What has happened?
On 5 October 2015, the OECD issued its final report on BEPS Action 4 – Limiting Base Erosion Involving Interest Deductions and Other Financial Payments (Paper).
In this Alert we consider the main issues, recommendations and options for taxation reform raised in the Paper and consider the current Australian rules, and impact of the OECD paper if adopted in Australia.
Background - considering Australia's current rules
The purpose of Action 4 is to address base erosion and profit shifting by the use of third party and related party interest. The Paper identifies the generation of excessive interest deductions or financing of exempt or deferred income with deductible debt as 'one of the most simple of the profit-shifting techniques available in international tax planning'. While the Paper notes that within domestic tax systems, income from debt and equity instruments may be subject to similar rates of overall taxation, the difference in the treatment of the payer 'creates a tax-induced bias, in the cross-border context, towards debt financing'. This bias is compounded where the payee pays little or no tax on receipt of the interest income.
Many jurisdictions already have a number of integrity rules to prevent excessive interest deductions.
Australia, for example, has a comprehensive thin capitalisation regime in Division 820 of the Income Tax Assessment Act 1997 (Cth) (ITAA97). The Australian thin capitalisation safe harbour rules are currently an example of a fixed ratio based on the debt/equity of the test entity. Although the best practice approach set out in the Paper is a variation of the Australian approach, the Paper specifically considers and dismisses the debt/equity fixed ratio approach.
It is acknowledged that the debt/equity fixed ratio approach is relatively simple to apply. However, the Paper notes that the approach still provides significant flexibility in terms of the rate of interest an entity could apply. The Paper also concludes that because the debt/equity fixed ratio approach permits entities with higher equity to borrow more, it makes it relatively easy for a group to manipulate the outcome of such a test by increasing the level of equity in a particular entity.
The Paper sets out a 'best practice approach' which should be applied to both external and internal debts and which should be supplemented by specific integrity rules to address any tax planning strategies which are not addressed by the suggested best practice approach. The Paper notes, however, that it is desirable that the general rule be designed in such a way as to limit the need for complex integrity rules.
Existing approaches considered in the Paper
The Paper identifies the following 6 existing approaches to tackle base erosion and profit shifting involving interest deductions or other financial payments:
- Arm's length tests, which compare the level of interest or debt in an entity with the position that would have existed had the entity been dealing entirely with third parties;
- Interest withholding taxes;
- Rules which disallow a specified percentage of the interest expense of an entity
- Rules which limit the level of interest expense or debt in an entity with reference to a fixed ratio, such as debt/equity
- Rules which limit the level of interest expense or debt in an entity with reference to a group's overall position; and
- Targeted anti-avoidance rules which disallow interest expense on specific transactions.
The Paper considers and rejects the first three approaches.
The arm's length tests are considered too resource intensive and uncertain. While the Paper acknowledges that interest withholding taxes can reduce the benefit of base erosion, unless the rate of withholding tax matches the corporate rate, there is still a benefit available.
On the other hand, imposing or increasing interest withholding tax may be difficult, especially given the number of bilateral treaties which reduce the interest withholding tax rate, as well as the Interest and Royalty Directive within the European Union.
Finally, a rule which disallows a specified percentage of the interest expense of an entity is not seen as effective at tackling base erosion, but rather imposing an additional cost on debt.
The recommended approach in the Paper – fixed ratio rule
The best practice approach recommended by the Paper is a combination of the final three approaches above. The critical objective of the work on Action 4 is to identify a coherent and consistent approach that provides an effective solution to the risks countries face from base erosion using interest and payments economically equivalent to interest. The approach must be straightforward but robust against planning to avoid or reduce its application or effect.
The Paper concludes that a best practice approach is based around a fixed ratio rule, which limits an entity's net interest deduction (or deduction for net costs economically equivalent to interest) to a fixed percentage of its profits, measured using the Earnings Before Interest Tax Depreciation and Amortisation (EBITDA).
