Interest limitation for tax legislation in the European Union. An obstruction of fundamental freedoms?

Abstract

 

Tax planning is a practice used by many corporations in order to minimise their tax paid while being able to maximise their profits. One common way to undertake such conduct is by increasing the negative components of the tax base computation, for example, the interest expense deductibility. This practice is deemed harmful by many lawmakers, as it will imperil its tax legislation. Hence, to tackle this behaviour, the European Union has adopted an Anti-Tax Avoidance Directive in 2016, where the rules on interest expenses as a tax planning tool are addressed in Article 4. The Directive is to be transposed into the Member States’ tax laws. Nevertheless, there are some concerns on the comparability between the national rules implementing this Directive and the existing fundamental freedoms that are the cornerstone of the European Union. This thesis shall examine the possible infringements of the Directive’s transposition to the fundamental freedoms enshrined in the Treaty of the Functioning of the European Union. Some recommendations with regards to ameliorating the identified incompatibilities will also be given by using comparative legal research.

 

Keywords: EU, ATAD, fundamental freedoms, BEPS, interest, tax planning.

List of Abbreviations

 

List of Tables

 

Table 1: A comparison of Article 4 Anti-Tax Avoidance Directive (EU) and Action Plan 4 of Base Erosion and Profit Shifting (OECD) Incompatibilities of the ATAD Article 4 implementation with the EU freedoms and solutions

Table 2: Synopsis of the analyses in Chapter 5

List of Figures

 

Figure 1: An example of using debt to lower tax in a group, international vs domestic setting

Figure 2: An example of hybrid mismatches for the same payment/financial obligation

Figure 3: The effect of interest limitation rule to tackle using interest as a tax-reducing strategy

Figure 4: Overview of the best practice approach

Figure 5: An abuse of separate de minimis threshold by the creation of debt-borne entities

Figure 6: Steps for applying the fixed ratio rule

Figure 7: Multinationals affected by fixed ratio on EBITDA for interest deductibility limitation

Figure 8: Procedural approach to applying the group rule

Figure 9: A recapitulation of the dual holding case for the sister companies as related parties

Figure 10: Testing scheme for the justification of a tax legislation

Figure 11: Options regarding Art. 4 of the ATAD

Figure 12: Divergence in treatment of depreciation and amortisation

Figure 13: Divergence in treatment of depreciation and amortisation (variables parameterised)

Figure 14: Summary of tax base and tax due computation in the CCCTB

List of Equations

Equation 1: Fixed ratio calculation

1.    Introduction

 

Tax is a crucial element for a functional society where it is not simply a transfer of wealth from private property to the government but also serves as primary means to provide public goods such as upkeeping law and order, public infrastructure, and public welfare.^[1] However, tax collection has encountered significant challenges as the current tax rules are outpaced by the changes brought about by globalisation. These changes allow multinational enterprises (MNEs) to abuse the tax law for pursuing their own financial interest. This non-compliance imperils not only state budgets but also incentivises other taxpayers defying the laws, which will eventually jeopardise public welfare. With the revelation of Luxembourg Leaks^[2], Panama Papers^[3], and most recently Pandora Papers^[4], such undertaking, termed as tax planning, has since sparked global furore and drawn attention from the public.

 

Tax planning is gaining more sophistication due to the growing digital economy, as this conduct can be ‘disguised’ under various forms where businesses no longer need brick-and-mortar venues. Such conduct is particularly asserted in the context of the European Union (EU), wherewith the most drastic measure is the Directive 2016/1164 setting rules against tax avoidance practices that hinder the Internal Market, also known as the Anti-Tax Avoidance Directive (ATAD), adopted by European Commission.^[5] The ATAD aims not only to safeguard the revenues of MS but also attain a “fair and efficient corporate taxation” within the EU^[6], which eventually upkeep the integrity of the Common Market.^[7] This Directive requires the Member States (MS) to eradicate mismatches and loopholes in handling tax matters under their jurisdiction to deter aggressive tax planning. The ATAD introduces six measures that resemble the Base Erosion and Profit Shifting (BEPS) Action Plan of the Organisation of Economic Cooperation and Development (OECD),^[8] with interest limitation being one of the mandatory foci.^[9] Interest payments as a tax planning device are of particular concern for lawmakers due to their versatility and flexibility in the context of the EU market.

 

While the ATAD will play an active role in generating MS’ revenues, especially in the post-pandemic EU^[10], it raises numerous questions regarding its compatibility to the tenets of the EU – the fundamental freedoms enshrined in the Treaty of the Functioning of the European Union (TFEU). These freedoms, i.e., free movement of goods, persons, capital, and freedom to provide services, are to facilitate the economic activities in the EU and the mobility of the people therein. Restriction without any justification against any of these aforementioned freedoms will be deemed incompatible with the Union’s laws. Some restrictions, even with their imperative to prevent tax planning, may still prima facie infringe on said freedoms. As interest payments harbour many possibilities for MNEs to engage in tax planning, this has made any measures combating this practice become especially troublesome.^[11] As such, the question of the compatibility of ATAD’s interest limitation to the EU’s primary law, especially the fundamental freedoms, becomes imminent, and it calls for apt solutions to the current judicial contradictions.

 

Hence, this thesis which is organised in three body chapters seeks to analyse this subject by employing comparative legal research based on a doctrinal approach. The method used in this paper will explain the interaction between the fundamental freedoms under TFEU as the primary EU law and the ATAD as secondary law, in addition to rulings from the CJEU. Moreover, the thesis will detail and emphasise the concept of tax planning and the functionalities of ATAD, as well as elucidating the two’s interactions with interest payments. In other words, this paper aims to answer two questions:

 

(i)                 To what extent does the interest limitation, especially the implementation of these measures at the national level, violate fundamental freedoms?, and

(ii)               If so, what are plausible solutions for such infringements?

