Applying the best practice approach to limit an entity’s gross interest expense or net interest expense

• 60. Another key question is whether a general interest limitation rule should apply to the interest an entity incurs on its borrowings without any offset for interest income (gross interest expense) or after offsetting the interest income it receives (net interest expense).
• 61. A gross interest rule has the benefit of simplicity and is also likely to be more difficult for groups to avoid through planning. However, a gross interest rule could lead to double taxation where each entity is subject to tax on its full gross interest income, but part of its gross interest expense is disallowed.
• 62. A net interest rule would reduce the risk of double taxation, as an entity’s interest income would be set against its interest expense before the interest limitation is applied. It would also allow an entity to raise third party debt and on-lend borrowed funds within its group, without the entity incurring a disallowance of part of its gross interest expense. Taking into account these considerations, the general interest limitation rules contained in this report apply to an entity’s net interest expense paid to third parties, related parties and intragroup, after offsetting interest income.¹ Rules should apply to all of an entity’s net interest expense, as discussed in Chapter 2, to ensure that a broad range of base erosion and profit shifting risks are addressed, including where excessive third party interest expense is incurred in a high tax country.
• 63. However, the fact that an entity has a relatively low net interest expense does not mean that base erosion and profit shifting is not taking place. For example, an entity with net interest income could use interest expense to shelter this income from tax. An entity may also disguise other forms of taxable income as interest income, reducing the level of net interest expense to which the rule can apply. Therefore, it is recommended that countries supplement the general interest limitation rules with targeted provisions which disallow gross interest expense in specific situations identified as posing base erosion and profit shifting risk. This is discussed in Chapter 9. Rules which apply to limit an entity’s net interest expense will also have no impact on entities which, because of their business model, are typically receivers of net interest income. This arises in particular in the banking and insurance sectors, which are discussed in Chapter 10.