Policy Proposals Business Law Comments on the Public Discussion Draft on BEPS Action 4 (Interest Deductions and Other Financial Payments)
Committee on Fiscal Affairs
Organisation for Economic Co-operation and Development
Comments on the Public Discussion Draft on BEPS Action 4
(Interest Deductions and Other Financial Payments)
Keidanren hereby submits its comments on the OECD public discussion draft "BEPS Action 4: Interest Deductions and Other Financial Payments" published on December 18, 2014.
Keidanren generally supports the OECD's initiatives to prevent base erosion and profit shifting ("BEPS"). We are aware that, although many developed countries have taken measures of some kind against the problem of BEPS using interest and other financial payments that this public discussion draft addresses, further discussions and actions are needed to stop the prevalence of BEPS. From that standpoint, we endorse the proactive analysis and review made by the OECD for the public discussion draft.
However, most companies make financing naturally in an economically most reasonable way, according to the needs for business activities. Most companies make financing for the purpose neither of tax avoidance nor tax merit. Therefore, when translating this and other BEPS Actions into concrete rules, it is absolutely imperative to ensure that measures to be instituted to prevent tax avoidance will neither hamper ordinary business activities nor create an excessive administrative burden. The OECD's proposals for group-wide rules in this public discussion draft appear innovative on paper by incorporating the latest theories; but they seem to be insufficiently targeted, and too mechanical and impractical to be adopted in the real world. Should such widely applicable rules be established, taxpayers and tax administrations that have had nothing to do with BEPS will be affected by and need to address those rules. In addition, compliance with group-wide rules will dramatically increase the administrative burdens on taxpayers and tax administrations.
In view of these points, we propose the following: countries that have no existing rules for BEPS using interest should start with considering the introduction of a fixed ratio rule; and countries with such rules already in place should first review whether those existing rules work effectively, and then, if there are still needs for introducing a group-wide rule, it should be cautiously designed with due attention to linkage and consistency with the existing ones.
From this perspective, we submit the following comments:
2. Problems of Group-Wide Rules
Although group-wide rules may be theoretically clear, their application in the real world requires the following problems to be solved; otherwise, the rules can hardly be deemed the best practice.
Even within the same corporate group, financing methods taken by individual companies vary. If a group-wide rule is applied mechanically, individual companies will lose some latitude in financing, which may affect sound business activities and financial markets as well. Careful consideration should be given to whether group-wide rules are an excessive measure that may have an adverse impact on corporate activities and financial markets, going beyond the purpose of preventing base erosion.
Suppose a corporate group makes a concerted effort to grow without debt, by utilizing shareholders' equity effectively or with financial subsidiaries in a group. Under group-wide rules, due to the group's third party interest expense being small, a limit on interest deductions for each group company is reduced. This treatment is inappropriate as it may induce companies to issue bonds that would be otherwise unnecessary, to external investors.
It remains unclear whether group-wide rules are compatible with cash management systems. In reference to this point, Paragraph 138 in Section G of Chapter VIII of the public discussion draft states, "The application of a group-wide rule should not impact the ability of a group to manage its third party balances through cash pooling." However, with what considerations rules should be applied and their other details are not specified. More specific details would be needed for further consideration.
How group-wide rules are linked with transfer pricing taxation should be clarified. In some cases, a company that is not allowed to claim interest deductions under group-wide rules may still have to pay interest to another group company according to the arm's length principle from the perspective of complying with transfer pricing tax rules. Such a treatment which limits interest payments is particularly unreasonable.
If REITs and other pass-through entities that are permitted in a wide range of countries become subject to taxation under group-wide rules, it is highly likely that their interest payments will be severely restricted. Furthermore, once interest deductions are restricted, funds for dividend payments decrease correspondingly. We are gravely concerned that this may undermine the benefits of pass-through entities and deteriorate the liquidity of REITs and other financial instruments in markets.
Even in a corporate group in which local subsidiaries make financing decisions on their own, a limit on each company's interest deductions is determined on a group-wide basis. This may result in the narrower discretion and weaker financial management function of local subsidiaries. For example, even though local subsidiaries autonomously make financing from external debt for the purpose of capital investments, their limit of interest deduction is determined by a relation to other group entities. Therefore, it may lead to narrow options to raise funding. Consequently, companies are forced to choose equity financing. Eventually it runs counter to helping nurture and build the capacity of management and finance personnel in other countries especially in developing countries.
If foreign exchange gains and losses on borrowings are included within the scope of interest expense as stated in paragraph 35 of the public discussion draft, the amount of interest will vary depending on the taxpayer's reporting currency, making unified measurement difficult. Also, preparers will be unable to reflect in tax returns the borrowings and other financing made in multiple currencies without the harmonization among countries of specific rules, especially those regulating in which currency measurement should be made and which exchange rate should be used in that case.
If data on interest expense for accounting purposes or EBITDA is used, the convergence of accounting standards will also be required. Especially, the treatment of derivatives will demand detailed rules.
As the amount and extent of interest may vary depending on the treatment and interpretation of interest in each country, group-wide rules will lead to an unstable system and drastically increase the administrative burden. Specifically, companies will be required to track the basis for interest allocation while making adjustments for consolidated reporting, taxation periods, accounting standards, and differences between accounting and tax figures. The administrative burden and difficulties of calculation demanded by these tasks will virtually make it impossible for companies to cope with them.
3. Support for Fixed ratio rule but Need to Modify
As a result of above, we suppose that a fixed ratio approach on a jurisdiction-by-jurisdiction basis is preferable to group-wide tests.