2.    Relevance of the EU fundamental freedoms to interest barrier measures

 

This chapter aims to provide some insights into the fundamental freedom of the EU that may be at odds with the interest barrier measure. Traditionally, four freedoms are guaranteed under the TFEU. This includes the free movement of goods, free movement of capital, free movement of persons, and freedom to establish and provide services. The group-ing of these freedoms is not static, however, since scholars have different interpretations.

 

However, as the free movement of persons deals primarily with the mobility of workers within the Union, it matters little to interest demarcation and tax planning. This right will be excluded from the legal framework recapitulation underneath to keep the coherence and relevance of the paper. The same could also apply for freedom of goods, where the Treaty involves the custom duties and other similar measures but not the actual direct taxation of the MS with regards to the corporate tax planning behaviour; hence, this freedom will be excluded from this paper as well.  Moreover, some overarching legal aspects based on these fundamental freedoms shall also be introduced as they concern not only one but multiple Treaty freedoms at once. In this regard, the concept of state aids in the context of direct taxation measures will be summarised in Subchapter 2.3.

 

It should be noted that while the Interest – Royalty Directive^[12] and its close predecessor, Parent – Subsidiary Directive^[13], also regulates taxation matters vis-à-vis the reimbursement for financing instruments, they do not examine the tax bases of these payees nor payers themselves. These Directives only concern the eradication of the withholding taxes in the respective MS for the corporation paying such amount, given that the requirements thereof are fulfilled.^[14] This puts them out of this paper’s scope, where the interest limitation doctrine only confines the determination of the tax bases for calculating the interest paid restriction.

2.1.         Free movement of capital

 

2.1.1    Concepts of capital

 

The freedom of capital is enshrined under Articles (Art(s).) 63 to 66 of the TFEU, with Art. 63 and 65 being the core.^[15] Same as goods, capital is not defined explicitly under the TFEU until 1988, when the Council stipulated what can be is considered as capital in Directive no. 88/361.^[16] Although being succeeded by the implementation of the Maastricht Treaty,^[17] the Direct still remains pertinent as the CJEU continues to use the nomenclatures contained in Annex 1 to this Directive to interpret what constitutes capital in the TFEU.

 

Capital is, however, not defined exhaustively but rather as an approximation to serve the full liberalisation of capital movements.^[18] The list given by the Directive covers a vast array of capital movements where most of the important conducts used for tax planning with interest are also included since the Directive also addressed “[the] economic nature of […] liabilities.”^[19] This encompasses direct investment (regardless of the leverage type) and instruments yielding interest (bonds, securities, insurances, loans, inter alia). The concept of tax planning with these instruments will be explained in Chapter 3.

 

A notable effect of freedom of capital is that such freedom not only concern capital movement within the intra-Community but also from EU MS to third countries, codified under Art. 63.^[20] The rationale behind this application is to bolster the Common Market, promote the eurozone, and contribute to the leading role of the Union in the global economy.^[21] It might seem that Art. 63 mandates the treatment of capital within the Union and the capital between an MS with a third country the same; however, this is not the case.^[22] This will be subsequently further elaborated in Section 2.1.2. In principle, freedom of capital can be triggered (i) when the capital departs from investors or (ii) when such capital is received to develop the corresponding economic activities of recipients.^[23] Moreover, due to the versatility of capital, this freedom often overlaps with other freedoms as well, e.g., freedom of establishment in Cadbury Schweppes^[24], or freedom to provide service in Fidium Finanz.^[25]

 

2.1.2  Restrictions and justifications on freedom of capital

The free movement of capital is the sole freedom that is explicitly allowed to be contested by the national law under Art. 65 no. 1 lit. a.^[26] The divergence in treatment with regards to capital is permitted due to the fact that this freedom also has third country nexus, where the EU vests more competence to deviate therefrom on the MS so that the rules under the TFEU can be applied with more flexibility.^[27] There are two sets of derogations from the free movements covered by the Treaty, which can be categorised as (i) grandfathering rule and rules to third country under Art. 64 as well as (ii) tax liability determination and other objective reasons for serving public interests under Art. 65. The first half of the former rule will be disregarded in this thesis, as it only concerns the event that arose before 1993, 1999, and 2002^[28], which holds little relevance to the application of the ATAD.

 

In Art. 64 no. 2 and no. 3, the Treaty states that “endeavouring to achieve the […] free movement of capital between Member States and third country to the greatest extent possible”. Legal scholars widely agree that a restriction on outflow and inflow of capital with third country nexus is possible^[29] as this is a lex specialis of what has been stipulated under Art. 63. It should be noted that the restriction prescribed here should be approved “unanimously” by the Council with the counsel from the Parliament only.^[30] Therefore, the MS’s legislation may still be red-flagged by the aforementioned apparatuses. In this regard, the restriction on capital movement with third country encompasses “direct investment, which necessarily includes investment in real estate – establishment, […] provision of the financial services or […] admission of securities to capital markets.” ^[31] The other items that might trigger freedoms of capital that are overarched by “direct investment” are to be interpreted based on the wordings of the annexe in Capital Directive.^[32]

 

Under letter (lit(s).) a of Art. 65 no. 1 of the TFEU, MS are allowed “to apply the relevant provisions of their tax law which distinguish between taxpayers who are not in the same situation with regard to their place of residence or with regard to the place where their capital is invested.” Via this provision, the Treaty emphasised that the differentiation of the taxpayers’ circumstances may be justified based on the source state and residence state principle in taxation. However, to what extent “not in the same situation” can be interpreted relies upon the adjudication of the CJEU. A notable case for this is Schumacker, wherein a Belgian resident working in Germany did not receive the same tax benefits he should have had, were he a German resident instead.^[33] The Court of Justice ruled that regardless of Schumacker’s residency within the EU, the fact that he derived his total income from Germany would objectively be tantamount to those with habitual abode therein.^[34]

