Step 1: Calculating the measure of earnings
89. An entity’s EBITDA should be calculated by adding back to its taxable income, the tax values for: (i) net interest expense and net payments equivalent to interest payments as defined in Chapter 2; and (ii) depreciation and amortization. Tax exempt income, such as exempt dividend income or foreign earnings that are tax exempt, should not form part of the entity’s EBITDA figure. The rationale behind excluding exempt dividend income is to address concerns related to the outbound investment scenario as described in Action 4.
Step 2: Applying the statutory benchmark fixed ratio to earnings
90. Following the calculation of the entity’s EBITDA, the statutory benchmark fixed ratio will be applied to the EBITDA figure. The result determines the maximum amount of interest expense that the entity is allowed to deduct for tax purposes.
Step 3: Comparing maximum deductible interest expense with actual interest expense
- 91. In the last step, the maximum amount that the entity is allowed to deduct for tax purposes is then compared with the entity’s actual net interest expense.
- 92. Net interest expense in excess of the maximum allowable amount is disallowed. An illustration of how a fixed ratio rule might operate in practice is included as Example 4 in Annex D. This example also illustrates the potential advantages and disadvantages of applying a fixed ratio rule at the level of the local group.