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Earning Stripping Rules

Earning Stripping Rules

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Earning Stripping Rules

A significant Budget 2018 announcement potentially affecting many corporates, is the Earning Stripping Rules (“ESR”).  The Prime Minister has announced that the ESR, advocated by the Organisation for Economic Cooperation and Development (“OECD”), will replace the existing thin capitalisation legislation which has been in abeyance since 2009. 

The ESR will be effective from 1 January 2019.

What is ESR?

ESR is relevant for companies with interest expense.  ESR is a method endorsed by the OECD to limit tax deductions for interest expenses and is one of the OECD’s action plans under the Base Erosion Project Shifting (“BEPS”) strategy. 

Broadly, the amount of interest to be restricted is ascertained by a ratio to be determined, ranging from 10% to 30% of the company’s profit before tax using either Earnings Before Interest and Taxes (“EBIT”) or Earnings Before Interest, Tax, Depreciation and Amortisation (“EBITDA”).  The OECD has suggested that there could also be an additional group ratio calculated with reference to a group’s third party interest expense.  This would help to cater for groups in industries where high gearing is more common. 

Interest in excess of the prescribed ratio will not be deductible in the year it is incurred.  The OECD report raises the issue of whether the excessive interest can be carried forward to later periods or carried back and claimed as a deduction if there is unused capacity in those years.

ESR versus Thin Capitalisation

ESR has similarities with thin capitalisation, as both essentially centre on whether the amount of debt and hence interest deduction is excessive.  Thin capitalisation determines the issue of excessiveness by reference to a debt to equity ratio.  Under ESR, excessiveness is determined by referencing the quantum of a company’s interest expense to its profit before tax. 

Both ESR and thin capitalisation are in contrast to transfer pricing which looks at whether the rate of interest is excessive.

What Now?

It is envisaged that the Ministry of Finance will need to draft legislation to implement the ESR.  This legislation is likely to be complex; the OECD report in which ESR is endorsed is 120 pages long. 

A key aspect will be the ratio and whether this will be fixed or will include group ratios.  Also the extent to which ESR will be limited to related party debt needs to be understood.  It is hoped that there will be a consultation phase although this is uncertain.

Steps to be Taken in Anticipation of ESR

In view of this proposal, corporates should review their debt to EBIT or EBITDA profiles to consider whether a limitation on the tax deduction for interest expense is likely.  At this stage it is unknown whether there will be any grandfathering provisions.

If you wish to discuss the potential impact of ESR for your company, please don’t hesitate to reach out to us via email or call (603) 7721 3388.

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