Action 4 – Limitation on Interest Deduction - International Taxation - Income Tax

Action 4 Limitation on Interest Deduction Generally, International Group taking loan or debt in High Tax Jurisdiction because interest is deductible expenses they can reduce their overall tax liability. The OECD is concerned that multinational group can reode their tax base (i.e. reduce their taxable profits) with interest example by: Groups placing higher levels of third party debt in high tax countries. Groups using intragroup loans to generate interest deductions in excess of the group s actual third party interest expense. Groups using third party or intragroup financing to fund the generation of tax exempt income. BEPS action plan 4 calls for the development of recommendations for the design of domestic rules to prevent tax base erosion through the use of interest expense and other financial payments that are economically equivalent to interest. To address the risk, Action 4 of the Action Plan on Base Erosion and Profit Shifting (BEPS Action Plan, OECD, 2013) called for recommendations regarding best practices in the design of rules to prevent base erosion through the use of interest expense. The 2015 Report established a common approach which directly links an entity s net interest deductions to its level of economic activity, based on taxable earnings before interest income and expense, depreciation and amortisation (EBITDA). This approach includes three elements: Fixed Ratio Rule Based on benchmark net interest/EBITDA ratio. Interest deduction should be based on the level of economic activity. As per this rules interest is allowed at certain percentage of EBITDA. Group Ratio Rule This rule allows an entity to deduct more interest expense based on the position of its worldwide group. Targeted Rules These Rules address specific risks. There should be certain rule to address specific risk in case of Banking and Insurance business. If there is no risk then country can exclude banking and insurance business. Updation of BEPS Action 4 Report: Guidance on the design and operation of the group ratio rule and approaches to deal with risks posed by the banking and insurance sectors. In December 2016, the OECD released an updated version of the BEPS Action 4 Report (Limiting Base Erosion Involving Interest Deductions and Other Financial Payments), which includes further guidance on two areas: the design and operation of the group ratio rule, and approaches to deal with risks posed by the banking and insurance sectors. The design and operation of the group ratio rule - The 2015 Action 4 Report set out a common approach to address BEPS involving interest and payments economically equivalent to interest. This included a 'fixed ratio rule' which limits an entity's net interest deductions to a set percentage of its EBITDA and a 'group ratio rule' to allow an entity to claim higher net interest deductions, based on a relevant financial ratio of its worldwide group. The report included a detailed outline of a rule based on the net third party interest/EBITDA ratio of a consolidated financial reporting group, and provided that further work would be conducted in 2016 on elements of the design and operation of the rule. The updated report does not change any of the conclusions agreed in 2015, but provides a further layer of technical detail to assist countries in implementing the group ratio rule in line with the common approach. This emphasises the importance of a consistent approach in providing protection for countries and reducing compliance costs for groups, while including some flexibility for a country to take into account particular features of its tax law and policy. Banking and insurance sectors - The 2015 report also identified factors which suggest that the common approach may not be suitable to deal with risks posed by entities in the banking and insurance sectors. The updated report examines regulatory and commercial requirements which constrain the ability of groups to use interest for BEPS purposes, and limits on these constraints. Overall, a number of features reduce the risk of BEPS involving interest posed by banking and insurance groups, but differences exist between countries and sectors and in some countries risks remain. Each country should identify the risks it faces, distinguishing between those posed by banking groups and those posed by insurance groups. Where no material risks are identified, a country may reasonably exempt banking and/or insurance groups from the fixed ratio rule and group ratio rule without the need for additional tax rules. Where BEPS risks are identified, a country should introduce rules appropriate to address these risks, taking into account the regulatory regime and tax system in that country. The updated report considers how these rules may be designed, and includes a summary of selected rules currently applied by countries. Progress in implementation As at mid-2019, a number of OECD and Inclusive Framework members have adopted interest limitations rules or are in the process of aligning their domestic legislation with the recommendations of BEPS Action 4. From the commencement of 2019, the EU Member States apply an interest cap that restricts a taxpayer s deductible borrowing costs to generally 30% of the taxpayer s earnings before interest, tax, depreciation and amortisation (EBITDA). Various other countries have also taken steps to limit interest deductibility (e.g., Argentina, India, Malaysia, Norway, South Korea) or are in the process of aligning their domestic legislation with the recommendations of Action 4 (e.g., Japan, Peru, Viet Nam). The latest edition of Corporate Tax Statistics published in July 2020 collected, for the first time, information on interest limitation rules, which can assist in understanding progress related to the implementation of BEPS Action 4. The data highlights that interest limitation rules can limit base erosion via the use of interest expense to achieve excessive interest deductions or to finance the production of exempt or deferred income. It also shows that information on the presence and design of interest limitation rules is available for 134 Inclusive Framework jurisdictions, of which 67 had interest limitation rules in place in 2019. Provision in Indian Tax Regime Section 94B of the Income Tax Act, 1961: Addressing Thin Capitalization Debt financing of cross-border transactions is often favorable than equity financing for taxpayer. In view of the above, in line with the recommendations of OECD BEPS Action Plan 4, Section 94B inserted in Income Tax Act, 1961 by Finance Act 2017 to provide a cap on the interest expense of 30% of its earnings before interest, taxes, depreciation and amortization (EBITDA) or interest paid or payable to associated enterprise for that previous year, whichever is less, shall not be deductible.