Factors to assist countries in setting a benchmark fixed ratio

  • 99. It is recommended that countries set their benchmark fixed ratio within the corridor of 10% to 30%. However, it should be recognised that countries differ in terms of their legal framework and economic circumstances and, in setting a benchmark fixed ratio within the corridor which is suitable for tackling base erosion and profit shifting, a country should therefore take into account a number of factors, including the following:
  • 1. A country may apply a higher benchmark fixed ratio if it operates a fixed ratio rule in isolation, rather than operating it in combination with a group ratio rule.
  • 2. A country may apply a higher benchmark fixed ratio if it does not permit the carry forward of unused interest capacity or carry back of disallowed interest expense.
  • 3. A country may apply a higher benchmark fixed ratio if it applies other targeted rules that specifically address the base erosion and profit shifting risks to be dealt with under Action 4.
  • 4. A country may apply a higher benchmark fixed ratio if it has high interest rates compared with those of other countries.
  • 5. A country may apply a higher benchmark fixed ratio, where for constitutional or other legal reasons (e.g. EU law requirements) it has to apply the same treatment to different types of entities which are viewed as legally comparable, even if these entities pose different levels of risk.
  • 6. A country may apply different fixed ratios depending upon the size of an entity’s group.
  • 100. These factors are considered in more detail below.

A country may apply a higher benchmark fixed ratio if it operates a fixed ratio rule in isolation, rather than operating it in combination with a group ratio rule

101. Where a country operates a fixed ratio rule alongside a group ratio rule, an entity which exceeds the fixed ratio may be able to deduct more net interest expense up to the relevant financial ratio of its group. The country is therefore able to apply a benchmark fixed ratio at a lower level, relying on the group ratio rule to moderate the impact of this on entities in groups which are highly leveraged. On the other hand, where a country introduces a fixed ratio rule without a group ratio rule, it may apply a higher benchmark fixed ratio.

A country may apply a higher benchmark fixed ratio if it does not permit the carry forward of unused interest capacity or carry back of disallowed interest expense

102. Unused interest capacity is the amount by which an entity’s net interest expense is below the maximum amount permitted under the fixed ratio rule. As discussed in Chapter 8, where a country permits unused interest capacity to be carried forward, this could give rise to a tax asset which may be monetised by increasing the entity’s net interest expense or by reducing its EBITDA. As these behaviours should not be encouraged by a rule to tackle base erosion and profit shifting, a country which allows the carry forward of unused interest capacity should apply a lower benchmark fixed ratio to reduce this incentive. Similarly, a country which permits the carry back of disallowed interest expense, which gives rise to the same risk, should also apply a lower benchmark fixed ratio. The weight which should be attached to this factor would depend upon the extent to which a country incorporates the restrictions discussed in Chapter 8. A country which does not allow either a carry forward of unused interest capacity or a carry back of disallowed interest expense may apply a higher benchmark fixed ratio.

A country may apply a higher benchmark fixed ratio if it applies other targeted rules that specifically address the base erosion and profit shifting risks to be dealt with under Action 4

103. Action 4 focuses on the development of best practices in the design of rules to prevent base erosion and profit shifting through the use of third party, related party and intragroup interest, including payments economically equivalent to interest, to achieve excessive interest deductions or finance the production of exempt or deferred income. The recommended best practice approach includes the fixed ratio rule described in this chapter, but it is recognised that other targeted interest limitation rules may also be effective in tackling some of these risks. For example, a country may have a targeted rule which disallows all interest expense used to fund tax exempt income. Where a country has targeted rules which specifically address the base erosion and profit shifting risks to be dealt with under Action 4, and it applies these rules in practice, these may reduce pressure on the fixed ratio rule meaning that a higher benchmark fixed ratio could be applied. The extent to which this factor supports a higher benchmark fixed ratio depends upon the extent to which the specific base erosion and profit shifting risks involving interest and targeted by Action 4 are addressed. Where a country does not have other rules which specifically deal with the base erosion and profit shifting risks targeted by Action 4, it should apply a lower benchmark fixed ratio.

A country may apply a higher benchmark fixed ratio if it has high interest rates compared with those of other countries

104. The net interest/EBITDA ratio of entities which raise third party debt locally can be impacted by a number of factors, including the level of a country’s interest rates. Where a country’s interest rates are high relative to those in other countries, the country may recognise this by applying a higher benchmark fixed ratio. This is not intended to favour entities operating in a high interest rate country, but simply recognises the fact that these entities are likely to be subject to a higher cost of funds. The extent to which this factor supports a higher benchmark fixed ratio depends upon the extent to which interest rates are higher than those in other countries. However, a country with high interest rates may still apply a low benchmark fixed ratio. For example, where a country applies the same benchmark fixed ratio to all entities, including those in large groups which are less likely to be exposed to differences in interest rates between countries, it may decide that it is not appropriate for its high interest rate to be taken into account when setting the ratio. Where a country has low interest rates compared with other countries, it should apply a lower benchmark fixed ratio. In comparing its interest rates with those of other countries, a country may take into account one or more relevant rates, such as the central bank rate, the long-term government bond rate and the average corporate bond rate for entities with a good credit rating (for example, equivalent to a credit rating of "A" or above). Whether a particular interest rate is high or low must be judged in comparison with other countries and will change over time as interest rates move. Currently, it is suggested that a longterm government bond rate that is above 5% may be considered to be high.

