The reports, endorsed by the G20 Finance Ministers on October 8 and by the G20 leaders at their November 15-16 summit, consist primarily of recommendations for significant policy changes that affect fundamental elements of the framework used by OECD member countries to tax international activities.
These recommendations are designed to be implemented as changes to domestic law as well as through treaty provisions. The OECD has an expectation that the suggested rules will be “implemented accordingly” by the countries that participated in the BEPS project.
Ongoing negotiations are taking place on a “multilateral instrument” envisioned by the OECD as a mechanism for amending bilateral treaties to incorporate treaty-based BEPS recommendations without requiring separate bilateral negotiation for each. These negotiations are expected to be completed by the end of 2016.
Project Origin and Scope
BEPS became an issue of focus for the OECD in 2012, and a formal project in February 2013 with the issuance of a preliminary report. The original concept of the BEPS project was to target limited, overly aggressive tax planning that resulted in inappropriate tax avoidance, particularly the elimination of “cash boxes” – shell companies with few employees or economic activities and subject to little or no taxation.
However, as frequently occurs, the project expanded and eventually transformed into a fundamental rewrite of global tax practices, including 15 focus areas.
The final recommendations are so far-reaching that the U.S. Senate’s Committee on Finance and the Tax Policy Subcommittee of the U.S. House of Representatives’ Committee on Ways and Means held back-to-back hearings on December 1, 2015, to discuss potential implications for domestic companies.
Policy Interpretation and Implementation
While no one would dispute the need for reform of U.S. tax policy, particularly in light of recent inversions, the BEPS recommendations arguably would go in the wrong direction, making the United States less competitive than is currently the case. In fact, some argue that the whole project is a directed attack on U.S. multinationals and their tax-planning proficiency.
Each participating country will, of course, interpret the BEPS recommendations from its own perspective and will implement – or not implement – domestic law changes accordingly. This will inevitably result in wide variation between countries, creating great uncertainty and more complicated compliance and audit requirements for multinational companies.
Interest Deductibility Recommendations
While the BEPS recommendations cover a wide variety of topics, one in particular may have the most potential for far-reaching domestic implications. BEPS Action IV: Interest Deductions and Other Financial Payments embodies a significant departure from current accepted standards regarding interest deductibility. Basically, Action IV recommends that interest on debt should not be fully deductible (as is current practice) and provides three mechanisms by which to limit the deduction:
The Fixed Ratio Rule
This provision has the strongest OECD support and also represents the most significant departure from previous OECD standards by contradicting the general rule that groups should be able to obtain tax relief for third-party interest costs. The report recommends that, at a minimum, all countries should adopt a rule to limit deductions on interest claimed by an entity to a fixed percentage of earnings before interest, taxes, depreciation, and amortization (EBITDA). The report does not specify an actual number, but suggests a range between 10 and 30 percent. Current thin capitalization rules in the United States place the limit at 50 percent of EBITDA.
The Group Ratio Rule
This is an optional recommendation intended to supplement the fixed ratio rule. It would provide flexibility to groups that are highly leveraged with third-party debt for non-tax reasons. If the entity qualifies for a higher group ratio rule, it can exceed the country’s fixed ratio rule up to the level of the group net interest/EBITDA ratio of the worldwide group to which it belongs. This ratio would likely rely on consolidated financial statements, but determination of this ratio has been left open to further consideration. Interestingly, this similar to the approach taken in the U.K.
The Equity Escape Rule
The equity escape rule is essentially the inverse of the group ratio rule. It allows an entity to exceed the country’s fixed ratio threshold if the individual entity’s debt-to-equity ratio is lower than that of the rest of its worldwide group.
Carryforwards and Carrybacks
The OECD suggests a supplement to these rules to address the difficulty in long-term planning that may result. The fixed ratio and group ratio rules rely on EBITDA, which makes them subject to earnings volatility. The OECD would ameliorate this effect by allowing entities to carry forward unused interest capacity and to carry forward or carryback disallowed interest expenses. Limits for carryforwards and carrybacks have yet to be established.
Exclusions
The OECD anticipates the need for special considerations for some industries and has, in fact, already recommended an exception for interest paid to third-party lenders on loans used to fund “public-benefit projects,” such as infrastructure. The report lists a number of other industries that may qualify for special consideration, but does not come to any conclusions in this regard.
