The Base Erosion and Profit Shifting (“BEPS”) project evidences an aggressive push by the OECD to prevent multinational taxpayers from using interest expense deductions (and other deductible payments) to reduce or “erode” income in high-tax jurisdictions (i.e., “base erosion”) and in so doing, move profits from high-tax jurisdictions to low-tax jurisdictions (i.e., “profit shifting”).

The OECD`s final report on Action 4 interest expense recommends that a limitation be imposed upon a company`s deduction of interest (and other payments economically equivalent to interest) equal to a benchmark percentage (between 10 percent and 30 percent) of a company`s earnings before interest, taxes, depreciation and amortization (“EBITDA”). Such a benchmark percentage is markedly stingier than the fixed percentage employed by the corresponding US limitation (i.e., 50 percent of adjusted taxable income) imposed on the deductibility of outbound interest payments by US corporations (i.e., the “earnings stripping” rules of Section 163(j)). However, the limitation on interest deductibility imposed by the U.S. earnings stripping rules applies only to certain U.S. corporations (i.e., corporations having a debt-to-equity ratio exceeding 1.5-to-1, a threshold intended at one time to implicate only US companies having leverage perceived to be excessive). Thus, the limitation on interest expense proposed by the BEPS Action 4 report would apply indiscriminately to all companies regardless of the adequacy of a company`s capitalization.

In this article, we discuss the mechanics of the US earnings stripping rules of Section 163(j) as well as the history and shortcomings of the Section 163(j) limitation. Finally, we consider the inadequacies of the BEPS Action 4 recommendations including the inability of the fixed ratio approach to reflect actual credit market conditions and borrowing costs specific to individual market participants.

Source:
Trusting, January – June 2016 issue