(1) Benchmark ratio
With regard to a benchmark ratio underlying a fixed ratio rule, the public discussion draft states that the ratios of 30 to 50 percent currently applied by various countries may be too high to be effective in preventing BEPS. However, in light of the purpose of addressing risk posed by BEPS that deviates from the substance of corporate activities, it is not appropriate to recommend such a low benchmark ratio as to affect numerous multinational enterprises doing business in compliance with rules and regulations.
The best approach would be for each country to set the most appropriate ratio on its own after careful and thorough discussions taking into account the state of domestic companies, such as the use of BEPS, management and financial conditions, and possibility of using BEPS. Particularly, setting a benchmark ratio at below 30 percent may cause disruption, as 30 percent or so is now adopted in many countries. Also, attention should be paid to the possibility that setting low benchmark ratios globally may have an especially negative impact on the growth of developing countries with high interest rates.
(2) Basis for measurement
As a basis for measuring economic activity under a fixed ratio rule, the public discussion draft refers to two possibilities: assets and earnings including EBITDA. In this respect, it is preferable that taxpayers should be given a choice to use either assets or earnings.
Choosing assets, however, entails a challenge because the calculations will be difficult if intangibles are included in the basis. In particular, the treatment of self-created intangible assets and self-created goodwill will require careful consideration. On the other hand, if choosing earnings as the basis, the company will be greatly affected by fluctuations in business performance and other factors, but this problem will be resolved by instituting a system whereby disallowed interest expense can be carried forward into future periods. Earnings reflect the substance of the company's business activities more accurately, and are currently adopted as the basis for a fixed ratio rule more widely, than assets. In view of these, each country should be allowed to design its own rule. In addition, if choosing earnings, it should be taken into consideration that choosing earnings may deepen a recession because a reduction in the ability to report an interest deduction due to a decrease in earnings could lead to a decrease in the incentive to borrow in steep recession periods.
4. Evaluation for mixed approaches
Approach 1 that is centered on group-wide rules has a number of problems as explained in Section 2. Therefore, it might be said that influences of economic activities and the administrative burden of taxpayers could be less damaged in Approach 2 which is centered on the fixed ratio rule.
However, although approach 2 adopts a fixed ratio rule as the general rule, and applies a group ratio rule as a carve-out from the general rule, room for application of a group ratio rule should be limited to the extent possible, and it would be important to set the fixed ratio in a practical level, given especially the problems involved in group-wide rules as described above. From the perspective of ensuring stability in rules and transactions, it is also desirable to introduce a targeted rule that clarifies the mutual targets based on the existing and widely-used tax system in each country, for the purpose of addressing the kinds of transactions conducted with the clear intention of BEPS.
5. Other Issues
(1) The Treatment of Non-deductible Interest Expense and Double Taxation (Chapter XII)
The public discussion draft proposes that non-deductible interest expense be allowed to be carried forward. We support this proposal, and request that the carryforward period be determined by each country. When designing this system, each country should allow a sufficient period of time, bearing in mind that theoretically, non-deductible interest can be carried forward indefinitely and considering a balance with the ledger retention period under domestic law. It is desirable that such a system also permits a carryback of disallowed interest expense into earlier periods and a carryforward of unused capacity to deduct interest into future periods.
(2) Who Should a Rule Apply to? (Chapter V)
The public discussion draft states that interest limitation rules should also apply to a related party that directly or indirectly holds a 25 percent or greater investment in the company concerned. However, in many cases, a related party holding a 25 percent or more stake in a company cannot be said to substantially control the company. Another concern is that it is not easy to garner information on interest and other financial transactions from a company that the taxpayer does not directly control or oversee regarding business and other activities. The related party threshold should, at least, be set at more than 50 percent ownership.
In case of Scenario 4, where no capital relationship exists between the interest payer and the payee, it should be clarified that there is no room for interest limitation rules to be applied.
(3) Should a Small Entity Exception or Threshold Apply? (Chapter VII)
It is desirable to apply a small-entity exception in order not to increase the administrative burden on those entities. At the very least, it is not appropriate to take the policy of not recommending the application of a small-entity exception at a national level.
(4) Considerations for Groups in Specific Sectors (Chapter XIII)
(a) Financial sector
It is necessary to recognize that the capital structure of banks and other financial institutions is subject to financial regulations in each country and financial markets' discipline. Therefore, while the existing regulatory requirements for financial institutions act as an effective general interest limitation rule, we do not believe it appropriate to apply the group-wide rule to the group's interest expense other than that on its regulatory capital. Rather, it is desirable to carefully discuss whether or not to introduce the targeted rules to address specific issues or transactions to be dealt with.
If a group controls financial business companies, Paragraph 213 of Chapter XIII states "special provisions may be required". It is predicted that applying a group-wide rule to a group controlling financial business companies confronts a big problem. If applying a group-wide rule, different rules should be separately applied to financial business entities and non-financial business entities. Instead, it is also suggested that financial business entities are exempt from application of a group-wide rule.
(b) Infrastructure projects
Project finance structures based on non-recourse or limited recourse loans are absolutely essential for engagement in projects which need massive funds. In structuring such project finance, the D/E ratio or the debt-service-coverage-ratio, which deserves a standard, is prescribed by contracts, thus it is not appropriate to limit deductions for interest expense according to a group-wide rule. Based on the fact that the D/E ratio or the debt-service-coverage-ratio deserves a standard for the arm's length principle, infrastructure projects should be exempt comprehensively from a general interest limitation rule.
In addition, the project should not be distinguished as being either public or private.
Subcommittee on Taxation