Widespread adoption of new guidelines will change the contours of debt financing, driving companies to look at alternative methods.
Changes to interest tax deductibility rules (stimulated by the G20/Organisation for Economic Cooperation and Development (OECD) Base Erosion and Profit Shifting (BEPS) project) may be starting to change the relative attractiveness of equity (or quasi-equity) funding and debt-based funding, changing multiple decades of government policies and business behaviors.
The OECD first proposed limiting interest deductions in 2015, when it issued a final report on BEPS Action 4 (“Limiting Base Erosion Involving Interest Deductions and Other Financial Payments”). The OECD justified its position by arguing that multinational enterprises can:
- Selectively place higher levels of third-party debt in high-tax countries
- Use intercompany loans to generate interest deductions in excess of the group’s actual third-party interest expense
- Borrow to generate tax-exempt income, such as dividends, from subsidiary corporations
These, it said, all constituted base erosion and/or profit shifting techniques.
The proposed solution? A new rule would allow an entity to deduct net interest expense only up to a benchmark net interest/earnings before interest, tax, depreciation and amortization (EBITDA) ratio, within a range of 10%–30% (with the vast majority of countries choosing the upper limit). An optional group ratio rule would allow an entity to deduct net interest expense up to its group’s external net interest/EBITDA ratio, where this is higher than the benchmark fixed ratio.
Fast forward to 2017, and 9 of 51 countries (just under 18% of the total) in our Global tax policy outlook have either enacted or are forecasting some form of interest limitation change that will result in a higher overall tax burden this year — with, again, a majority of countries choosing to align their policies to the OECD’s upper limit of 30%. This follows six countries making similar moves in 2016. A new European Anti-Tax Avoidance Directive, which goes into effect on 1 January 2019, also limits the deductibility of interest in all EU Member States to 30% of EBITDA. So in effect, many countries — albeit with some inconsistencies in approach — are moving in the same direction.
What does it all mean?
Essentially, the tax advantages of debt over equity are changing as a result of these developments.
Previously, debt was usually deductible for the borrower and taxable for the lender. Equity was usually nondeductible for the issuer but also nontaxable for the investor. All things were, roughly speaking, equal.
That said, other issues tended to tip things toward using debt: exemption systems to relieve double taxation tend to be partial, rather than complete, and credit systems don’t always recognize the full taxation of the earnings out of which the dividend on the equity has been paid. Hence, the status quo has been that debt funding has, over the years, generally provided a much better tax answer than equity.
That status quo is becoming less true with BEPS Action 4 now in place. The fixed ratio rule denies a tax deduction above a certain level but leaves the interest income taxable. So once such interest cap takes effect, it effectively converts the advantage of debt into a disadvantage — rather than leveling the playing field with equity.
Some — but definitely not all — countries (and also the EU, within its yet-to-be-implemented Common Consolidated Corporate Tax Base proposal) are proposing a more generous tax treatment of equity. That may actually give rise to a greater level of certainty for investors, who instead of hoping that the interest that is taxed on one side will actually get a deduction on the other.
In essence, the future is likely to see far less certainty with the use of debt instruments than may potentially be gained with using equity shares or even quasi-equity (i.e., different types of capital that have features of both debt and equity). If that does come to fruition, we may see a fundamental change in the way that cross-border investment is financed. In essence, as the level of debt increases, the tax reasons to choose debt instruments are diminished.
This is not a simple equation, though — there are other complex issues that interplay, such as the transfer pricing of related-party debt, BEPS Action 2 and EU action on “hybrid mismatches” (i.e., arrangements exploiting differences in the tax treatment of instruments, entities or transfers between two or more countries), all adding complexities to the job of the tax department.
The call to action
Financing costs are a significant factor for any business — more so when private equity investments (which tend to be more highly leveraged) are at play or an M&A target is under the microscope.
This trend to restrict the deductibility of debt expense is not new, but it is gaining momentum. And with the warning lights flashing at the intensity that they now are, it is without doubt time for all companies to make a frank assessment of current and future impacts in this area. It could be far more expensive if you don’t.
This article was originally published in Tax Insights on 27 July 2017.