by Julie Martin
Government and OECD tax officials at a February 17 OECD hearing suggested that, contrary to business representative assertions, a 30 percent of EBITDA fixed ratio is too high to effectively combat excessive multinational corporation interest deductions. Officials suggested that a lower percentage is appropriate for guidance on interest deductions being drafted under the OECD/G-20 base erosion and profit shifting (BEPS) plan.
The day-long hearing concerned draft BEPS guidance under action 4, released December 18, that would limit MNE interest deductions by using either group-wide tests, a fixed ratio test, or a combination of the tests.
Under the proposed group-wide tests, a multinational group’s net interest deduction would be limited to the group’s net third-party interest expense. The deduction would be allocated among companies based on a measure of economic activity.
The fixed ratio test would limit a company’s interest deductions to an amount determined by applying a fixed benchmark ratio to an entity’s earnings or asset value on a jurisdiction-by-jurisdiction basis.
William Morris, Chair of BIAC’s Tax Committee, was among business representatives that expressed support for combined approach 2 of the draft, which would limit interest deductions using a fixed ratio, but if net interest expense exceeded that ratio, would allow the taxpayer to test again at the global group-wide level.
Business wants the percentage for a fixed ratio to be high under combined approach 2 so that the group-wide test would be used only very rarely, as a fallback, Morris said. The group-wide test is impractical and would be very difficult to apply, Morris asserted.
According to a US delegate, though, some countries are considering an approach that would allow MNEs to deduct an amount equal to the greater of the result under a fixed ratio test or a test that measures in-country leverage relative to worldwide external leverage. Under such an approach, the fixed ratio would need to be set “at the right level” so that some companies would rely on one prong while other companies would rely on the other prong, the official said.
“Ideally, we would like some people to be in the second prong,” the US delegate said, because if all companies are able to use the fixed ratio test, nothing would be achieved from a BEPS standpoint. He added that he believed that earnings or EBITDA should be used for a worldwide test, instead of assets or equity.
Germany’s delegate suggested that business representatives that argue that group-wide tests are too difficult to apply may be exaggerating. The delegate said that Germany’s experience is that if a group wants to avoid nondeductiblity of interest, “all of a sudden they seem to be quite able to show us the numbers we are asking for.”
Peter Merrill of PwC presented data designed to refute the contention, set out in the discussion draft, that a 30 percent net interest to EBITDA test would be too high a ratio to prevent BEPS. Merrill argued that the conclusions in the discussion draft, which were based on the study of financial statements of the largest 100 companies by market capitalization, were not representative of all companies.
PwC’s analysis, included with BIAC’s written submission on the draft, used a much larger sample of companies. PwC began with about 20,000 nonfinancial active parent companies, and then separated out companies shown to be MNEs because foreign taxes were mentioned in their financial statement footnotes.
The data from this group of MNEs showed that during 2009-13, about 39–45 percent of MNEs would have been affected by a 10 percent net interest to EBITDA test; 24–29 percent would have been affected by a 20 percent test; and 17–22 percent would have been affected by a 30 percent test, Merrill said. He also presented data showing that “smaller” cap companies, namely those with less than $5 billion market cap, and companies in capital intensive industries, had even higher ratios of interest expense to EBITDA.
US Treasury official Danielle Rolfes said that while PwC’s contribution was very helpful, she questioned the 2009-13 period selected for analysis. She said that 2009 was “an extraordinary year” as it was during the great recession, and that “2010 was no banner year either.” Rolfes said she recalculated PwC’s data, excluding the 2009 data, and found that “the range shrinks considerably, such that it shows a fixed ratio that is much lower.”
Rolfes added that the five-year range selected was also “problematic” because interest rates were historically low during the period. Analysis of a different period would be helpful, she said.
Further, Rolfes said she did not “think the answer can be that we have to design fixed ratios that are high enough to be okay for small cap when we can see that would allow for an awful amount of excess leverage for large cap.”
She asked if business supported different fixed ratio rules for smaller cap companies, namely, for those with capitalization of less than $5 billion.
“The PwC data certainly suggested that one size does not fit all, and that small cap versus large cap is a distinction that, in my own mind, probably ought to be made under a fixed ratio approach,” she said.
New Zealand’s delegate noted that according to PwC’s written submission, in 2013 about 43 percent of firms have external net interest as a percent of EBITDA of 5 percent or less, not including firms with negative EBITDA.
If countries set fixed ratio rules that permit interest deductions of up to 30 percent of EBITDA, then 43 percent of companies would be able to claim interest deductions in excess of 600 percent of their external interest expense, the New Zealand delegate said.
Similarly, Kate Ramm, OECD senior advisor to the BEPS project, noted that “if we set the threshold as say, 30 percent, and some groups do not have external debt anywhere near that level, there would seem to be a potential danger that they could use internal debt in certain countries to gear up to that level.”
A BIAC representative responded that deductions are limited by commercial realty. “There has to be a commercial underfooting for all this . . . . You can’t just have money sloshing around the system for no reason,” he said. Neil Anthony of CBI noted that companies’ deductions would be offset with income inclusions, so “you end up in a net neutral basis.”
According to Rolfes, though the “commercial reality” argument falls flat. For example,”right after an inversion transaction in the United States, you can observe afterwards a $7 billion intercompany note [without] new investment to come with it,” she said.
Moreover, Rolfes said she would need to “have another glass of wine” if there was more discussion about how offsetting interest income deters BEPS from excessive interest deductions. “That’s just silly,” she said, noting that “you don’t need a fancy letter ruling regime to get zero tax on interest, you can just go to Belgium and get single [digit] rates on the income.”
Sol Picciotto of the BEPS Monitoring Group argued that countries would be best off adopting a simple, clear, rule allowing companies to deduct borrowing costs only under a group-wide test. There exists a unique opportunity to establish effective rules to deal with this problem, which effects all countries, he said.
Picciotto, whose group represents several NGOs, said the combined approach would allow companies to pick and choose their rules, setting up a tax regime that would “test their morality.” The interest deduction rules should be designed so morality does not come into play, he said.
“We would strongly urge the OECD to hold their nerve . . . . This could be one of the great achievements of the BEPS project,” Picciotto said.
Tom Neubig, Deputy Head, OECD Tax Policy & Statistics, presented additional data compiled after the release of the OECD consultation document analyzing the 242 largest non-financial multinational consolidated groups, each with annual revenue in excess of $20 billion. Neubig’s data showed that a higher proportion of the interest burden tended to fall in high-tax countries.
Nick Houghton, HMRC Deputy Director Head of International Tax Policy and Structure, explained that countries decided to not pursue an arm’s length solution for interest deductiblity because “if you focus on the level of debt that a third party lender will provide, an arm’s length approach may not take full account the level of debt and interest a group actually has.” He also said that an arm’s length approach does not solve the issue of debt being located in countries with a high tax rates.
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– Julie Martin is a US tax attorney and a member of MNE Tax’s editorial staff.
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