherent bias by introducing a tax deduction for the deemed cost of equity finance.
  2. It must be remembered that the starting point for the Discussion Draft is a company that has interest or other finance costs paid as a result of borrowing, and those costs would otherwise be deductible for tax purposes. That is, the costs of finance meet an arm’s length transfer pricing test, are not recharacterised as non-deductible distributions, and are not ignored or recharacterised under an anti-avoidance or anti-abuse rule. In these circumstances, the Discussion Draft posits that interest and other financial payments may still be “excessive”, meaning that the company pays less tax than it should.
  3. The approach taken in the Discussion Draft seems to suggest that borrowing to finance investment in a related company is wrong: borrowing to invest in equity typically creates tax exempt income, but borrowing to lend on to other group companies may create excessive debt deductions for the borrowers. Distortion is not caused by lending between related parties, if that lending is on arm’s length terms: it is caused by different countries making different choices about their corporate taxes rates.
  4. The main proposal is to align the interest expense of individual companies with the debt position of the overall group. This approach has the appearance of being a step along a road where the logical destination is that related companies should be taxed as a single entity – that is, it seems to be a move towards a form of unitary taxation. We do not believe that many states would willingly surrender control over their tax base in that manner.
  5. The proposals imply that the deployment of spare cash by a related company to provide debt finance to an affiliate, on a fully arm’s length basis, is less acceptable than the equivalent lending by a third party.  There also appears to be an unfair penalisation of capital-intensive businesses.  If lending from group resources is excessive, and involves lending from group companies established in low-tax jurisdictions, controlled foreign company (CFC) rules become relevant, to tax the interest receipt, rather than the denial of debt deductions for the interest expense.
  6. As we have commented before on other Discussion Drafts, coordination is essential with other BEPS Actions that cover similar ground.  The Discussion Draft on Action 4 explicitly does not consider transfer pricing and withholding taxes (see paragraph 21 on page 13)., but any proposals from Action 4 must be coordinated with the allocation of income and profits through correct transfer pricing (within Actions 8 to 10), and the proposals that emerge later this year on CFCs (within Action 3), and the denial of deductions in hybrid mismatch arrangements (withinAction2)
  7. Finally, it is important that any proposals are proportionate, as simple as possible to apply, and do not create excessive compliance costs or areas for potential disputes between taxpayers and tax authorities.