The key features of the fixed ratio rule addressed in the Paper are addressed below.
(1) Application and de minimis threshold
As a minimum, the Paper recommends that the best practice approach apply to all of the entities in a multinational group. This is defined as all of the entities that are commonly controlled (directly or indirectly) where the group operates in more than one jurisdiction, including through permanent establishments. Though the concept of control is not further discussed, it will be an important aspect of limiting the scope of the application of the rule.
The fixed ratio rule could also apply to members of domestic groups and standalone entities. In these circumstances, the rules may be applied for other tax policy reasons, for example, to prevent a tax bias in favour of debt or to prevent a more favourable treatment of domestic over foreign controlled entities.
The Paper also recommends that a de minimis threshold based on net interest expense to exclude low risk entities from the scope of these rules. Anti-fragmentation and grouping rules are recommended to ensure that the de minimis thresholds are not abused.
In Australia, the current thin capitalisation rules apply to foreign controlled and outbound investors, though there are specific de minimis concessions available to Australian outbound investors that are not available to inbound investors. Both outbound and inbound investors are not subject to thein capitalisation in Australia where total debt deductions of an entity and its associate entities is less than $2 million.
(2) Fixed ratio should relate to net interest expense and not to the level of debt
The Paper concludes that the best practice approach involves a fixed ratio based on the level of interest expense not the level of debt in an entity.
The Paper concludes that this is preferable for the following reasons:
- base erosion and profit shifting is driven by the level of tax deductible expenses in the entity, not the level of debt;
- a fixed ratio based on debt/equity will need an additional mechanism to prevent base erosion by charging high interest rates; and
- the level of debt can fluctuate in the period and averages can be manipulated.
The Paper also considers whether the fixed ratio should apply to the gross interest expense or net interest expense of an entity or group. The conclusion is that it would be appropriate to use a net interest amount (i.e. interest and economically equivalent expenses paid to external and related parties net of any interest income) to prevent inappropriate double taxation outcomes, but that a specific integrity rule should be enacted to ensure that a company cannot disguise other income as interest income to defeat the operation of the limitation.
Under the best practice approach, interest will be deductible to the extent that the net interest expense to EBITDA is less than the allowable threshold. An earnings based approach was recommended in the Paper for the following reasons:
- earnings is a close proxy to taxable income and value creation;
- an earnings rule is robust against planning, as the deduction limit can only be increased by increasing the income derived in a particular jurisdiction; and
- the definition of earnings can exclude exempt income (e.g. non-portfolio dividends) so that the limit cannot be easily manipulated.
The Paper then considers the most appropriate method of calculating 'earnings' and concludes that the EBITDA is the appropriate measure of 'earnings' in this context, as it is the best guide to whether an entity can meet its interest commitments.
The Paper does not recommend a benchmark rate to be applied to the EBITDA. Rather, the Paper recommends that countries consider the factors set out in the report to arrive at an appropriate benchmark rate within the range of 10% to 30% of EBITDA, which prevents base erosion but also permits commercially driven borrowing activity. Countries could adopt higher benchmark EBITDA ratios where the country:
- does not offer group relief;
- does not offer carry forward/back relief;
- applies other targeted anti-avoidance or integrity rules;
- has higher interest rates; or
- must apply the same treatment to different types of entities for legal or constitutional reasons.
The Paper also acknowledges that the benchmark rate could change depending on the size of the group to which it is applies, economic conditions (e.g. financial crises) and to meet other legitimate non-tax policy aims of the Government (e.g. encouraging infrastructure investment, which requires significant debt capital).
(3) Group ratio relief
The Paper recognises that a fixed ratio rule does not take into account the fact that groups in different sectors may be leveraged differently and that some groups within the same sector may be more highly leveraged. In order to address these concerns, the best practice approach should include a group ratio rule, which will allow an entity that exceeds the entity fixed ratio rule to deduct net interest expense up to the group's net third party net interest to EBITDA ratio. The concept is broadly similar to Australia's existing worldwide gearing ratio under Division 820 of the ITAA97.
