Overview of Action 4 and the recommended approach
Throughout the last few decades, it has been possible to identify the ways in which multinational enterprises can shift profits from one jurisdiction to another in order to minimize taxes.
Among others, one of the most widely-employed method involves the payment of interest to related parties and third parties. Considering interest is, in principle, deductible to the payer and included in computing the recipient’s income, related-party debt can be used to increase deductible interest expenses in relatively high-tax jurisdictions with corresponding income inclusions in relatively low-tax jurisdictions.
Before the OECD’s Action 4 Final Report, jurisdictions had thrived in imposing their own approaches to interest limitation and thin capitalization. Methods varied, although fixed ratios were commonly used, and some countries used only transfer pricing to determine whether a company’s amount of debt was an arm’s length amount.
Despite the interest limitation rules around the world, it was consensual that multinationals were using excessive interest deductions to reduce their tax paid. It was commonly understood that the intragroup debt of multinationals is in substance similar to equity but presenting an advantage from a tax perspective, as, in principle, interest is deductible, while dividends are not.
As such, it is reasonable to assume that the tax implications of the operations described influenced greatly the choice to finance a group with intragroup debt rather than equity. Furthermore, the inconsistency among jurisdictions in the tax regulation of this matter provided for even more inefficiency.
Considering this context, it was urgent to determine an interest limitation that was both effective and uniform throughout jurisdictions, in order to reduce the potential for both double taxation and double non-taxation. [1]
The OECD’s Action 4 Final Report was published in October 2015. It presented a “best practice recommendation” for countries to adopt in their domestic laws, which we will further analyze in the next segment.
The practical effect of Action 4
Action 4 has been implemented throughout the years, being relevant to mention that the European Union members are also subject to the European Commission’s Anti-Tax Avoidance Directive (ATAD)[2], which also establishes interest limitation rules similar to those recommended in the Action 4 Final Report.
As mentioned in the previous chapter, Action 4 has established a best practice recommendation, which consists in a fixed ratio rule, limiting interest deductions to 10-30% of the entity’s earnings either before interest, taxes, depreciation and amortization (EBITDA). Countries can select where (between 10% and 30%) the limit is set. As an alternative, it is also established that the taxpayer could choose to rely on a group ratio which presumably it would do if it is higher than the fixed ratio.
The implementation of a fixed ratio rule entails that a company is able to deduct interest expense to a part of its earnings, while still ensuring the remainder of such company’s earnings is subject to tax.
It is also to be noted that the OECD recognizes special circumstances in certain business sectors, as some groups of companies face the need of being highly leveraged in debt for non-tax reasons. For this reason, Action 4 also encompasses a group rule, which countries may choose to implement in their own jurisdictions, that allows entities to deduct interest up to the level of the EBIDTA level of the worldwide group.
There are several variations in the rules being implemented by these countries. For instance, these variations can be found at:
- The level of the fixed ratio – the majority of jurisdictions have adopted 30% but, for example, Finland and Norway have adopted 25%;
- Whether the denominator is EBITDA or EBIT –most countries apply EBITDA but, however, in the United States it is programmed to be changed to EBIT in 2022;
- Whether the fixed ratio rule applies to net or gross interest expense – many countries it is applied to net interest expense but, for example, in Iceland the gross interest is considered;
- Whether a group-wide ratio alternative is included – in about a third of the jurisdictions’ rules, thus far, it is applicable.
Considering the particular example of Portugal, the limitation to interest deductions, in terms similar to the one recommend by BEPS Action 4, was introduced in December 2012, and is established in article 67 of the Corporate Income Tax Code.
The article has suffered numerous alterations, in order to be adapted to both ATAD and OECD’s Action Plan. The redaction currently in force determines that the deduction of net financing expenses, in general terms, limits the deduction of those expenses for the purposes of calculating taxable income, in terms of corporate income tax, to the greater of two levels:
EUR 1.000.000 or 30% of EBITDA adjusted for tax purposes.
So far, Action 4 has faced great success in its implementation, as the key players in the global economy have adopted the rules proposed. Even though there may be small variations throughout, they do not affect the final purpose of the Action, which is to implement efficient and cohesive restrictions to interest deductibility. In specific, the work developed by the European Commission in ATAD is commendable, as it is providing the much needed guidance for the EU countries to implement the practices in accordance to the BEPS package.
However, OECD’s guidance regarding the matters addressed by BEPS Actions is far from final. In February 2020, the Transfer Pricing Guidance on Financial Transactions: Inclusive Framework on BEPS: Actions 4, 8-10 was published, which established follow-up work on the transfer pricing aspects of financial transactions. On 20th January 2022, the Organization released the 2022 edition of the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, which incorporates the TP Guidance published in 2020, further addressing specific issues related to the pricing of financial transactions such as treasury functions, intra-group loans, cash pooling, hedging, guarantees, and captive insurance.
Maria Lima Ferreira
January 2022
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[1] In 2012, G20 asked OECD to address the base erosion and profit shifting issue, and devise an action plan, in order to provide a practical approach to these issues. As such, in July 2013, the OECD presented its Action Plan, containing 15 actions. Action 4 addressed the use of interest deductions to diminish the taxable base of companies.
[2] Council Directive (EU) 2016/1164, art. 4 (12 July 2016).