  1. What is interest?
  1. ​​​In response to Question 1 and Question 2, we do not see difficulties in including payments that are economically equivalent to interest within the best practice rule, although as the Discussion Draft acknowledges, the precise perimeter of tax-deductible finance costs remains a matter for individual states. For example:
  • payments under profit participating loans may be considered to be non-deductible distributions of profits, rather than interest on debts;
  • amounts paid under deferred payment provisions  for the provision of goods or services may be economically equivalent to interest, but may be more properly treated as part of the price for the goods or services, if there is no element of lending;
  • some commercial arrangements, for example, sale and repurchase (repo) transactions include payments between the parties that may be considered to economically equivalent to be interest;
  • net payments under swaps and other derivative contacts may be calculated by reference to interest rates on an underlying notional principal amount, which could be considered to economically equivalent to be interest, but should not ordinarily be treated as interest income.
  1. ​It would be helpful for it to be confirmed whether or not these and other similar amounts are intended to fall within the best practice rule.
  1. Who should a rule apply to?
  1. In response to Question 3 and Question 4, in our view, any rule denying debt deductions should be applied on a consistent basis to all companies.
  2. It is not clear to us why borrowing on arm’s length terms from related companies is penalised, compared to the equivalent borrowing from independent third parties.
  3. It is also not clear to us what kind scenario might be considered to be a “structured arrangement”, which would bring ostensibly third party borrowing into scenario 3. That said, we would not object to a 25 per cent direct or indirect shareholding test to identify persons with a substantial interest in a company,
  1. What should a rule apply to?
  1. In response to Question 5, we agree that any limitation rule should apply to the net debt expense of a company. Applying a limitation to the gross expense of any particular borrowing or the gross expense of all borrowings, without taking into account debt income, is liable to create double taxation, with the potential for multiple lenders to be taxed on what is in essence the same taxable income with no allowance for the cost of related debt finance, rather than each being taxed on the appropriate profit margin.
  1. Should a small exception or threshold apply?
  1. In response to Question 6, we would advocate a “de minimis” or “safe harbour” level of interest deductions that would not fall within the proposed limitation, to reduce  the compliance burden for smaller companies and focus attention on situations where the potential tax risks are greater. Any such exclusion should be as simple as possible to apply.
  2. One alternative might be to exempt smaller enterprises that satisfy objective criteria: for example, within the EU definition of a small or medium sized entity, which takes into account annual turnover, assets and employees, and includes related enterprises. An alternative might be to accept that the new limitation will not apply if a company’s annual net finance deductions are below a defined level: for example, £1m or €1m or US$1m or equivalent.
  3. It would be possible to combine safe harbours of this  kind, to focus the new limitation only on larger companies or (companies in larger groups) which have substantial interest deductions, where the perceived risks are greater.
  1. Whether interest deductions should be limited with reference to the position of an entity’s group
  1. Group tests risk eroding the principle of taxing each entity separately and on its own merits: in paragraph 66 on page 28, the Discussion Draft acknowledges that “countries introducing a group-wide rule may no longer be concerned about the pricing of individual intragroup instruments”.We should be slow to cast aside long-standing and well- understood principles, such as treating entities individually with transfer pricing transactions between related parties on an arm’s length basis.
  2. Group-wide tests are also liable to ignore the different funding needs of, and costs of capital for, separate businesses in different sectors within a single diversified corporate group.  The proposals appear to involve unfair penalisation of more capital-intensive businesses, which might require proportionately more debt funding than the group as a whole, but will only be able to claim a pro rata share of debt deductions.
  3. It is also not clear to us why borrowing from a related company which has the cash resources available, on a fully arm’s length basis, should be less acceptable than the equivalent borrowing from a third party.  Such tests have the potential to encourage increased levels of third party borrowing rather than equity funding, or at least give tax benefits to groups with higher gearing, and to encourage an increase in borrowing to ensure that the maximum capacity is utilised in each jurisdiction.
  4. Group companies may also find their interest capacity constrained due to factors entirely beyond their control, such as volatility in exchange rates used to translate the finance expense on third party borrowings by affiliates in other currencies, or volatility in interest rates paid by affiliates on third party borrowings in other jurisdictions.
  5. All that said, if a group test is adopted, it should be as simple to implement as possible, using information that is already available (such as consolidated accounts) with as few adjustments as possible. However, this approach does to some extent involve delegating control over the deductibility of debt expenses to the accountants who draw up the relevant accounts, and the setters of the relevant accounting standard.
  6. It is notable that the leading proposal is a “one-way” cap, to deny debt deductions which are “excessive”, without allocating the denied deductions to other members of the group that would be entitled to claim the denied deductions but, in fact, do not have borrowings.  The practical result might be that all group companies in high-tax jurisdictions will borrow as much as possible from affiliates in low-tax jurisdictions, so they are all subject to the proposed cap to some extent but do not miss out on any deductions that might be available.
  1. Whether interest deductions should be limited with reference to a fixed ratio
  1. The main advantage of fixed ratios is that they are relatively simple to operate, particularly if they are based  on information relating to the relevant company rather than the wider group. But simple fixed ratios can be relatively crude instruments if they do not take account of the particular circumstances of a company, its business, and the sector in which it operates.
  1. Whether a combined approach could be applied
  1. As mentioned above, if a group test is adopted, we would recommend a form of combined approach, with carve-outs or safe harbours for smaller companies and/ or companies with low net interest expense, similar to Approach 1, and group-wide tests for other companies .We do not advocate a fixed ratio test of the sort proposed in Approach 2, which are liable to be simple but crude.
  1. The role of targeted rules
  1. As mentioned above, we expect that countries will still want to set the precise perimeter of tax-deductible finance costs, and will impose their own targeted rules to tackle areas of difficulty that they have identified. It is to be hoped that the wider adoption of more general rules will reduce uncertainty, and will reduce the need for specific or targeted rules. However, experience suggests that tax authorities and governments will be reluctant to remove rules that target particular behaviours and rely instead on general rules, until at least those general rules have been shown to be effective in practice.
  2. In our view, the OECD should not be proposing targeted rules to deny debt deductions under Action 4
  1. The treatment of non-deductible interest expense and double taxation
  1. On question 32 and 33, we would support an indefinite carry forward of disallowed interest expense or unused interest capacity to future periods. We do not see a rationale for imposing a time limitation on the carry forward of denied deductions or the carry forward of available interest capacity.
  2. For disallowed finance expense, an affected company  will have actually incurred the commercial expense, and should be allowed to claim the tax benefit of that expense

in later periods to the extent that spare borrowing capacity, below the proposed cap, is available. Similarly, low-geared companies within a group that has higher gearing overall should not be penalised by losing all ability to claim debt deductions within the unused capacity.  Such measures will in particular prevent unfairness caused by volatility and timing differences between recognition of expenses and receipts.

  1. Specific sectors

  1. With regard to question 33 and 34, we agree that special attention is required to capital intensive sectors, where special regimes may apply, such as banks and insurance companies and other financial businesses, oil and gas, and real estate.
  2. We note the concern expressed about the potential impact of Action 4 on the viability of highly-geared public infrastructure projects. No doubt businesses in other sectors would express similar concerns.
  1. Interaction with other areas in the BEPS Action Plan
  1. We agree that the rules on hybrid mismatch arrangements under Action 2 should apply first, before any limitation under Action 4. It is hard to comment on the interaction  of Action 4 with proposals on CFCs until the Action 3 proposals they are published.
  2. Transfer pricing remains a critical component on determining the level of debt deductions that should be permitted.