OECD: Impressions of discussion draft (BEPS Action 4) | KPMG | GLOBAL

OECD: Initial impressions of discussion draft (BEPS Action 4)

OECD: Impressions of discussion draft (BEPS Action 4)

The Organisation for Economic Co-operation and Development (OECD) yesterday released a discussion draft on Action 4 (Interest deductions and other financial payments) under the base erosion and profit shifting (BEPS) Action Plan.


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The BEPS Action 4 discussion draft [1.14 MB] is one of six BEPS releases* this week.

*The other items were discussion drafts addressing (1) commodities transfer pricing issues, (2) the use of the profit split method in transfer pricing with respect to global value chains, (3) changes to the OECD’s transfer pricing guidelines to address risk, recharacterisation, and special measures, (4) potential improvements to treaty dispute resolution mechanisms, and (5) international VAT/GST guidelines.


The aim of BEPS Action 4 is to identify solutions to address base erosion arising from interest and economically equivalent payments. In this regard, the primary concern expressed in the BEPS Action 4 discussion draft (Discussion Draft) appears to be that multinational groups may be able to claim total interest deductions that significantly exceed their actual third-party interest expense.

As discussed in more detail below, the Discussion Draft describes a consensus approach to:

  • Focus on related party and otherwise structured financing regimes
  • Proscribe rules that are triggered based on interest expense, and not on an amount of debt
  • Limit those rules to net interest expense, and not gross interest expense

In implementing these principles, the Discussion Draft describes two main approaches to limit the deductibility of interest expense (and a third approach that is a combination of the first two), and solicits comments from stakeholders regarding those approaches.


Payments - The Discussion Draft states that to address this issue appropriately, a rule must apply not only to interest but also to payments that are economically equivalent to interest, as well as other expenses incurred in connection with the raising of finance. Some examples in this regard include: profit participating loans; imputed interest on convertible or zero-coupon bonds; foreign exchange gains and losses connected with the raising of finance; guarantee fees with respect to financing arrangements; and loan arrangement or similar fees.

Parties - The Discussion Draft recommends that the rule apply to companies and other entities in three different scenarios: (1) when they form part of a corporate group; (2) when they are under common control, but are not part of a corporate group (for example, when a fund, individual or trust exercises the common control); and (3) when the parties are (otherwise) related, using a 25% common ownership test, or in the case of a structured arrangement. This scoping rule is similar to that used in the Action 2 Hybrid Mismatch Report released by the OECD in September.

Small entity exception - The Discussion Draft ultimately does not recommend a de minimis threshold, although many countries already have such a provision. The Discussion Draft does suggest, however, that if a country wishes to include such a provision, the better option is to apply a monetary threshold based on an amount of net interest expense, with related parties treated as one, to prevent avoidance through the “atomising” of operations, as opposed to a threshold based on the entity’s size.

Approaches under consideration

The BEPS Action 4 discussion draft sets forth three principal frameworks for a general limitation on the deductibility of interest expense.

Limitation based on the worldwide group - Under this framework, an entity’s net interest expense would be limited by reference to its allocable share of the group’s net interest expense, either by proportionately allocating group capacity by reference to an economic indicator (such as earnings or asset values), or based on a group ratio that compares, for example, the entity’s net interest vs. earnings to the group’s overall ratio of net interest vs. earnings.

Limitation based on a fixed ratio - Under a fixed-ratio framework, an entity would be entitled to deduct net interest expense up to a specified proportion of its earnings, assets or equity. For example, the current U.S. section 163(j) rules use this method through the 50% of adjusted taxable income limitation. For purposes of determining the appropriate limitation under this approach, the Discussion Draft notes a perception that even the lower 25% and 30% ratios currently used by other countries may be too high to address BEPS concerns.

Combined approach - This framework describes two approaches that combine elements of the foregoing, each of which includes a general rule and then a carve-out from the general rule.

  • “Approach 1” is a general group-wide interest allocation rule with a carve-out for entities meeting a low fixed-ratio test, to help alleviate the compliance costs in lower-risk situations.
  • “Approach 2” is a fixed-ratio rule with a carve-out for entities that may permit them to deduct additional interest expense when the group’s overall ratio exceeds the standard fixed ratio.

The Obama Administration’s FY2015 “Greenbook” budget proposal contained a “combined approach” rule based on a general worldwide group limitation, with an alternative cap set at 10% of the U.S. taxpayer’s section 163(j) adjusted taxable income.

Targeted rules

In addition to the general limitation frameworks (described above), the Discussion Draft suggests that targeted rules may be needed to address specific interest disallowance situations, such as for interest paid to connected or related parties; interest accrued on excessive debt push-downs; and interest used to fund or acquire tax-exempt or tax-deferred income-yielding assets. The Discussion Draft does not recommend any specific targeted rule, and instead presents such inclusion as a discussion point.

Specific industries

The Discussion Draft acknowledges the special issues presented by banking and insurance companies, and suggests separate rules apply in that context because the proposed general rule (focused on net interest expense) will not be effective at addressing BEPS concerns for financial companies.

Consideration will also be given to other sectors such as those taxed under special regimes (e.g., natural resources); infrastructure; and non-bank or insurance financial companies (including asset management, leasing, and credit card companies).

Approaches that were rejected

The Discussion Draft discusses several other types of interest expense restrictions currently in use, and rejected these approaches as the basis for a best practice rule.

Specifically, the delegates decided that a fixed debt-to-equity ratio test is not to be included because of perceived manipulability and efficacy concerns. Furthermore, the delegates agreed not to recommend an arm’s length test as the sole general rule. Although financial transactions are, of course, typically subject to transfer pricing rules, specific interest expense restrictions based on arm’s length measures were considered likely to be ineffective and/or burdensome to apply and enforce. The imposition of withholding taxes on interest payments was also rejected as a solution in part because the EU’s Interest and Royalty Directive would make it very difficult for EU member states to impose withholding tax on interest payments made within the EU.

The Discussion Draft does note, however, that each of these provisions can play a useful role within an overall approach.

Interaction with other BEPS action items

The Discussion Draft acknowledges the interaction of any limitations on interest expense with many of the other BEPS action items, including Action 2 (hybrid mismatch arrangements), Action 3 (CFC rules), and Action 4 (transfer pricing guidance for related-party financial transactions). The Discussion Draft generally focuses on the need for coordination between the action items and does not rank the overlapping solutions.

Next steps

Comments are due on the Discussion Draft by 6 February, 2015. The recommendations ultimately agreed upon with respect to Action 4 will be delivered to the G20 Leaders and Finance Ministers in late 2015, along with other 2015 BEPS deliverables.

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