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Thursday, 25th April 2024 |
| BEPS - the impact on financing |
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| While the OECD's Base Erosion and Profit Shifting (BEPS) initiative has been a central area of focus for multinational corporations' tax teams as they try to assess the impact on their business structures. However, the effect that these new rules could have on the financing activities of multinational organisations is very significant writes Graham Williams. He analyses four areas that will be heavily impacted by the OECD proposals - Interest Deductibility, Treaty Abuse, Controlled Foreign Companies and Tax Arbitrage - and how it may change how companies finance their activities to comply with the proposed rules. |
Readers may be aware of the OECD’s current initiative on international taxation, aimed to counter with certain activities by multinational corporations to reduce their tax liabilities by 'Base Erosion and Profit Shifting' (BEPS).
This is not, however, simply an item for a company’s tax teams to address. Some of the OECD’s proposals significantly affect all parts of an international business. In particular, the impact on the financing of multi-national companies is likely to be material. This article sets out some of the key developments which companies should be monitoring, and reacting to, if they are to ensure that the companies financing activities operate effectively post-BEPS.
The BEPS actions
The OECD set out a number of 'actions', or areas on which they would put forward recommendations. These cover specific areas where there is a concern that tax avoidance occurs (e.g the use of hybrid instruments or entities) and also areas where global tax compliance frameworks could be enhanced (e.g. disclosure of avoidance schemes).  | | Graham Williams |
The OECD’s recommendations are being published gradually during 2014 and 2015. In each case, the idea is that individual governments will co-operate to enact similar legislation to bring these recommendations into force across the world on a co-ordinated basis. Although it is too early to say whether this will happen in practice, there is currently broad international consensus for the BEPS activities.
Whilst most of the actions will apply widely to multinational groups, the ones most applicable to financing activities are those dealing with Interest Deductibility, Treaty Abuse, Controlled Foreign Companies and Tax Arbitrage.
Interest deductibility
The OECD’s paper on interest deductibility is hugely significant. If incorporated into legislation by major countries, it could represent a fundamental change to the way in which interest costs are treated as tax deductible. Instead say "treated for tax purposes".
This could, in turn, raise material questions for a multi-national group’s financing strategy. For example, the decision on whether to finance the group’s balance sheet by debt or equity would be affected. Where debt is needed, the question of which territory should bear the cost may also change. Intragroup lending and cash concentration arrangements could also be impacted.
The OECD paper itself states that the offset of interest expense against taxable profits in high tax territories is a form of “base erosion” which should be countered even where the interest deduction is acceptable under the principles of transfer pricing (i.e. that the interest deduction should be no greater than would be available if it were paid to an unconnected lender).
Two main solutions are proposed. The first possibility is a fixed cap on interest deductibility, based on (for example) a proportion of a group’s EBITDA in a territory. It might be, for example, that only 50% of EBITDA could be offset for tax purposes by interest expense. Some territories such as Germany already have a rule along these lines, and US “earnings stripping” rules are also comparable. The difficulty is that it is not clear how a single cap should be set: different industries have different mixes of capital so that any simple ratio test is likely to impact some sectors more than others.
The second possibility is an apportionment of external interest costs. The idea would be that an international group’s external interest expense, as measured in the consolidated accounts, should be deducted for tax purposes once only. This deductible amount (restricted to the amount of group’s external interest expenses) would be allocated between the territories in which the group operates by some allocation key (e.g.pro rata to EBITDA). If the actual net interest expense in the territory was lower (e.g. because the territory holds surplus cash or receivables, or because it is funded by equity) no deduction would be available. Similarly, groups with no net interest expense would find that no deduction arises at all for interest.
A third possibility would be a mix of approaches (perhaps the first test as a basic filter with companies being able to use the more complex secondary rules if beneficial).
It is clear that these proposals would significantly reduce the ability of groups to deduct interest expense for tax purposes. This could well increase the cost of debt significantly. It would also mean that the marginal tax deduction available on any new borrowing would be complex to calculate, as it would depend on the marginal ability of all the group’s territories to deduct additional interest costs, apportioned under the allocation method. Assuming this was by reference to earnings, it would mean that volatility of profits by territory, and fx rates, could result in further distortions.
Treaty abuse
The OECD’s recommendations on 'treaty abuse' may also impact on financing activities, because it could have a significant impact on intercompany lending, including cash pooling.
Broadly, the paper proposes that the access to tax treaties (in order to reduce or eliminate withholding tax on intercompany payments) should be restricted to situations where a payment is being made between an overseas operating subsidiary and the territory of the group’s ultimate parent. In other situations it is suggested that the recipient of the payment should not be entitled to benefit from reduced withholding taxes.
There is a suggestion that the new rule may be relaxed in some circumstances. Broadly, these are that (a) the recipient of the payment obtains no more favourable tax result than the ultimate parent would have done, and (b) that there should be no tax avoidance purpose in making the payment.
Without the proposed relaxation, this proposal would lead to withholding taxes arising on many intercompany interest payments, whether they arise on long term structural loans or short term deposits or cash sweeps. Taking into account the relaxation, some situations may still be impacted, especially where loans are made from a treasury centre which may happen to have more favourable withholding taxes than the group’s ultimate parent would be entitled to.
CFC rules
The main aim of the OECD’s CFC paper is to encourage more territories to adopt CFC rules and, for those who already have such rules, to amend these rules along the lines of OECD recommendations. Many countries already have CFC rules, but these may not comprehensively counter BEPS.
In its current form, the discussion draft it is difficult for groups to accurately assess the impact of any prospective changes to domestic rules but they should seeking identify whether any current of their current activities are likely to be impacted by these changes.
Groups should be reviewing their business and corporate structures to make a fuller assessment of risk.
Anti-arbitrage
The fourth OECD proposal which could impact financing arrangements is that which attempts to prevent tax avoidance through arbitrage. “Arbitrage” in this context has a particular definition: the structuring of arrangements using hybrid instruments or entities. These are instruments or entities which fall to be treated differently in different territories (e.g. preference shares which some territories regard as debt and others as equity).
The proposal as drafted specifically excludes simple arbitrage between different tax rates, where there is no qualitative difference between how an instrument is treated. For example, a simple payment of interest to a tax haven would not be classed as arbitrage.
The remedy proposed by the OECD is that where such structures lead to double tax deductions (i.e. the same expense deducted in two tax regimes) or tax deductions with no taxable income, this should be corrected so that impact of the arbitrage is countered. This measure is likely to impact various structured intragroup loans.
Support
The OECD proposals are widely supported by taxing authorities and governments, and it is likely that many of them will be brought into force by many countries. The impact on financing activities is likely to be significant. Companies will need to monitor developments, and plan their operational and long term financing structures accordingly. In the meantime companies will also need to monitor unilateral action being taken individual tax authorities as many tax authorities are not waiting for the conclusion of the BEPS project to start amending their local rules. |
Graham Williams is director international and treasury tax at
PwC UK.
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