BEPS Project: Time to take a closer look at treasury and intercompany financing


OECD Base Erosion & Profit Shifting (BEPS) Project: Time to take a closer look at treasury and intercompany financing

Just before the New Year’s break, the OECD issued new discussion drafts in the context of the so-called ‘Base Erosion & Profit Shifting’ project as mandated by the G20, better known as ‘BEPS’. They are particularly relevant to group financing structures.

It is important to keep in mind that these documents are consultation documents. The OECD seeks comments from stakeholders on the principles or options put forward. The documents do not represent conclusions and neither reflect consensus. As some of the ideas are novel and far-reaching, input from the business community is of paramount importance to balance their interests with how certain policy makers want to tackle tax structures.

1. Limit base erosion via interest deduction or other financial payments (Action 4)

Two topics that will be covered by Action 4 are the development of transfer pricing guidance regarding financial transactions and the development of rules to prevent base erosion through excessive interest deductions. The transfer pricing guidance is not yet covered by these new publications. The principles of such guidelines will be highly influenced by the interest limitation rule(s) that will be retained.

To combat excessive interest deductions, the OECD has developed 3 options for interest limitation rules and comments on various design and implementation aspects. These options are:

  • group-wide rules, i.e. limitations based on the group’s consolidated interest expenses
  • fixed ratio approaches, which broadly speaking correspond to thin capitalisation rules
  • targeted anti-avoidance rules for specific transactions and structures

The OECD also refers to other methods but excludes them from the consultation process, such as arm’s length debt capacity tests. Generally it is considered that these are burdensome and resource intensive to apply, give rise to uncertainty and do not appropriately deal with the BEPS risk. Equally, changing withholding tax rules as a response to certain BEPS structures is neither considered appropriate to take forward.

Group-wide rules

The idea is to limit interest deductions by the various subsidiaries so as to reflect a group’s consolidated interest expenses and to accept business relief for local interest expenses proportionate to the importance of the local activities. The OECD mentions two alternatives of group-wide rules:

  • Approach 1 ‘Group-wide interest allocation rule’ whereby the consolidated external interest expense would be allocated to the various subsidiaries/permanent establishments (‘PE’ or branches). The allocation would be done based on a measurement of the local economic activity (e.g. earnings or assets). This rule can be implemented as a ‘deemed interest rule’ (allocating part of the external financing costs irrespective of the interest allocated for accounting or other tax purposes) or an ‘interest cap rule’ (actual interest expenses of a subsidiary can be deducted as long as they does not exceed the allocated part).
  • Approach 2: ‘Group ratio rule’ whereby first a relevant financial ratio at group level is computed (e.g. ‘interest/earnings’, or ‘interest/assets’). Afterwards, the same ratio is applied to the subsidiary/PE. In the case where the subsidiary’s/PE’s ratio exceeds the group’s ratio, that part of its interest expenses is not deductible.

The introduction of a group-wide interest cap could have significant implications for a group’s funding and cash management strategies. For example, subsidiaries in territories that have generated net cash and deposited it intra-group would be taxable on interest income, but, the intra-group loan would actually lead to a disallowance in another territory.

Fixed ratio rules

Under these rules, the actual interest expense is tax-deductible to the extent it does not exceed a fixed ratio. The OECD considers various ratios linking the interest deductibility to assets and to certain earnings (e.g. interest/EBITDA).

Based on anecdotal evidence of large groups, the OECD indicates that existing fixed ratio rules (e.g. in Germany) are set at levels that are too high to be effective in preventing base erosion.

Targeted rules

 As the above rules may still leave room for BEPS, the OECD indicates that targeted rules may be applied on top of the other rules. Structures that could be covered by targeted rules could include:

  • ‘artificial debt’ where no additional funding is raised by the ‘borrower’ (leaving a dividend or other obligation outstanding, or circular flows of money)
  • routing funding through intermediate finance companies for tax benefits
  • the use of debt to fund tax-exempt or tax-deferred income

A combination of approaches

The OECD indicates that group-wide rules and fixed ratio rules can be combined, and supplemented by targeted rules.

Such combined approach could be based on a general group-wide interest allocation rule with a carve-out based on a fixed ratio (set at a low level). Alternatively, the fixed ratio rule could be the primary rule, with a carve-out possibility based on the group ratio test.

