International debt shifting is rife, with multinational groups leveraging greater debt in subsidiaries located in high tax jurisdictions, thereby reducing their international tax incidence.
In October 2015, the OECD BEPS Action 4 Report on Limiting Base Erosion Involving Interest Deductions and Other Financial Payments (Report) was released setting out a common approach to address BEPS involving interest and payments economically equivalent to interest. The Report included a `fixed ratio rule' which limits an entity's net interest deductions to a set percentage of its tax earnings before interest, taxes, depreciation and amortisation (tax EBITDA) and a `group ratio rule' which permits an entity to claim higher net interest deductions, based on the financial ratio of its worldwide group.
To elaborate briefly, BEPS Action 4 emphasises the need to address BEPS through the use of deductible payments such as interest (particularly related and/or connected party interest) and other financial payments economically equivalent to interest. The use of deductible payments such as interest to achieve inter-jurisdictional profit shifting is one of the simplest and most effective weapons in the international tax planning armoury. Multinational groups take advantage of the heterogeneity of tax deduction rules by reallocating debt to high tax jurisdictions. International debt shifting is rife, with multinational groups leveraging greater debt in subsidiaries located in high tax jurisdictions, thereby reducing their international tax incidence. Accordingly the leverage of a multinational group is acutely sensitive to a jurisdiction's tax rate, and fiscal authorities are confronted with ever diminishing corporate tax receipts from multinationals that employ excessively high leverage and concomitant interest deductions. Further, research indicates that developing countries are more susceptible to the adverse impact of debt shifting than developed countries.
The mobility and fungibility of money facilitates the easy intra-group manipulation of the combination of debt and equity. It is due to the above stated facts that BEPS Action 4 emphasises the need to address BEPS through the use of such deductible payments, which practice has the potential to facilitate double non-taxation in both inbound and outbound investment scenarios.
In the main, BEPS risks arise within the context of interest deductibility in three scenarios:
- multinational groups placing higher levels of third-party debt in high tax jurisdictions;
- multinationals using intra-group loans to generate interest deductions in excess of the relevant group's actual third-party interest expenditure; and
- multinationals using third-party or intra-group financing to generate tax exempt income.
As stated above, the Report's recommended approach to address these BEPS risks is based on a fixed ratio rule which limits an entity's net deductions for interest and payments economically equivalent to interest to a percentage of its tax EBITDA. As a minimum this ratio should be applied to all entities within a multinational group. To ensure that countries apply a benchmark fixed ratio that is low enough to combat BEPS, while recognising that jurisdictions are not all in the same position from a leveraging or economic perspective, the recommended approach includes a band of possible ratios ranging from 10% to 30%. The Report also includes factors to be taken into consideration by a country when determining the appropriate benchmark fixed ratio. Factors which may lead a country to consider applying a higher benchmark fixed ratio rule include circumstances where the jurisdiction in question:
- operates the benchmark fixed ratio in isolation as opposed to in conjunction with a group ratio rule;
- does not permit the carry forward of unused interest or the carry back of disallowed interest expenditure;
- applies other targeted rules that specifically address BEPS risks as envisaged under Action 4;
- has higher interest rates relative to other countries (as does South Africa); or
- is required to apply the same treatment to different types of entities which are considered legally comparable even if those entities pose varying levels of BEPS risks (eg in the EU where legal requirements prescribe parity of treatment for legally comparable entities).
The Report also proposes the introduction of a group ratio rule in conjunction with the fixed ratio rule to allow an entity within a highly leveraged multinational group to deduct net interest expenditure in excess of the amount permitted under the fixed ratio rule, based on the relevant financial ratio of its worldwide group. In effect the group ratio rule entitles an entity to deduct net interest expenditure up to the net third-party interest expenditure/ EBITDA ratio of its group. The OECD issued a further Public Discussion Draft: BEPS Action 4 Elements of the Design and Operation of the Group Ratio Rule on 11 July 2016, calling for responses by 16 August 2016. We await the outcome in due course.
On 28 July 2016 the OECD released a further Public Discussion Draft: BEPS Action 4 Approaches to Address BEPS involving Interest in the Banking and Insurance Sectors (Discussion Draft), which is the core focus of this article.