There are a number of practical issues identified in the Paper in relation to the operation of a group ratio rule, which will need further technical work in 2016, including:
- Definition of a group – although the Paper appears to endorse a financial accounting approach;
- Determining group net interest expense – the Paper identified a number of alternatives, but appears to endorse an approach based on unadjusted financial reporting figures as the most practical, although the Paper acknowledges that an uplift may be applied to these unadjusted figures to ensure that taxpayers are not adversely impacted by volatility and accounting treatment of certain items;
- Determining EBITDA – there is an issue as to whether the EBITDA should be based on group accounting profit or group taxable income (which would exclude exempt dividends and branch profits). The policy choice between the two alternatives would give rise to different results depending on the book to tax differences for each group; and
- Impact of loss making entities on the EBITDA will need to be considered and rules allowing adjustments for such entities will need to be developed.
(4) Carry forward/back excess capacity
Under the best practice approach, there is no requirement for countries to permit entities to carry forward to carry back disallowed interest expenses or unused interest capacity. However, there is an option for countries to do so, particularly if they set their fixed ratio at a low level and do not provide grouping relief.
While this concept is familiar in Europe, it has not traditionally been used in Australia. The Paper acknowledges that there may be some risk of base erosion from providing this concession, however, these risks are considered to be manageable by introducing integrity rules, including a cap on the number of years carry forward/back permitted, a limit on the amount that can be used or the rate at which it can be used and a continuity of ownership style rule which would reset the carry forward to nil where there is a majority acquisition.
(5) Targeted anti-avoidance
In addition to the fixed ratio and group ratio rules, a best practice approach would include targeted anti-avoidance rules to prevent groups undertaking planning to reduce the impact of the fixed ratio and group ratio rules. The key risks identified in the Paper include planning to convert items from interest into non-interest amounts, entering into arrangements to increase group debt (and consequently the group ratio) and entering into arrangements to split an economic group for the purposes of the group ratio rules.
(6) Specific rules for banking and insurance
The Paper recognises that the banking and insurance sectors have specific features which must be taken into account and notes that further technical work in 2016 will be conducted on specific areas of the recommended approach, including the detailed operation of the worldwide group ratio rule and the specific rules, to address risks posed by banking and insurance groups.
If the proposals in the Paper were adopted, what would be the impact in Australia?
The best practice approach identified in the Paper is markedly different from Australia's existing thin capitalisation regime. The Treasurer's BEPS Press Release on 6 October 2015, suggests that the Australian Government is happy with the thin capitalisation regime, following the amendments to that regime. This may signal that responding to this particular BEPS Action point is not high on the Government's reform agenda.
If the Government were to adopt the recommendations in the Paper, most multinational groups and outbound investors operating in Australia will need to revisit their gearing ratios and financing arrangements to ensure that they comply with the new thresholds. Highly geared entities, including infrastructure entities would also need to consider their position, particularly where a joint venture is established to design and construct an asset and to operate the asset in a securitised PPP model, but there is no wider 'group' or the wider group is not highly geared. In these circumstances, it would be important for Australia to retain its current thin capitalisation securitisation exemption under section 820-39 of the ITAA97.
While not specifically addressed in the Paper, if the Paper was to be further considered in Australia, the focus on base erosion through interest expenses may place a renewed focus in Australia on whether a specific interest deduction under section 25-90 of the ITAA97 is appropriate or should be modified. This is because the policy articulated in the Paper in relation to the fixed ratio and group ratio rules seems inconsistent with the existence of section 25-90.
The further technical work to be carried out in relation to banking and insurance entities would also likely result in proposals which could impact the business of banks and insurance companies deducting debt in Australia if the proposals were adopted in Australia. The nature and impact of these proposals will be clearer once the OECD undertakes further work in 2016.