On 22 December 2016 the OECD released more guidance on action 4 of the action plan on base erosion and profit shifting (BEPS). The latest guidance is an updated version of the report providing more detail on the measures outlined in the BEPS report including more information on the operation of the group ratio rule. It also looks at the application of action 4 to the banking and insurance sectors.

The approach recommended by the BEPS report is a restriction on the tax deduction for interest based on a fixed ratio rule applied to EBITDA (earnings before interest, tax, depreciation and amortization). The tax deduction for interest and payments economically equivalent to interest would be limited to a percentage of EBITDA. The approach recommended by the BEPS report suggested that the ratio applied should be between 10% and 30% and the report suggested factors to be taken into account by countries when setting the percentage level.

The fixed ratio rule can be supplemented by a rule that relates to the worldwide group and this would allow the limit imposed by the fixed ratio rule to be exceeded in certain cases. The fixed ratio rule alone would be unnecessarily restrictive where a multinational group has to take on high levels of third party debt for non-tax reasons. Therefore a group ratio rule would apply where an entity within a multinational group has interest expense exceeding the fixed ratio.

Under the group rule the entity would be permitted an interest deduction up to the level of the net interest/EBITDA ratio of the worldwide group. To prevent double taxation national legislation would be permitted to apply a 10% uplift to the group’s net third party interest expense.

Countries would also be permitted to introduce different types of group ratio rule. The permitted rules include the “equity escape” rule that looks at the level of equity and assets in the entity and compares this to the equity and assets in the worldwide group. Countries would also be able to introduce just a fixed ratio rule without a group ratio rule.

Countries introducing the fixed ratio and group ratio rules would be permitted to supplement them with other measures such as a de minimis threshold for entities with low net interest expense; an exclusion for interest paid to third parties on loans for public benefit projects; or a provision to carry forward disallowed interest expense (or carry forward unused interest capacity where interest payments are below the permitted threshold in a particular year). There would also be a need for targeted anti-avoidance provisions to prevent artificial reduction of interest expense by taxpayers.

In the case of banking and insurance groups the regulatory rules limit the extent to which they could engage in BEPS activities involving interest. However the regulatory rules are different in different countries. The draft therefore notes that countries should look at the characteristics of banking and insurance groups and the requirements of regulators in drafting their legislation. If there are no material risks they could exempt banking or insurance groups from the fixed ratio rule and group ratio rule. If they identify BEPS risks they can introduce rules that deal with these risks taking into account the regulatory regime and tax rules already in place.

The tax deduction available for interest payments is also affected by transfer pricing rules. The OECD intends to perform further work during 2017 on the transfer pricing issues relating to financial transactions.