On 11 February 2015 the OECD published on its website comments received from interested parties in respect of the discussion draft on interest deductions and other financial payments, corresponding to action 4 of the OECD/G20 action plan on base erosion and profit shifting (BEPS). The OECD will hold a public consultation on the issues on 17 February 2015 at the OECD Conference Centre.

Action 4 of the BEPS action plan aims to limit base erosion that takes place through interest and other financial payments. Recommendations will be developed on dealing with the use of related party or third party debt to obtain excessive interest deductions or to finance tax-exempt income within a group, including the use of financial payments that are economically equivalent to interest. The Working Party also intends to develop transfer pricing recommendations on the pricing of related party financial transactions.

Discussion draft

On 18 December 2014 the OECD published a discussion draft on interest deductions and other financial payments. Tax deductible payments such as interest can give rise to double non-taxation. Interest payments can reduce the profit of a taxpayer even though the whole group may have little external debt. From the outbound point of view a company may produce tax exempt or deferred income and thereby create a mismatch between the tax deduction in one jurisdiction and the tax exempt income in another.

The OECD Working Party has looked at the best practice currently used by countries to combat profit shifting by this method. The consultation document therefore set out options for types of measure that could be used to combat tax avoidance through financial payments.

The discussion draft looked at what is interest and what are payments equivalent to interest, and who the legislation should apply to. It also looked at the question of whether the new rules should apply to the level of debt or to the interest expense itself, and whether the gross or net position should be considered. The draft looked at whether interest payments should be limited by reference to the position of the group to which the entity belongs or whether it should be limited by reference to a fixed ratio, or perhaps a combined approach could be taken.

The discussion draft also considered:

• The role of targeted rules;

• A small entity threshold;

• The treatment of non-deductible interest expense and double taxation;

• Considerations for groups in specific sectors; and

• Interaction with other areas of the BEPS action plan.

As mentioned above there will be interaction with the parts of the BEPS action plan concerned with transfer pricing and with other actions such as those concerned with hybrid mismatch arrangements, controlled foreign companies and prevention of treaty abuse.

Comments received

Reponses to the discussion draft were received from around one hundred commentators from industry, professional firms and trade organizations. There is a general view among commentators that the proposals in the discussion draft would go beyond limiting base erosion and would affect legitimate and necessary business financing activities. Financing activities are essential for commercial success and involve legal issues, credit risk, currency risk, and consideration of exchange controls and transaction costs. Tax considerations are only one factor to be taken into account and the proposals put forward would have the effect of denying tax deductions for legitimate financing costs that are incurred for reasons that have nothing to do with tax avoidance or base erosion.

Although the OECD discussion draft states that a group should be able to obtain a tax deduction for all its third party financing costs, the effect of the main tests proposed in the discussion draft is that some of these third party costs would not be deductible. This would be a brake on business activity that could affect economic growth globally. Global tests do not take into account the fact that groups cannot allocate debt around their various entities in the way that tax authorities would require them to.

It is difficult for business reasons to locate finance in a country where activity is on a small scale. There is also a problem with placing financing in an associated company that has minority interests, as often happens in the emerging and frontier economies. The allocation of debt around the group will not therefore match economic activity or profits in each country where the group operates, owing to commercial reasons. Company law restrictions, exchange controls and withholding taxes also make it difficult to place debt in some countries.

Tests that restrict interest deductions on the basis of a global, group-wide test are seen by some commentators as complex and time-consuming to administer, increasing compliance costs for the taxpayer and tax administration. This could even provide the group with an incentive to increase their overall external debt for tax reasons which would not be a good business outcome.

If a fixed ratio approach is taken looking at just the jurisdiction in which the taxpayer operates then the interest to EBITDA ratios need to be sufficiently high that they do not impact on legitimate business activities. The fixed ratio approach may not be appropriate to all industrial sectors and the OECD work must take this into account. The ratio would need to take into account different industrial sectors, debt taken out in different currencies that could have different interest rates, and allow for changes in interest rates. Although not considered in the discussion draft the real estate sector and the private equity industry both have high rates of third party debt and this has nothing to do with base erosion.

The commentators make the general point that debt is preferable for financing new ventures for legal, regulatory and commercial reasons. It is flexible and repayable, and cross-border on-lending is a flexible tool for new ventures or acquisitions. The solutions proposed by the discussion draft would increase uncertainty and inhibit new commercial ventures. Commentators appear to lean towards the idea that the fixed ratio rule taking into account the jurisdiction where the taxpayer is based is more realistic, but attention must be given to ensuring that the ratio is not too restrictive. There must be separate consideration of capital intensive businesses.