On 11 July 2016 the OECD released a discussion draft on the operation of the group ratio rule under Action 4 of the project on base erosion and profit shifting (BEPS). Comments are invited from interested parties by 16 August 2016.
The BEPS report on Limiting Base Erosion Involving Interest Deduction and Other Financial Payments under BEPS Action 4 looked at a common approach to combating base erosion involving interest and payments economically equivalent to interest. The common approach uses a fixed ratio rule to limit the net interest deductions to a fixed percentage of earnings before interest, tax, depreciation and amortization.
The report on Action 4 also suggested that countries could consider a group ratio rule to allow entities in highly leveraged groups to claim a tax deduction in excess of the amount permitted under the fixed ratio rule. The excess deduction would be calculated on the basis of a relevant financial ratio for the worldwide group. The report on BEPS Action 4 set out an outline of the main elements of the design and operation of the group ratio rule with a view to further work being done on the issue.
The further work now being conducted therefore concerns approaches to calculating a group’s net third party interest; a definition of group EBITDA; and the impact of losses on the operation of the group ratio rule. It should be noted however that countries may also apply a group ratio rule based on another relevant financial ratio of an entity’s worldwide group, such as a different ratio of net interest to earnings or equity to total assets. There are however benefits from application of the group ratio rule by all countries in a consistent manner.
Calculation of net third party interest
Calculation of the net third party interest expense should be based on the group’s consolidated financial statements prepared under International Financial Reporting Standards (IFRS). The report notes three ways of using these figures to determine the net third party interest expense:
- Using the interest income and expense figures from the consolidated income statement without any adjustment;
- Using interest figures from the consolidated income statement with adjustments for items included in the definition of interest and payments economically equivalent to interest as set out in Chapter 2 of the report on BEPS action 4; and
- Identifying the income and expense items falling within the definition of “interest and payments economically equivalent to interest” as set out in Chapter 2 of the BEPS report on action 4 and measuring them based on their treatment in the consolidated financial statements.
The discussion draft considers these approaches in more depth and sets out the issues on which comments are invited. Commentators are asked to suggest any further practical issues with use of the three approaches in addition to those mentioned in the discussion draft, and to suggest how these issues could be dealt with. Interested parties are also asked to comment on issues arising if countries are allowed to apply any of the three approaches.
Some adjustments may need to be made in the case of some approaches. For example in the case of approaches 2 and 3 there may need to be adjustments to net third party interest expense to reflect particular policy goals. There may be practical issues preventing a group aligning net interest expense and EBITDA. There may be some payments that are of interest or similar to interest but are not tax deductible under the law of the particular country, and the calculation of the group ratio would need to be adjusted for these. There is also the issue of interest paid to related parties that are not treated as part of the group where adjustments may therefore be needed.
Adjustments are also needed to take into account the group’s third party interest expense of an associate or joint venture. In this case the interest itself would not appear in the consolidated income statement but the group ratio would take into account the share of the earnings of the related party. To avoid disadvantages to groups with such related parties an adjustment is required; but this adjustment should be optional as the compliance costs could outweigh the benefits for some groups.
Interested parties are asked to consider any further practical issues raised by the adjustments other than those discussed in the draft and if there are any further areas where a country’s tax policy should be taken into account in calculating the net third party interest expense. The draft also asks for suggestions of any further situation where net third party interest expense should be adjusted to include interest income or expense from outside the group.
Definition of group EBITDA
The group EBITDA is found by deducting interest, tax, depreciation and amortization from group earnings. The consultation document notes that consideration is needed of items to be included in the adjustment for interest income and expense and the adjustment for depreciation and amortization. The treatment of dividend income, the group share of profits of an associate or joint venture, and of non-recurring items also needs to be considered. Comments are invited on any practical issues arising from these adjustments and how they could be addressed.
Impact of losses
The report on BEPS Action 4 pointed out loss-making entities in the group (with a negative EBITDA) would have an impact on the group ratio rule. A group may have a positive EBITDA but with some loss-making entities or it may have a negative EBITDA. The consultation document sets out ways of dealing with these situations and asks for views on practical issues raised and how to deal with them.