Payments covered

 The interest limitation rules would cover:

  • interest on all forms of debt
  • payments that are economically equivalent to interest
  • expenses incurred in connection with raising financing.

Based on the above definition, this would therefore include payments on profit participating loans, imputed interest on discounted bonds, amounts under alternative financing arrangements, finance cost elements of financial lease payments, amounts re-characterised as interest under transfer pricing rules, amounts equivalent to interest paid under derivative instruments or hedging arrangements, FX gains and losses on borrowings, financial guarantee fees, and arrangement fees and similar costs.


Design and implementation items

The OECD recommends that the rules should apply directly to the level of interest expense and not the quantum of debt. Furthermore, it recommends application to net interest expense after offsetting interest income.

The paper also comments on various implementation issues, like mismatches between tax values and accounting values, the impact of accounting standards, the impact of loss-making companies, FX conversion issues, and the entities to be included and excluded from an interest limitation group.

No procedures to avoid double taxation are provided. The OECD suggests that double taxation can be avoided by allowing a carry-forward of non-deductible interest or of the unused capacity to deduct interest. Such carry-forward would be limited in time.

Specific rules and approaches may be required for particular industries. In this respect, the OECD mentions the bank and insurance industry, oil & gas, infrastructure joint ventures, asset management, leasing companies, etc.


 II. Risk re-characterisation and special measures (Action 9)

 This public discussion draft covers proposed changes to the OECD Transfer Pricing Guidelines on risk allocation as well as some options for ‘special measures’. While the first item covers a detailed description of potential changes, special measures have been outlined on a very high-level basis only at this stage. If (some of) these special measures are retained, a considerable amount of design work will have to be further undertaken. It will be interesting to observe the level of support these special measures will get from the countries involved in the BEPS project and whether a consensus can be reached.

Risk re-characterisation

The proposed changes are not specific to certain activities or types of transactions. Noteworthy is the following:

  • There is a strong emphasis that risks should be allocated to entities that have control over that risk (and a contractual allocation can thus be disregarded).
  • An important section comments on circumstances where transactions as structured by groups can be disregarded by tax authorities. This can be the case when the set-up is missing the ‘fundamental economic attributes of arrangements between third parties’. However, it is not because a certain arrangement is not observed between independent parties that it is disregarded as a matter of principle.

Special measure – Inappropriate returns for providing capital

One of the special measures is aimed at combating strongly capitalised asset owning companies that are perceived to have excess or unanticipated returns.

An option to combat such structures would cover the introduction of so-called ‘thick capitalisation’ rules. If a company’s capital exceeds a certain capitalisation ratio, that company is deemed to have paid interest. The parent company that has provided the capital will then have deemed interest income. The level of thick capitalisation might be based on a group ratio (similarly to the group-wide interest capping rule), or by reference to capital requirements as if the company was a regulated financial company.

III. Takeaways

The proposed interest limitation rules create a real risk of double taxation because groups are unlikely to be able to match their actual interest expenses perfectly with the imposed interest deduction limitations.   It is proposed that a carry-forward of disallowed interest expenses might alleviate some of this risk, with the potential for a carry-forward of unused capacity. In practice, it is very unlikely that allowing for carry-forwards will alleviate substantially the double taxation risk. This is further exacerbated in case thick capitalisation rules would also be applied and by the suggestion that certain territories would want to retain or introduce specific targeted rules.

The discussion drafts illustrate the fast pace at which the OECD is executing its G20 mandate to address a number of Base Erosion & Profit Shifting rules and policies. It will be critically important that consensus is reached among the parties rather sooner than late as some of the proposals would imply a major overhaul of the ‘rules of the game’ of international taxation taxpayers and tax authorities have been relying on for several decades. As the OECD reaches out to the public for input, taxpayers have an interest in participating in the debate. Should you be interested to do so, responses are to be sent to by 6 February 2015. Alternatively, your regular PwC contact or the undersigned would be most happy to take your observations and/or suggestions on board.



The Action 4 discussion draft can be found here.

The Action 9 discussion draft can be found here.

A PwC Tax Policy Bulletin on the various BEPS documents released can be found here.