 

Another relevant case with regards to the unjustifiable restriction of capital is under the decision of Commission v Belgium.^[35] In this case, Belgium forbids its own natural persons residing therein to acquire securities of loans issues abroad as the Belgian authority justified that an MS is allowed autonomy in its direct taxation decision. Moreover, the Belgian tax authority claimed that such prohibitive measure was to combat tax evasion of natural persons where these taxpayers could just not declare their interests even when they are subject to Belgian tax.^[36] The CJEU subsequently rejected this argument, proclaiming that while combating against tax evasion was a legitimate reason to impose restriction on capital freedom,^[37] the measures taken must align with the proportionality set forth in the Treaty.^[38] In other words, tax evasion or any harmful practices against tax collection in an MS may be an eligible argument for restricting the freedom of capital; however, such restriction must not be overly excessive. If such persists, then the MS’ measure is deemed nullius juris by the CJEU.

 

Under lit. b of Art. 65 no. 1, MS are also allowed to impose restrictions on freedom of capital provided that these measures serve public interest. Here, the MS may introduce measures to (i) prevent infringement of tax law and exert control on financial institutions, (ii) establish procedural law on reporting obligations to fulfil administrative or statistical information, and (iii) undertake actions to ensure the integrity of public security or policy. By the same token as the rulings in Commission v Belgium, the measures conferred must not be made with disproportionality or crafted under discrimination. It should be reiterated that the amelioration of aggressive tax planning’s detrimental effects renders certain restrictions of capital movements or dissuasion of investing in another EU MS^[39] possible. Nevertheless, the measures by MS must not overstep their boundaries on setting these rules should a less restrictive but equivalently effective measure avail.

 

2.2.         Freedom to provide services and freedom of establishment

The freedom to provide services and freedom of establishment are widely considered as intertwined since the Internal Market call not only for goods and capital but also the guarantee of EU entrepreneurs’ mobility.^[40] These freedoms are the extension of the free movement of workers, where the scope of application not only concerns worker but also covers all types of persons designated by the law who need to have cross-border transitory or permanent entrepreneurial conducts. This section will only refer to the establishment and services of a legal person with corporation income tax liabilities.

 

2.2.1    Corporation establishment and freedom of establishment limitation

 

It is imperative to understand what might constitute an establishment based on the wordings from the Treaty to understand how services can be rendered. This concept will be further specified in Section 2.2.2. The term establishment, however, is not clearly defined in the TFEU.^[41] Regarding legal persons, the establishment can be construed via the wording of the Art. 49. Here, the Article states that “[such] prohibition [on the freedom of establishment] shall also apply to restriction on the setting up of agencies, branches, or subsidiaries by nationals of any Member State established in the territory of any Member State.” ^[42]

 

The rights of companies or firms are explicitly stipulated under Art. 54, where the Treaty requires “company or firms formed in accordance with the law of a Member State and having registered office [and similar places] within the Union […] be treated in the same way as natural persons who are nationals of Member States”. Nevertheless, due to the idiosyncrasy between a legal and a natural person, the requirement of the Treaty is to be applied relatively. Moreover, due to discrepancies in company regulation across the Union in conjunction with MS autonomy in fiscal matters, there exist considerable differences in corporation handling amongst MS.^[43] This distinctive treatment vis-à-vis an establishment is reiterated via Art. 65 no. 1 lit. a on the tax autonomy of the MS in conjunction with the second half of Art. 49 TFEU on which establishment of the company is also “subject to the provision of the chapter [of the Treaty] relating to capital.” ^[44]

 

Nonetheless, the differences in handling corporations at the level of MS must be approached with scrutiny and do not constitute either direct or indirect discrimination. For example, in Centros, the Court held that a company deliberately choosing a jurisdiction with the most lenient requirements to register a business while conducting a business in another MS shall not constitute fraus legis of the Treaty.^[45] Despite that, the rulings emphasised that an MS is still entitled to take measures against any circumvention that elicits the Treaty, where the Court found that it is necessary to keep the integrity of the Treaty’s interpretation.^[46] This once again affirmed the views of the CJEU on legal abuse, especially in fiscal matters: an MS can justify its restriction on the Treaty freedom if such acts can be proven as measures against tax avoidance, so long as the national rules do not exceed the proportionality. Unlike the provision on capital, the restriction on freedom of establishment is not determined by the Treaty itself but by the decision of the CJEU.

 

Indeed, the Court’s rulings historically permit distinctive tax treatments on the basis of MS’ exclusive power on direct taxation. These distinctions are allowed as the CJEU respects the importance of allocation rules for taxing rights^[47] in international taxation, especially within the EU MS.^[48] However, it should be re-addressed that the matter of proportionality here is of paramountcy. For instance, in Marks & Spencer, the Court deemed it acceptable to prevent a resident parent company from deducting from its taxable income losses incurred by a non-resident subsidiary.^[49] On the other hand, an MS denying such conduct based on the loss-surrender purpose of the mother company to its subsidiary is considered as a contravention of Art. 49 and 54 TFEU.^[50] Furthermore, the proportionality of the MS law can be further scrutinised, that even when a corporate undertaking resembling a “wholly artificial arrangement” has genuine economic activities, any measure to strike down such arrangement will be incompatible with the EU law.^[51]

 

2.2.2  Concepts of services and restriction of freedom to provide services

 

