Applying a best practice approach based on the level of interest expense or debt

57. A key cause of base erosion and profit shifting is the ability of a group to artificially separate taxable income from the underlying activities that drive value creation. Therefore, one of the aims of the best practice approach set out in this report is to link the amount of interest deductions in an entity to the level of its taxable economic activity.

Applying the best practice approach to limit the level of interest expense or debt in an entity

• 58. A general interest limitation rule may operate directly, by restricting the amount of interest an entity may deduct for tax purposes, or indirectly, by restricting the amount of debt with respect to which an entity may claim deductions for interest. In considering which approach to include in the best practice recommendation, a number of factors have been taken into account. These include the following:
  • • Base erosion and profit shifting using interest is driven by the level of tax deductible expense incurred by an entity. A rule which directly limits the level of interest deductions an entity may claim addresses this.
  • • A rule which limits the level of debt in an entity will not necessarily address base erosion and profit shifting risks where an excessive rate of interest is applied to a loan. Therefore, such a rule would need to have a further mechanism to identify the maximum interest on the permitted level of debt. This could be done by applying an arm’s length test or apportioning an entity’s actual interest expense, but these approaches add a step to the operation of a rule and increase complexity.
  • • A best practice approach should apply to base erosion and profit shifting involving interest and payments economically equivalent to interest. However, for some payments economically equivalent to interest, there may be no existing requirement for an entity to separately recognise a debt linked to the payment. It should therefore be easier for entities and tax authorities to identify and value the payments of interest (and economically equivalent payments) for which tax relief is being claimed.
  • • The level of debt in an entity may vary throughout a period, which means that the amount of debt on a particular date, or even an average for the period, may not be representative of an entity’s true position. On the other hand, the level of interest expense in an entity will reflect all changes in borrowings throughout the period. This is therefore likely to give a more accurate picture of the entity’s actual position over the period.

• • A rule based on the level of debt in an entity could take into account the fact that two entities with the same amount of debt may for commercial reasons be subject to different rates of interest (e.g. taking into account the currency of borrowings and credit risk). This could also be done under a rule that directly limits an entity’s interest expense (e.g. by taking a group’s actual level of interest expense into account).
• • The level of debt in an entity is under the control of the entity’s management and so is generally predictable. The amount of interest expense, however, may vary reflecting changes in interest rates. This means that a rule that directly limits the level of interest expense could make it difficult for an entity to enter into longterm borrowings if there is a risk that interest rates could increase and it would suffer an interest disallowance in future periods.
• 59. Taking these factors into account, and given the key policy objective is to tackle base erosion and profit shifting involving interest and payments economically equivalent to interest, the best practice set out in this report includes rules which directly limit the level of interest expense that an entity may deduct for tax purposes. It also includes features, such as the group ratio rule, which should address some of the possible issues this raises. For example, if a group represents a greater credit risk and is required to pay a higher rate of interest on its third party debt, a group ratio rule will take this into account in setting a limit on tax deductions for entities within the group. As set out in the Introduction, a country may continue to apply an arm’s length test alongside the best practice approach. For example, this could ensure that the amount of interest expense claimed by an entity is in accordance with the arm’s length principle, but this amount is then subject to limitation under the best practice approach in this report.