A country may apply a higher benchmark fixed ratio, where for constitutional or other legal reasons (e.g. EU law requirements) it has to apply the same treatment to different types of entities which are viewed as legally comparable, even if these entities pose different levels of risk

105. As set out in Chapter 3, the main base erosion and profit risk involving interest is posed by entities in multinational groups. Therefore, within the best practice approach, a country may restrict the application of the fixed ratio rule to these entities. However, in some cases, constitutional or legal requirements mean that a country is also required to apply the fixed ratio rule to other entities which are seen as legally comparable, including entities in domestic groups and/or standalone entities which may pose less risk of base erosion and profit shifting involving interest. In this case, because the country is required to apply the same treatment to entities which are legally comparable, including those which pose less base erosion and profit shifting risk, the country may apply a benchmark fixed ratio at a higher level within the corridor. In such situations, a country may alternatively decide to apply a lower ratio in order to ensure that base erosion and profit shifting involving interest is addressed, even though this would also be applied to entities which pose less risk.

A country may apply different fixed ratios depending upon the size of an entity’s group

  • 106. In general, entities in large groups are in a different position to other entities when raising third party debt. For example, large groups are more likely to raise third party debt centrally, they may have better access to global capital markets, and they may have greater bargaining power with lenders. Large groups also often have sophisticated treasury functions to manage the financial position of the group, including its interest cost. This has two important implications for the application of a fixed ratio rule to entities in large groups compared with other entities:
    • • Firstly, the analysis of financial data provided to the OECD during the public consultation on Action 4 indicates that large groups tend to have lower net third party interest/EBITDA ratios compared with other groups. For example, a benchmark fixed ratio of 30% would allow around 95% of publicly traded multinational groups with market capitalisation of USD 5 billion or above and with positive EBITDA to deduct all of their net third party interest expense, compared with around 85% of groups of all sizes. Therefore, to create a level playing field, a country may apply one benchmark fixed ratio to entities in large groups, and a higher benchmark fixed ratio to other entities.
    • • Secondly, because large groups are more likely to raise third party debt centrally, they are less likely to be exposed to differences in interest rates in the countries in which they operate. Therefore, in setting a benchmark fixed ratio to apply to entities in large groups, a country should not take into account whether its interest rate is higher or lower than those in other countries (i.e. factor 4 above should not be taken into account).
  • 107. Where a country applies a different benchmark fixed ratio to entities in large groups compared with other entities, the definition of a large group should be based on the position of an entity’s worldwide group and not only the local group including entities in the country. Although the data referred to above defined a large group based on market capitalisation, it is not recommended that this definition be used to set a benchmark fixed ratio. For privately held groups, a definition based on market capitalisation could not be applied. For publicly held groups, market capitalisation depends on many factors other than the group’s level of economic activity. It is therefore suggested that a country’s definition of a large group should be based on group consolidated revenue or group assets. Information on a group’s consolidated revenue or assets may be obtained from the group’s consolidated financial statements or directly from entities in the group where consolidated financial statements are not prepared. Information provided for the purposes of Country-by-Country reporting (Transfer Pricing Documentation and Country-byCountry Reporting (OECD, 2015)) may be used as a risk assessment tool to identify groups which may exceed this threshold, although this information should not be used by itself in order to apply a lower benchmark fixed ratio. Where a country applies different benchmark fixed ratios to entities in large groups and to other entities, it should include provisions to accommodate groups which cross the threshold, for example through a merger or divestiture. Such transitional provisions should be available for at most three years, to give groups an opportunity to adjust their capital structures.

Other factors that may be taken into account

  • 108. When setting a benchmark fixed ratio within the corridor of 10% to 30%, countries may also take into account other relevant factors in addition to those set out above. For example:
    • • A country may apply a higher ratio within the corridor where data shows that there are high levels of net interest expense or debt due to economic or business policies and not due to base erosion and profit shifting.
    • • A country may apply a higher ratio within the corridor where it applies a macro-economic policy to encourage third party lending not related to base erosion and profit shifting, to increase investment (e.g. in infrastructure).
    • • A country may apply either a higher ratio or a lower ratio within the corridor where this is justified by local data on the external gearing of its domestic groups or the worldwide gearing of multinational groups operating in the country. This local data may for instance be based on tax rather than accounting figures.
    • • A country may apply a lower ratio within the corridor where it wishes to apply a stricter approach to tackling base erosion and profit shifting involving interest.
  • 109. However, a country should not take into account any factor which is inconsistent with this report, which introduces competition issues or which fails to take into account the level of base erosion and profit shifting risk involving interest in that country. For example:
    • • A country should not apply a higher ratio where it has high levels of net interest expense or debt compared to those in other countries, which does not have a non-tax j ustification.
    • • A country should not apply a higher ratio due to a policy of attracting international investment into a country through lenient interest limitation rules.

Applying factors to set a benchmark fixed ratio within the best practice corridor

  • 110. It is recommended that a country uses the factors in this chapter, along with other relevant factors, to set its benchmark fixed ratio within the recommended corridor. A country may develop its own approach as to how to apply the factors in setting a ratio, including applying a different weighting to each factor depending upon the extent to which it applies. In all cases, a country is able to choose to apply a lower benchmark fixed ratio within the corridor.
  • 111. Illustrations of ways in which a country could use the factors to set its benchmark fixed ratio within the recommended corridor are included as Example 5 in Annex D. These are intended to illustrate possible ways in which a country could apply the factors in this chapter, but are not exhaustive and a different approach may be used.
 
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