Meanwhile, the term services are regulated by Art. 56 to 62 of the TEFU. In Art. 56, the Treaty mandates that the freedom to provide services within the EU must not be restricted regardless of the EU’s nationality of the service providers. Moreover, with respect to legal person, the said entity must prove a factual and non-disruptive link with the economy of an MS instead^[52] to enjoy the benefits of this provision. In opposed to goods or capitals, which are not exclusively defined in the TFEU, services are delineated as follows by the Treaty:

 

Services shall be considered to be ‘services’ within the meaning of the Treaties where they are normally provided for remuneration, in so far as they are not governed by the provisions relating to freedom of movement for goods, capital and persons.^[53]

 

In addition, the provision of the Treaty defines four sets of hallmarks of activities that must be necessarily regarded as services, including (i) industrial, (ii) commercial, (iii) craftsmanship, and (iv) professional.^[54] Based on the wording of the Treaty, it can be inferred that the freedom of services results from a so-called ‘catch-all’ mechanism for facilitation of trade conducts within the Union, i.e., other freedoms’ scope of application must be first tested before the applicability of freedom to provide service. Notwithstanding, within the realm of case law, the Court does not necessarily consider providing services as residual freedom but rather deems it as equal to its other counterparts.^[55] For example, in the Commission v Portugal, the CJEU found that construction which was made by another EU’s MS in Portugal, albeit taken many years, does not preclude the application of Art. 56 TFEU.^[56] In this case, the Court determined that some services might require a longer time period to fulfil the reciprocal performance; hence, the stationary status of the service provider does not fall into the application scope of freedom of establishment.^[57]

 

It is, however, unclear how an undertaking with the characteristics of one of the four stated above or regulated elsewhere in the Treaty – such as transport, banking, or insurance – be treated.^[58] A prominent instance of this is a loan given from a bank to another company from the same company group as the bank. Due to the existence of the financial institute, this is deemed possessing features regulated both under the freedom of capital and the freedom of services where this financial institute renders financial loan to its related company. So far, there is no set of fixed guidelines or hierarchies on what freedoms are to be applied or on which occasion such freedoms could or must be applied. Such a decision is made on an ad hoc basis by the CJEU on tribunal proceedings based on the fact of each case as well as the relevant MS jurisdiction.^[59] It should be noted that the CJEU’s approach on national legislation is founded upon a teleological basis, i.e., what the results rendered from the law of that country actually are, not the wordings stipulated in the legal corpora.

 

Similar to the freedom of establishment, the restriction on the freedom to provide services is not well-articulated in the Treaty itself but rather case law. Here, the CJEU also recognises that the restrictive tax rules may be in line with the freedom to provide services based on the basis of preventing tax fraud or tax avoidance and/or effectiveness on procedural matters on collecting taxes.^[60] Nevertheless, the Court has recently rejected the arguments posited by the MS since a mere presumption of tax avoidance must not lead to the justification of the restriction on the service for all parties involved.^[61]

 

2.3.         State aid in the context of direct taxation and interest limitation

 

As seen from the two previous subchapters, international corporate taxation matters interlace heavily with freedom of capital, establishment, and freedom to provide service. To ensure the integrity of the Common Market, the CJEU has extensively widened the scope of these fundamental freedoms via the legislation of state aid.^[62] Due to the extensiveness of the state aid concept in the EU context, this thesis accentuates the aspect of direct taxation.

 

2.3.1    Definition

 

State aid is defined under Art. 107 TFEU, where its sub-provisions explain/provide the conditions under which an aid is compatible with the Union’s law.^[63] Moreover, should an MS wish to grant an aid to certain beneficiaries, this aid must be approved by the European Commission.^[64] Failure to comply will result in the unlawful grant under the purview of the EU, where the beneficiaries are, if necessary, requested to return the aid of up to the past ten years with interest^[65]. The scope of application for state aid is of an extensive array, wherein Art. 107 TFEU states:

 

[…] [A]ny aid granted by a Member State or through State resources in any form whatsoever which distorts or threatens to distort competition by favouring certain undertakings or the production of certain goods shall, in so far as it affects trade between Member States, be incompatible with the internal market.^[66]

 

It should be noted that the four criteria^[67] need to be simultaneously fulfilled for a conduct to be considered as state aid: (i) advantage – aid­, (ii) state resources, (iii) distortion, and finally (iv) favours certain undertaking, also known as selectivity requirement.^[68] With regards to taxation, from the wording of “in any form whatsoever”, this can be construed as either (i) tax cuts, (ii) tax exemption, or (iii) tax credit. Nonetheless, a prima facie favourable measure in the light of taxation might be justified if the MS in question can illustrate that the measure is derived directly from the foundation of its tax system.^[69] However, the Court of Justice also elaborates that these measures may be deemed incompatible to Union’s law if they manifest either (i) the intrinsicality of the tax system but has unforeseen effects beyond the scope of the tax law objective, or (ii) the extrinsic objective with the aim to grant aid.^[70]

 

2.3.2  Determination of unlawful state aid

 

When there is a difference in tax treatment that might result in an advantageous position of the taxpayer, this might not be automatically qualified as unlawful state aid. This can be explained through the regime of intellectual property (IP) ruling regarding tax law. The rationale behind such is to facilitate and promote research and development (R&D) amongst businesses and to minimise the deadweight losses that might hamper these activities.^[71] This IP rule allows certain tax deductions for incomes derived from these properties, namely interest or royalties. In this case, the objective of facilitating R&D is not within the scope of business taxation as it does not generate government budgets; hence such measure falls into the extrinsic objective of taxation. As an advantage provided by the state via taxation measure that favours R&D undertaking, it does not distort while aims genuinely to improve the respective MS’ market.^[72] Notwithstanding, should this be ineffective, the tax treatment in question might be considered as unlawful state aid.