To contextualise the Discussion Draft, we need to review the Report's treatment of the banking and insurance sectors. The Report acknowledges that certain sectors, due to their uniqueness, require dedicated scrutiny, hence the release of the Discussion Draft since the Report provides that countries may exclude entities in banking and insurance groups, and regulated banks and insurance companies in non-financial groups from the ambit of the fixed ratio rule and the group ratio rule.
The Report identifies banks and insurance companies as presenting unique issues that are not present in other sectors. Interest expenditure is typically the largest cost on a bank's income statement. As such any rule limiting the deductibility of gross interest expenditure will have a significant impact on a bank's business model. Generally for insurance companies, interest expenditure will be considerably less, the largest costs on insurance companies' income statements being policy benefits and claims. Banks and insurance companies both provide debt finance to groups in other sectors, either as lenders or investors in corporate bonds. As such they will generally be recipients of net interest income. A rule which caps net interest expenditure will not bear directly upon banks or insurance companies, although such a provision could limit the deduction of net interest expenditure in other group entities.
The Report observes further that the role interest performs in the banking and insurance sectors, differs from its role in other sectors. The nexus between interest expenditure and a bank's or an insurance company's income-generating capacity is much stronger than in other sectors. Financial sector businesses are generally subject to strict regulations which impose limitations on their capital structure and their ability to place debt in certain group entities. Basel III introduced a risk mitigation leverage ratio in 2011 to constrain leverage in the banking sector. In addition banks are subject to commercial constraints from credit rating agencies. The Report concludes that a specific rule would have to be designed to manage the BEPS risks presented by banks and insurance companies. One possibility the Report proposes, would entail focussing on the net interest expenditure attributable to regulatory capital instruments which perform a role comparable with debt in other sectors. A group-wide interest allocation rule could be formulated to limit a group's total net deductions on its regulatory capital to the amount of interest expenditure incurred on such instruments to third parties. The interest cap could be allocated within a group in accordance with regulatory requirements. Alternatively if existing regulatory requirements are found to limit excessive leveraging in groups, the Report suggests a best practice approach to hone in on a group's interest expenditure incurred other than in respect of its regulatory capital. This the Report observes, may require targeted rules to address risks presented by specific transactions.
The Discussion Draft does not change any of the conclusions agreed in the Report, but provides a more detailed consideration of the BEPS risks banks and insurance companies pose, as well as the BEPS risks posed by entities in a group with a bank or an insurance company, such as holding companies, group service companies and companies engaged in non-regulated financial or non-financial activities.
The Discussion Draft notes the significant differences between the business models, structures, financing and regulation of banking and insurance groups. Consequently it does not propose or anticipate that a country will apply equivalent interest deductibility limitations, if appropriate, to both groups.
While performing preparatory work on the Discussion Draft, several jurisdictions identified financing structures employed by banking and insurance groups which pose Action 4-type BEPS risks. The main BEPS risks involving interest were found to include:
- banks or insurance companies and entities in a group with a bank or an insurance company, using third-party or intra-group interest to fund equity investments which generate income which is either tax exempt or taxable at preferential rates; and
- entities in a group with a bank or an insurance company incurring excessive third-party or intra-group interest expenditure, which may be deductible against taxable interest income in the bank or insurance company within the group.
The Discussion Draft finds that the risk of BEPS involving excessive interest deductions is generally posed by entities in a group with a bank or an insurance company, rather than by banks or insurance companies themselves. The Discussion Draft postulates that this may be due, at least in part, to the regulatory capital rules which require minimum amounts of equity to be held and restrict the amount of leverage in a single regulated entity. Although the regulatory capital rules are intended to ensure that the leverage of a bank or an insurance company doesn't render it capitally inadequate in the face of financial or economic shocks; it may be that the rules serve a dual purpose by producing an appropriate outcome from a tax perspective too.
Accordingly, for banks and insurance companies, a limited BEPS risk has been identified in the Discussion Draft.
For other entities in a banking or an insurance group, the Discussion Draft identifies a greater BEPS risk and recommends that countries consider applying the fixed ratio rule and group ratio rule to these entities, duly modified as appropriate in the specific circumstances. In each case, flexibility is provided for a jurisdiction to take cognisance of the particular features of its tax law and policy.
The Committee on Fiscal Affairs (CFA) has called upon interested parties to submit comments on the Discussion Draft by 8 September 2016. We await the release of the CFA's final report in due course.