On 21 June, the Economic and Financial Affairs Council (ECOFIN) reached a consensus on the “Anti-Tax Avoidance Directive” (ATAD). Some of the measures of this Directive directly affect groups’ existing financing set-ups. The main impact is the implementation of BEPS Action 4 via a Directive, which will impose a general interest deduction limitation. Member States have the option to implement stricter rules.
1. 30% EBITDA or the equivalent effective rule
The main interest limitation rule is aligned with the BEPS Action 4 limitation. More in particular, if the “net borrowing costs” exceed 30% of an entity’s EBITDA, the excess costs are not tax deductible. However, up to EUR 3 million, the net borrowing costs remain fully deductible.
To this end, the term “borrowing costs” remains broadly defined and covers interest expenses, related hedging costs, guarantee fees, the finance costs embedded in financial lease payments, arrangement fees, etc. Borrowing costs cover both payments to related entities and payments to third parties, irrespective of whether these payments are domestic or cross-border payments.
Both the net borrowing costs and the EBITDA correspond to their “tax adjusted” values, i.e. the costs correspond to the tax deductible costs (e.g. disregard non-deductible amortising costs). Likewise, income corresponds to taxable income. Therefore, the EBITDA threshold will not increase if tax-exempted dividends are received.
The ATAD accepts that countries having “equivalent effective” interest limitation rules may – as a derogation – keep these rules. Such equivalent rules will have to be replaced by the EBITDA rules the year after the OECD issues the minimum standards under Action 4, and at the very latest on 1 January 2024. The Directive does not provide any further guidance on when an existing measure is “equivalent effective”. In its introduction to the Directive, the Council refers to EBIT as a ratio that is equivalent to EBITDA. It remains unclear at this stage whether other interest limitation rules – such as debt/equity – could also be considered equivalent, and how their effectiveness will be measured.
Finally, the Council also explicitly mentions that the proposed rules do not prevent further testing the transactions under the arm’s length principle.
2. Carve-out rule
Entities that are part of a consolidated group can deduct a higher amount of their borrowing costs if they are part of a more highly leveraged group. More in particular, the Directive includes an all-or-nothing rule and a proportional rule:
- The net borrowing costs are fully deductible if the group’s equity/asset ratio is lower than that of the tested affiliate. A 2% tolerance margin is provided for in favour of the affiliate.
- The affiliate can deduct its interest costs above the 30% EBITDA rule up to the group’s consolidated external borrowing costs/EBITDA ratio.
Member States have the option to implement one of following rules:
A simple carry-forward of the excess net borrowing costs. The Directive does not impose a time limitation.
A combination of the above carry-forward rule, combined with a carry-back. The carry-back is limited to 3 years.
A combination of the first rule, with a carry-forward of the “unused capacity” (i.e. in case the net borrowing costs are less than the threshold). This carry-foward should be capped at maximum 5 years.
4. Excluded entities and activities
Some entities may be excluded from the interest limitation rules. More in particular, this concerns entities not being part of a group, long-term public infrastructure projects, and financial undertakings. The latter broadly corresponds to banks, insurance entities, regulated investment funds and pension funds. For such entities, more tailored rules could be issued later.
5. Effective date
Member States should implement the interest limitation rules at the latest on 31 December 2018 so that they have effect on 1 January 2019. Countries with “equivalent effective” rules have some more time.
In principle, the rules apply to the borrowing costs due in a given year, irrespective of the question when the related funding has been granted. However, loans concluded before 17 June 2016 do not fall within the scope of the new rules, provided that they have not subsequently been modified or extended.
6. Other measures of the ATAD
Although the other measures of the ATAD are not specific to financial transactions, they may affect financing activities.
If a finance entity is not sufficiently taxed, its profits may become taxable at the level of its shareholder under the CFC rules. Such CFC rules, however, do not apply if the entity carries on “a substantial economic activity”. In other words, it should have the appropriate substance for its activities.
The Directive also provides a “general anti-avoidance rule” or “GAAR”, under which tax authorities can “ignore an arrangement or a series of arrangements which, having been put into place for the main purpose or one of the main purposes of obtaining a tax advantage”. In this respect, it will be tested whether or not the transactions have been put into place for valid commercial reasons which reflect economic reality. Hence, it will be important to properly document the business drivers behind a transaction or set-up.
Finally the ATAD also provides anti-hybrid rules combating hybrid instruments and entities.
The EU is building its post-BEPS world, and the ATAD is a key building block in this process. The political consensus on the rules within ECOFIN is a key milestone in the process. On most points, the ATAD text is broadly in line with the drafts that circulated the last couple of months. Some unclarity remains, especially with respect to the “equivalent effective” regimes.
The interest limitation rules will often result in double taxation. Non-deductibility at one side of the transaction does not exclude taxation at the other side. Although the carry-forward/carry-back rules may partially alleviate this, groups should carefully monitor how they finance their activities to avoid undesired consequences.
More information on the ATAD can be found here.
For more insights on the impact of the ATAD on your financing activities, please contact David Ledure or your regular PwC contact.