 

In another scenario, a tax regime may have a spill-over effect, i.e., the state aid is given unwillingly by the far-reaching effect of the tax law unbeknownst to the legislator. An example of this is the case Gibraltar.^[73] The Court found that Gibraltar’s tax regime for an exemption of interest income based on the company status in conjunction with the fact that corresponding interest payment has already been deducted elsewhere is not permissible since it has the element of a selective de facto undertaking.^[74] The ruling emphasises that while such a single rule by itself does not constitute a forbidden selectivity under state aids regime, the interaction of that rule with the whole tax system of Gibraltar yields the same effects as if that rule were to grant the aid. The judgement therein solidifies the evaluation on whether an MS’ tax legislation is at odds with the EU’s law, where that legislation in casu must be put under the light of that country’s tax system as a whole.

 

In the context of interest deductibility measure, both the ex- and intrinsicality of the tax system regarding state aid may be applied. On the one hand, the tax system may positively exclude certain undertakings from the interest limitation rule. On the other hand, the interest barrier rule may de facto leave some entities unwillingly outside the rule’s scope of application. In these two cases, the rule might be confronted with the state aid law from both the Treaty as well as the case-law from the CJEU. This is of paramountcy when transposing the implementation of the ATAD interest limitation into the national law.

3.    Interest barrier measure as means to combat aggressive tax planning

 

After examining the legal basis of fundamental freedoms under various EU legal instruments, this chapter will introduce the mechanism of interest limitation measures for tackling harmful tax behaviours. The first subchapter will introduce a short introduction to tax planning. In addition, the subsequent chapter encompasses the scheme using interest to conduct tax planning made by corporations. The final subchapter presents the relevant set of recommendations in the OECD Action Plan to combat against using interest payment to avoid taxes by corporations.

 

3.1.         A brief introduction to tax planning

 

The rationale of tax planning can be briefly explained by an adjudication from the United Kingdom. On the basis of the homo economicus, Lord Tomlin has stated in Inland Revenue Commissioners v. Duke of Westminster^[75] that:

 

Every man is entitled, if he can, to order his affairs so that the tax attaching under the appropriate Acts is less than it otherwise would be. If he succeeds in ordering them so as to secure this result, then, however unappreciative the Commissioners of Inland Revenue or his fellow taxpayers may be of his ingenuity, he cannot be compelled to pay an increased tax.

 

Tax planning can be thereby defined as a practice to minimise the tax under the legal confinement to the extent that the economic outcome of one’s activities remains unchanged, or at least the adverse effects on the economic results are overcompensated by the restrictions in the tax burden. In order words, tax planning is, in fact, legal.

 

Tax planning is, however, not to be confused with tax mitigation, tax avoidance, or tax evasion. While these nomenclatures seem to be resembling each other, there is a spectrum of differences in terms of legality as well as the scope of the law with regards thereto. Tax mitigation, so-called “the good,” is a scenario where a reduction of tax is expressly allowed or even encouraged by the law. For example, if an income is already taxed at the corporate level, it will be then either credited or exempted as the level or recipient of such, i.e., dividends. Another example would be the usage of a double tax agreement to avoid taxation levied by the concerned jurisdictions. These measures are designed to alleviate burdens on the taxpayer deemed unnecessary by the states. On the other end, tax evasion, “the ugly,” is an illegal act to blatantly avoid or lower taxes via means forbidden by law.^[76]

 

Tax avoidance, “the bad,” which is in the middle ground, is an arrangement or a set of arrangements that result in a tax advantage that is not intended nor foreseen by the legal system.^[77] Therefore, tax planning in the contemporary context lies within the realm of tax avoidance, as per the rulings from the UK. For example, taxpayers could either shift their profit elsewhere or make such profit untaxable at home jurisdiction or use deductibles such as interest or royalties to lower their tax bases via artificial means.^[78] These practices are now referred to as base erosion and profit shifting, first coined in 2013 by the OECD.^[79]

 

Tax planning, if left uncontrolled, would imperil the governmental budgets and the integrity of the legislative system, as one non-compliant taxpayer will encourage the other to follow. Moreover, this is even more relevant globally since MNEs operating cross-border could aggressively utilise tax planning to gain cost advantages over domestic ones,^[80] especially regional small and medium enterprises (SMEs). As a result, the Inclusive Framework on BEPS, consisting of 15 Action Plans to combat these practices, was actualised in 2015^[81] based on the reports made in 2013.^[82] It should be noted that these Action Plans were mere recommendations for combating harmful tax behaviour rather than a real and effective legislative instrument. Nevertheless, under the EU ATAD, partial of these Action Plans are now of mandatory nature for the EU MS, which will be explained in the next subchapters.

 

3.2.         Interest payments and equivalent instruments as a tax planning tool

 

Corporate tax is levied on the profit earnt by a legal entity within a certain period, where the profit is calculated by the revenue reduced by expenses. One of the most straightforward strategies to minimise such tax liability while still maximising the net income is to fabricate the costs insofar as these costs safeguard the final profit from the tax effect. Therefore, it is plausible to utilise the debt financing method to attain excessive interest deductions, which generally constitute deductible costs when determining the tax base. This interest is strategically created to ensure that the final profit is intact, especially in a corporate group.

 

This method proves to be an even more pertinent and pressing issue in the current economic context, which mainly concerns international corporate groups’ investments. For instance, a parent company could abuse such a rule by giving out a loan in a high tax jurisdiction. This country, however, has a double tax agreement with another low-tax country, where the high tax state forfeits its rights to tax this loan income of the mother company; thus, the tax is effectively due only in the low tax country. The subsidiary in this low tax jurisdiction, on the other hand, as it is financed through intragroup debt instruments, can, in turn, offset this interest payment to the parent company against the taxable income rendered. Altogether, these practices synergise and yield an undoubted advantage for MNEs in comparison to their domestic counterparts. This scheme is visually described below.

