Debt bias and Base erosion and profit shifting (BEPS) EC-IMF Conference on Corporate Debt Bias 23 February 2015 Tom Neubig Deputy Head of the Tax Policy & Statistics Division Centre for Tax Policy & Administration

What is BEPS? A system under pressure Over time, MNEs have identified and taken advantage of some of the gaps that exist between the domestic tax laws and tax treaties Treaties are negotiated on a bilateral basis and there are more than 3,000 of them in existence today Rules designed to prevent double taxation are now facilitating: Double non-taxation Less than single taxation Stateless income

What is BEPS? BEPS Strategies These strategies are collectively referred to as BEPS and generally involve: Separating the location where profits are reported from the location where the actual economic activity or value creation occurs Shifting costs into high taxing countries and shifting profits into low taxing countries

The BEPS Action Plan The BEPS Action Plan 15 point Action Plan Endorsed by the G20 Leaders at their meeting in St Petersburg, September 2013 OECD and G20 working together on an equal footing OECD Member and accession countries G20 countries In consultation with developing, non-OECD and non-G20 countries

The BEPS Action Plan The BEPS Action Plan is focused on achieving a better alignment between: the location of taxable profits; and the place where economic activities and value creation occurs A key focus of the BEPS Action Plan is to eliminate double non-taxation, while avoiding double taxation

The BEPS Action Plan Secure revenues and protect tax bases Improve integrity of international tax rules by creating a single set of consensus-based rules Must act quickly to prevent the unravelling of the existing consensus-based international tax framework Provide greater certainty and predictability to taxpayers Need to avoid unnecessary compliance burdens and restrictions on legitimate cross border activity

The BEPS Action Plan - Timeline G20 Leaders have adopted an ambitious timeline for the BEPS Action Plan: 2014 deliverables – 7 Actions (released September 16, 2014) 2015 deliverables – 8 Actions OECD developing detailed plans for implementation of the 15 Actions All actions due to be completed by end of 2015

The BEPS Action Plan - Timeline 2014 deliverables 2015 deliverables A1: Digital economy A2: Hybrid mismatches A3: CFCs A5: Harmful tax practices A4: Interest A6: Treaty abuse A7: PEs A8: Transfer pricing (TP): Intangibles A9: TP: risks & capital A10: Other highrisk TP A11: Analyse data A12: Disclosure of aggressive tax planning A13: TP documentation A14: Dispute resolution A15: Multilateral instrument

Actions addressing BEPS using interest Action 2: Neutralize the effects of hybrid mismatch arrangement which generate two tax deductions for same payment, or payments which are deductible in the payer but not taxed as ordinary income in the recipient Action 3: Strengthen CFC rules to address interest income in controlled companies in low tax jurisdictions Action 4: Limit base erosion via interest deductions and other financial payments, and transfer pricing guidance for related party financial transactions Action 9: Transfer pricing of risks and capital focuses on entities that are overcapitalized or assume excessive contractual risks

Debt bias in cross-border context Differences in the tax treatment of the payer and payee of debt creates a tax-induced bias, in the cross-border context, towards debt financing. Distortion compounded by tax planning techniques to reduce or eliminate tax in the jurisdiction of the payee. Creates competitive distortions between groups operating internationally and those operating only in a domestic market, and tax preference for assets to be held by overseas groups.

Interest deductibility (Action 4) Develop recommendations regarding best practices in the design of rules to prevent base erosion through the use of interest expense … … for example, through the use of related party and third party debt … … to achieve excessive interest deductions or to finance the production of exempt or deferred income … … and other financial payments that are economically equivalent to interest. In connection with and in support of the foregoing work, transfer pricing guidance will also be developed regarding the pricing of related party financial transactions 11

Interest deductibility: Two tests Group-wide tests Fixed ratio tests Combination of the two tests

Interest deductibility: Group-wide test A group-wide test would limit a company’s net interest deductions to a proportion of its group’s actual net third party interest expense, based on a measure of economic activity such as earnings or asset value Aims to allow groups to claim tax relief for their real cost of funds, while protecting countries from excessive deductions Groups can continue to centralise third party borrowings in the entity/country which is most efficient for non-tax purposes, while tax relief for interest is matched with economic activity A best practice recommendation could include an agreed approach to be applied consistently by all countries or provide flexibility for a country to incorporate existing tax principles within its rule.

Interest deductibility: Fixed ratio test A fixed ratio test operates by applying a fixed benchmark ratio to an entity’s earnings or asset value Should be more straight-forward for groups and tax authorities to apply Relatively inflexible, applying the same benchmark ratio to all entities Difficult to establish the correct benchmark ratio Work based on published data suggests that, where countries currently restrict interest deductions based on a fixed interest/EBITDA ratio, these ratios may be set at a level which is too high to tackle BEPS

Net third-party interest expense/EBITDA ratio for large non-financial MNE groups

Interest deductibility: Combined approach A combined approach would allow lower risk companies to apply a simple fixed ratio test, while more highly geared companies could claim higher deductions by applying a group-wide test: Approach 1 Approach 2 Main rule Group-wide test Fixed ratio test Carve-out For companies which meet a low fixed ratio test (or opt to apply the fixed ratio as a limit on deductions) For companies which exceed the fixed ratio but can demonstrate they are within the equivalent ratio of their group

Interest deductibility (Action 4) Discussion draft released 18 December 2014 for comment by 6 February 2015 Public consultation held in Paris on 17 February 2015 Final report with recommendations for best practices in the design of rules to address BEPS using interest by September 2015

Contact details Tom Neubig Deputy Head of the Tax Policy and Statistics Division Centre for Tax Policy and Administration Thomas.Neubig@oecd.org