Action Item 4: Limiting Base Erosion Involving Interest Deductions and Other Financial Payments

February 2016

Organisation For Economic Co-Operation And Development (OECD) Issues Final Report on Action Item 4, Limiting Base Erosion Involving Interest Deductions and Other Financial Payments

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The Organisation for Economic Cooperation and Development (OECD), a non-governmental forum established to promote economic growth, has developed a 15-point action plan to shape “fair, effective and efficient tax systems.” The OECD’s project regarding Base Erosion and Profit Shifting (BEPS) has addressed issues arising from tax planning strategies that exploit gaps or mismatches in member countries’ tax rules.


This tax alert is one installment in a series of alerts on the release of the OECD/G20 Base Erosion and Profit Shifting Project (the BEPS Project).

On October 5, 2015, the OECD released the final report (the “Report”) of the BEPS Project.  This alert discusses Action Item 4, Limiting Base Erosion Involving Interest Deductions and Other Financial Payments.

Background and Details

In an effort to address BEPS issues in a coordinated and comprehensive manner, the G20 finance ministers called on the OECD to develop an action plan to equip countries with instruments that will better align tax with economic activity.  The OECD recognizes that cash is fungible and easily transferrable, thus permitting multinational companies to reduce taxable income through financing and interest deductions. Action Item 4 of the BEPS Project specifically addresses the risk of BEPS through interest deductions, and identifies three basic scenarios involving such risk. These scenarios include groups engaging in the following:
  • Placing higher levels of third party debt in high tax countries;
  • Using intragroup loans to generate interest deductions in excess of the groups’ actual third party interest expense; and
  • Using third party or intragroup financing to fund the creation of non-taxable income.

The Report provides several recommendations to prevent base erosion through interest expense deductions but does not provide a definitive set of rules to apply in all situations.  Rather, it gives OECD countries great flexibility in determining their respective interest deduction restrictions.  Consequently, certain advocates of the BEPS project have criticized the Report for not providing simple rules that work.

As stated in the Report, interest deduction restrictions should apply to all forms of payment for the time value of money, including finance costs of finance leases, notional interest on derivatives, guarantee fees, imputed interest on zero coupon bonds, and gains/losses on foreign currency borrowings.  Notional interest deductions, where a company is entitled to a deemed interest deduction based on a company’s equity, is not treated as interest in the Report.  The OECD does plan to separately address notional interest deductions regimes, such as those in Belgium and Cyprus.

The OECD’s recommended approach to limit interest deductions is based on a fixed ratio rule which is similar to Germany’s interest deduction limitation rules.  Under the fixed ratio rule, a company’s net interest deduction (i.e., interest expense in excess of interest income) would be limited to a fixed ratio of the company’s earnings before interest, taxes, depreciation, and amortization (“EBITDA”).  For purposes of calculating EBITDA, dividends exempt from tax (e.g., dividends qualifying for participation exemption), untaxed branch profits (e.g., income derived through a permanent establishment that is exempt from home country tax), and capitalized interest would have to be subtracted from EBITDA.  The Report suggests possible ratios between 10 and 30 percent.

Some multinational groups in certain industries may be highly leveraged and have large interest deductions for non-tax reasons.  As such, the Report recommends the use of a group ratio rule in addition to the fixed ratio rule.  The group ratio rule would permit a company that is limited by the fixed ratio rule an interest deduction up to the level of the net interest/EBITDA ratio of the company’s worldwide group.  The ratio would compare net outside interest expense to the aggregate EBITDA of group members rather than the group’s consolidated EBITDA.  The ratio derived would be applied to each member’s EBITDA to set a limit on each member’s interest expense deduction.  Under the recommendations provided in the Report, the company would be entitled to deduct the greater amount determined from the fixed ratio rule and the group ratio rule.

There are some exceptions, such as (1) a de minimis exception which carves out entities that have a low level of net interest expense, (2) an exclusion for interest paid to third party lenders on loans used to fund public-interest  projects (subject to certain conditions), and (3) the carry forward of disallowed interest expense and/or unused interest capacity (where an entity’s actual net interest deductions are below the maximum permitted) for use in future years where the entity’s actual net interest deductions are below the limitation.

Finally, the OECD recognizes in the Report that the role interest plays for banks and insurance companies is different compared to companies in other industries.  While the Report states that banks and insurance companies should not be exempted from interest deduction restrictions, further work will need to be conducted and completed in 2016 to take into account the particular features of the banking and insurance industries.

BDO Insights

The finalized Report is similar to the discussion draft and does not include any groundbreaking concepts. As most multinational companies have intragroup borrowings and interest payments, these companies will need to carefully monitor how the OECD countries adopt the recommendations detailed in the Report and evaluate their current financings and structures.

For more information, please contact one of the following practice leaders:

Robert Pedersen
International Tax Practice Leader


William F. Roth III


Bob Brown


Jerry Seade

Scott Hendon

Joe Calianno
Partner and International Technical
Tax Practice Leader

Monika Loving

Michiko Hamada
Senior Director

Brad Rode
  Chip Morgan