 

 

Figure 1: An example of using debt to lower tax in a group, international vs domestic setting^[83]

 

Moreover, the situation prescribed above could also result in a double non-taxation scenario if two countries conferred treat a financial payment differently. For instance, a parent company in country A issued a convertible bond to its subsidiary in country B. The country of the subsidiary company deems such payment to be an equity payment (e.g., dividends), be left untaxed at the subsidiary recipient. Country A, however, regards such bond as a pure loan, where the mother company can deduct the interest thereon. Such a scenario is also known as hybrid mismatches, where the inconsistent treatment of the single tax object arises between the relevant jurisdictions. This is demonstrated in Figure 2.

 

 

Figure 2: An example of hybrid mismatches for the same payment/financial obligation^[84]

 

As a result, interest deduction as a tax planning tool has been acknowledged to be a paramount concern for the global tax system. The solution to this is rather simple: A jurisdiction could set a maximum level of interest deductibility on a taxpayer, where anything above the limit is deemed as harmful tax behaviour; hence, the excessive interest amount cannot be deducted against the tax base. This can be observed in Figure 3 below. Nonetheless, to set such a limit without violating the neutrality as well as equality of taxation, the law-making process must take into account a wide array of variables.^[85] The details of such variables will be further elaborated in the following subchapter in the recommendations of the BEPS Action Plan 4. Moreover, the recommendation thereof is widely considered a blueprint for designing the EU’s ATAD Article 4, which will be illustrated in Subchapter 3.4.

 

 

Figure 3: The effect of interest limitation rule to tackle using interest as a tax-reducing strategy^[86]

 

3.3.         The BEPS Action Plan 4 – Countermeasures against tax planning by using interest payments

 

The contents of this Action Plan focus on the use of third parties, related parties, and intragroup debt to render interest or equivalent instrument tax deduction.^[87] In fact, the recommendations as per Action Plan 4 are derived from six realised methods currently being used by many jurisdictions, with some states implementing a combination thereof: (i) Arm’s length tests, (ii) withholding on interest payments, (iii) rules which limit a specified percentage of the interest expense made by an entity regardless of its nature or payee, (iv) rules which restrict the level of interest expense or debt based on a fixed ratio, (v) rules which restrict the level of interest expense or debt based on the financial standings of the whole group, and (vi) targeted anti-avoidance rules which disallow deductions on some specific transactions or arrangements.^[88] Despite the prevalence of those methods, the OECD did recognise some primary inadequacies within the aforementioned approaches to alleviating interest payments for minimising tax purposes:^[89]

 

First, an arm’s length test is ineffective as it requires significant consideration of the circumstances of each individual taxpayer. This is due to a considerable number of exogenous variants to be taken into account, for instance, variety of industries, model of businesses, product types, customer bases, etc. Such practice is costly for the tax administration in terms of time and resources. Moreover, an arm’s length test does not negate the deduction claim for interest expenses to fund investment in non-taxable assets or income.^[90]

 

Second, a withholding tax would not completely prevent the base erosion if not levied at the same rate as the corporate tax.^[91] Furthermore, in an international setting, a mere withholding tax would be easily impeded by the tax treatment from a double tax treaty. This can be again seen in Figure 1, where the resident state will eventually grant relief to such income for alleviating the double tax burden. Such a levy could even invite more tax avoidant behaviour and can be problematic in the context of the EU as the pre-existing Interest and Royalties Directive would disallow such practice^[92], especially under CJEU rulings on Cadbury Schweppes.^[93]

 

Third, rules which set a ceiling for interest paid percentage regardless of transaction participants would only discourage the debt financing means rather than BEPS behaviour. This is due to the cost increase of said financing method over a certain minimum amount.^[94] Hence, the OECD has recommended that these three former rules be only used in conjunction with the other set of rules, as long as they do not hinder the effectiveness of anti-BEPS rules.

 

Therefore, the best practice approach was established based on the combination of aforesaid methods with some modifications, as illustrated in Figure 4. As seen therefrom, the best practice approach on combating the abuse of interest limitation also includes some special derogative rules and additional rules to address some specific risks. Nonetheless, these derogations are optional and are to be applied however the relevant jurisdiction deems fit to their economic and political backgrounds, as long as the baseline recommendations are fulfilled. These suggestions are based on the already implemented unilateral measures from a multitude of countries, in conjunction with significant developments and amendments. This is in order to simplify the application procedure for the tax authority, as well as to establish a sound and robust approach against harmful tax planning practices.^[95]

 

 

Figure 4: Overview of the best practice approach^[96]

 

3.3.1    Minimum threshold rule

 

The OECD suggests that a state should be able to eliminate all the entities that are not of particularly high-risk committing tax avoidance via interest expenses from the interest barrier rule’s scope of application. Such a rule is known as the minimum threshold or de minimis rule. To do so, the governments should impose a certain amount of loan expenses so that anything lower than this amount can be deducted freely. The purpose thereof is to enhance the administrative process and reduce the compliance costs of any low-risk entity or the costs burdened by the tax administration apparatuses themselves.^[97] The design of such de minimis threshold should be calculated based on the total net interest expense of all the entities in a corporate group. Nevertheless, should the legislators wish to have a ceiling for separate entities within a group, a caveat for the anti-fragmentation rule must be implemented therewithin as well to combat the artificial creation of debt-borne entities, as in Figure 5.^[98]

 

