BEPS Action 4 – Interest Deductions and Other Financial Payments

BEPS Action 4 “Limiting base erosion involving interest deductions and other financial payments” aims to limit base erosion via interest deductions and other financial payments. Recommendations are expected to be published for domestic law limitations on tax deductions for both related and unrelated party interest expense and economically equivalent payments. The workstream will also develop guidance for the transfer pricing of debt.

The Final Report on BEPS Action 4 recommends two main approaches to limiting deductions:

  • A “fixed ratio rule” which allows an entity to deduct net interest expense up to a benchmark net interest/EBITDA ratio within a corridor of 10%-30%; and
  • An optional “group ratio rule” that allows interest deduction up to the net interest/EBITDA ratio of worldwide group.

The Final Report further allows countries to apply a different group ratio rule to the worldwide group ratio (e.g. an “equity escape” rule, which compares an entity’s level of equity and assets to those held by its group), or not adopt a group ratio rule at all. It also protects the fixed ratio rule and the group ratio rule from planning and includes additional optional elements, including:

  • A de minimis threshold for entities with low levels of net interest expense
  • Carry forward/back provisions; and
  • An exclusion for third party interest used to fund certain public-benefit assets.

Transfer pricing guidance will also be developed regarding the pricing of related party financial transactions, including financial and performance guarantees, derivatives (including internal derivatives used in intra-bank dealings), and captive and other insurance arrangements. The work would be co-ordinated with the work on hybrids and CFC rules.

Australia’s response BEPS Action 4 

The Australian Government has indicated that it is unlikely to change the existing Australia’s thin capitalisation rules (based on debt-to-equity ratios) at this stage.  The Australian thin capitalisation rules were tightened from a gearing ratio of 75% to 60% and worldwide gearing ratio of 120% to 100% from the 2014/15 income year (see Tax and Superannuation Laws Amendment (2014 Measures No 4) Bill 2014).