International Competitiveness
Limiting interest deductibility would significantly increase the effective tax rate on new investment. This could hinder growth in participating OECD countries and may frustrate tax reform efforts. Countries adopting these new standards would become less attractive places to do business and create jobs, putting themselves at a distinct competitive disadvantage in the international arena. In short, limitations on interest deductibility would negatively affect output and investment in OECD countries because the return on leveraged investment would decrease relative to those countries where interest is fully deductible.
Compliance
Obviously, the U.S. Congress would have to pass conforming legislation for any of these changes to take effect domestically, but it is likely that the United States will face substantial international pressure to act. A number of other participating countries have already acted to change their laws governing the deductibility of interest, including Australia, Austria, Brazil, Poland, the Slovak Republic, South Africa, and Spain. Costa Rica, Indonesia, Japan, Korea, Lesotho, and Norway are also considering changes.
Most recently, on January 28, 2016, the European Commission (EC) published an Anti Tax Avoidance Package that includes four initiatives to ensure coordinated action by member states. The most relevant initiative to this discussion is the proposal for an Anti Tax Avoidance Directive, which aims to implement some of the final recommendations from the BEPS project into member states’ national laws. Approval has been tabled until May 25, 2016, and requires unanimity among the 28 member states. The Directive establishes de minimis rules against tax avoidance in six areas, one of which is deductibility of interest.
Domestic Application
Limiting interest deductibility could impact new and innovative companies. Easy access to debt provides options for business owners and investors. New entrepreneurs frequently do not have access to equity investment, or they may not want to dilute their interest in the venture by being forced to issue equity. Debt permits business owners to raise capital and finance growth without having to relinquish control or decision-making authority in their companies. It allows new ideas to come to fruition and become reality.
Inadequate Remedy
While the OECD recommendations suggest carryforwards or carrybacks to ameliorate the effects of limiting the interest deduction, this approach would not provide an adequate remedy to the possible increase in the cash tax rate. First of all, new enterprises will not have any prior years to which to carry back deductions. Secondly, delaying deductibility further limits funds available to launch a new enterprise in the current year(s). It is rare that an entrepreneur will begin a start-up with funds to spare, and every available dollar counts. Furthermore, carryforwards are often limited and expire after a certain number of years. The end result could be a higher cash tax rate and less capital available to launch the business, compromising its chances for success.
Workability – Practical Aspects
Even if the United States were to decide to adopt the OECD’s recommendations, a number of practical issues arise. The fixed ratio rules recommended are based on asset valuation or earnings. Both present their own problems, especially for privately held companies and start-ups. While an established privately held company may have a history of demonstrated earnings, a start-up enterprise will not, and valuation will present particularly acute issues in both circumstances.
Publicly traded companies are constantly valued by the marketplace. While that valuation, may be volatile based on a number of factors, there is at least some evidence of what the proper valuation is. Privately held companies, by virtue of not accessing an established free market, are not valued as easily. In the case of start-ups, the primary asset is frequently just an idea, the value of which is highly subjective.
Current U.S. Law
It is worth noting that U.S. law already employs an anti-abuse provision regarding interest payments between related parties. Section 163(j) of the Internal Revenue Code provides that if a taxpayer’s debt-to-equity ratio exceeds 1.5 to 1, interest payments to foreign related parties are disallowed to the extent that the taxpayer has “excess interest expense,” which is defined as net interest expense in excess of 50 percent of the taxpayer’s adjusted taxable income (taxable income without regard to deductions for net interest expense, net operating losses, some cost recovery, and domestic production activities). Disallowed interest deductions may be carried forward indefinitely, while any “excess limitation” (defined as the excess of 50 percent of the corporation’s adjusted taxable income over the corporation’s net interest expense) may be carried forward three years. This provision already addresses the stated goal of the BEPS project.
BEPS and Tax Reform
While the OECD’s original purpose was to address legitimate BEPS issues, the project grew well beyond that scope to address a number of areas that have far-reaching domestic implications and impact competitiveness. This is unfortunate because the initial focus of the project is not inherently inconsistent with the goal of tax reform to improve competitiveness for the benefit of all OECD member states.
The OECD, under the auspices of the BEPS project, should not sacrifice fundamental tax principles that are intrinsic to the conduct of business within and between OECD countries. Limiting the ability to deduct ordinary business expenses, or changing long-accepted definitions of those expenses to exclude interest, could impact capital formation and growth negatively.