An advantage of setting a minimum threshold for full interest expense deductibility is its simplicity and can ‘sieve’ out any highly debt-leveraged entities that the interest limitation rules targets. Nevertheless, it is needed to bear in mind that this threshold should be designed with meticulosity, as it depends on an ad-hoc basis, e.g., the interest rate environment, economic situations, inter alia. Therefore, such rules must be kept abreast of the latest macro- and microeconomic circumstances to yield the highest effectiveness.^[99]

 

 

Figure 5: An abuse of separate de minimis threshold by the creation of debt-borne entities^[100]

 

3.3.2  Fixed ratio rule

 

A fixed ratio is a calculation of debt expense in relation to other variables to set the deductible interest ceiling based on some characteristics of the taxpayer. As a result, the fixed ratio rule set has a similar mechanism as the de minimis threshold, where it aims to set a ceiling for how much the interest should be deductible. Its rationale is that an entity should be able to deduct its interest expense up to a pre-determined proportion of its gross earnings.^[101] The premise behind this method is based on the correlation between earnings and the ability to pay taxes.^[102] Measuring the economic activity using earnings could appropriately render the allowed interest deductible expenses that correspond to such activities yielding that taxable income. In order words, a higher income is deemed to match the higher interest expenses of an entity, which would in turn rules out any artificial and manipulative signs, should the interest expenses be made by the respective companies for tax avoidance purposes.^[103]

 

The earnings in question are defined as either the earnings before interests, taxes, depreciation, and amortisations (EBITDA) or earnings before interest and taxes (EBIT).^[104] The OECD also implies that the non-taxable income, especially the income that has already been exempted from the double tax treaty, should not constitute a part of calculating the EBITDA or EBIT. This is because they would dilute the total ratio and reduce the interest expenses, which should have been deductible, and eventually pose unwanted economic burdens. Nevertheless, the determination of EBITDA or EBIT should be adjusted appropriately to dividends and similar earnings to address the BEPS behaviour.^[105] The suggestions from the OECD have also laid out a systematic approach to determining the cap for interest expense via the fixed ratio, which can be shown via the following figure.

 

 

Figure 6: Steps for applying the fixed ratio rule^[106]

 

Moreover, the OECD accentuated that the consideration of the economic circumstances of jurisdiction is as paramount as the ability to tackle BEPS for designing the fixed ratio.^[107] Empirical research conducted by PricewaterhouseCoopers (PwC) USA and BIAC has indicated that the fixed ratios’ level correlates positively with the proportion publicly-traded stock MNE groups whose net third party interest expense is fully deductible.^[108] Such correlation took the shape of a piecewise graph as follow:

 

 

Figure 7: Multinationals affected by fixed ratio on EBITDA for interest deductibility limitation^[109]

 

From the result given as above, any rate above 30% excludes almost all the taxpayers who should have been put under the scope of the fixed ratio rule. On the other hand, if the rate is less than 10% of the EBITDA, this would significantly burden more than a haft of all taxpayers, signalling market failures. The OECD, hence, recommends the applicable ratio on the EBITDA for limiting interest expense lie between 10% to 30%, so-called “the best practice corridor,”^[110] as it can be adapted according to the relevant authority.

 

There are some precautions when stipulating a fixed ratio for interest expense deductibility. First, it should be noted that this rule must complement the implementation of the de minimis rule. Otherwise, economically, the implementation thereof would not be impactful.^[111] Second, as the interest expenses or equivalents are highly dependent on the economic activities, a country may allow a higher rate if the interest rate thereof is higher than other countries.^[112] By the same token, the rate in question can be applied with a different rate if it can better address the BEPS behaviour in one jurisdiction. Third, such a rate can be adjusted to fulfil certain constitutional or statutory reasons, e.g., EU law. ^[113]

 

Notwithstanding, the OECD does recognise that an application of a fixed ratio rule would disregard the intersectoral factors. An MNEs may operate in both high and low leveraged industries, where a fixed limit for such an entity may pose adverse effects.^[114] For example, a rigid fixed ratio may disallow the offsetting effect for interest payment of the lower leverage sector against the higher one, which will burden the business. Another disadvantage of this method is that as the rate resembles the hallmarks of the de minimis limitation, this would require an ad hoc modification,^[115] which may lead to some administrative problems.

 

3.3.3  Group ratio rule

 

The group rule ratio is introduced as a lex specialis for supplementing the previously introduced rule: Instead of an individual entity, the fixed ratio will be applied to a whole corporate group as if it were a single unit. Therefore, its mechanism is the same as the fixed ratio rule, with a caveat as the EBITDA as well as the interest expenses will be consolidated for group reporting, as if the group in question were an individual entity^[116]. Nonetheless, as the scope of this rule is onto the group itself, this would translate into some technical differences within its implementation.

 

To consolidate the financial data of the group, the definition of a group must be first determined. The OECD argues that the consolidated information should be centralised at the ultimate parent with no other higher holding participant^[117]. On the contrary, there exist some entities under the control of a company but would not form a part of the group^[118]. In spite of such design, it should be accentuated that a group unity within this context should be able to combat the fabricated related members that somehow fall outside the scope of the rule^[119]. An entity’s association to a group can be ascertained through a control test, which usually is under consensus as to the substantial control of one entity to another via either voting rights, capital, directing ability, etc.^[120]

 

 

Figure 8: Procedural approach to applying the group rule^[121]

 

Since the group rule is designed upon the pre-existence of the fixed ratio rule, the limitations of the latter rule a pari passu apply to this rule. Moreover, consolidating the financial data of the whole group may pose some administrative burden to local entities. It is thus recommended a group’s financial statement be consolidated based on the local generally accepted accounting principles (GAAP) instead, so long as such GAAP does not deviate substantially from any standardised accounting principles that are globally used, for example, International Financial Reporting Standards (IFRS) or US GAAP. Furthermore, another disadvantage of the group rule is an entity within a group may be heavily debt leveraged than it should have under the normal fixed rule ratio, and such phenomenon can be still offset at the level of the corporate group.^[122] Therefore, a country may or may not introduce a group rule as long as it does not impede the effectiveness of the fixed ratio rule.^[123]

 

3.3.4    Time-based rule

 

Time-based rule is a set of methods to address the time effect of the interest limitation. As taxation is assessed on a periodical basis, where the ability to render income of a taxpayer is determined,^[124] a barrier on the deductibility of interest expense may hinder the equity principle^[125] of the taxpayer when it comes to a different period. For instance, ceteris paribus, when an amount of interest remains the same in multiple periods, an EBITDA of one may be significantly high, then the interest deductibility would be more generously granted. On the contrary, the EBITDA in another period may reduce, and the deductibility is also then limited accordingly. Nevertheless, the interest payment of this taxpayer does not change; hence, it would be inappropriate to limit the deductibility due to the influence of the assessment period.

 

As a result, this entails that a robust limitation on the tax deductibility would not economically reflect the circumstances of that group. This may, in turn, enlarge the deadweight losses caused onto the market equilibrium and increase the risk of market failure.^[126] Therefore, the OECD has introduced two plausible options to ameliorate such effects: (i) Either allowing an average EBITDA in different periods or (ii) allowing the carry forward and back of disallowed interest as well as the unused interest capacity.^[127]

 

The first option is proposed to be applied on an average basis for the current assessing year in conjunction with the previous years.^[128] This would then allow a group to have some safeguarding effect from short-term volatility and achieve a fairer taxation result. Nevertheless, this would require the lawmakers to develop more regulations on the changes in the composition of the group and loss-making behaviour in the previous year. Similarly, this option would require some administrative and organisational effort from the taxpayer to keep records of the previous fiscal year at the group level.

 

The second option, which is deemed to be more plausible for both the legislators as well as taxpayers, is the carry forward and carry backward of disallowed interest alongside the rules for unused interest capacity.^[129] The OECD has suggested that there are three options for countries to implement: (i) only carry forward the disallowed interest expenses for deductibility of tax purpose, (ii) carry forward the disallowed interest and the unused interest capacity, or (iii) either carry forward or backwards such disallowance. This would relatively simplify the rulemaking process in comparison to the average EBITDA method, while can still address taxation’s equity principle, i.e., the tax paid should correspond to the earnings.

 

To have a better insight into the second option, let the group in Figure 5 be taken again as an example.^[130] For the case where the anti-fragmentation rule has been introduced, it is evident that 2 million USD cannot be deducted within the assessed year. Such amount, however, can be brought to the following year and be deducted, as it does not exceed the 3 million USD limit under the stipulation of carrying forward rule. If a capacity carrying rule is also introduced and provided that the entity does not have any interest expenses in the second year, the unused amount of 1 million within the range of deductibility in the second year can be even brought to the third year. Likewise, the carrying-backwards rule applies with the same mechanism but for a retrospective deduction.

 

While this method aims to combat the volatility and achieve a fairer fiscal outcome; nevertheless, the rule can be still abused if no further overarching rules are applied. For instance, if a carrying forward amount is allowed to be taken into account for infinite periods, then the attempt to address BEPS practices would be rendered futile in the long run. Thus, whenever there is a time-shifting rule for the exceeding interest limit amount, a country should impose some further limitations as follows:^[131]

 

        i.            The limitation on the number of fiscal years where the disallowed expense and/or unused expenses can be carried forward/backwards.

      ii.            “Depreciation” of the carrying forward amount over time (e.g., 25% per annum) so that after a defined period of time, this will be eventually used up.

    iii.            The ceiling for the carrying amount can be set as a fixed pecuniary level.

    iv.            The amount of carrying forward/backwards to be used in a year can be limited.

      v.            Disallowance of the carrying amount entirely after some certain conditions arise, for example, ownership linkage substantially changed, changes of nature of the economic activity incurred, etc.

 

3.3.5  Targeted rules to reinforce the general limitation barrier

 

Alongside the interest limitations, some specific stipulations on certain transactions or arrangements in order to enhance the overall effectiveness should be as well implemented. Furthermore, it aims to minimise the compliance cost for the entities, in particular the ones that do not engage in BEPS practices and, on the other hand, the tax authorities.^[132] The OECD proposed three targeted sets of recommendations to alleviate the issues left unaddressed by the general rules, which were previously introduced.

 

The first sets are the ‘catch-all’ rules. These are rules that fill any possible loopholes which can be exploited by taxpayers in the course of implementing other regulations on interest limitation. A country should be able to emphasise some following scenarios, whereby the legislations should be able to respond correspondingly. First, there is a risk of expense dilution, where the interest expenses are converted into something that falls outside the scope of the rule, which would reduce the interest level that subjects to the fixed ratio rule. Second, an affiliated entity enters an arrangement in order to increase the level of net third party interest expense that is subject to the group ratio, for example, by making an intragroup payment become a third-party payment. Third, by means of restructuring, the fixed ratio rule may not even apply. These risks can be addressed by standalone or some deviating rules within the fixed ratio and/or group rules. Another option would be implementing these targeting rules as other rules, namely the general anti-abuse rules (GAARs).^[133]

 

The second sets are the rules which address the synergistic behaviour of Action Plan 4 with other harmful practices on BEPS. There are some particular risks that need to be further confronted. These include the involvement of an entity to dilute the interest expense by net interest income or artificial loan. Moreover, an entity could use a third party to execute a back-to-back arrangement, where the interest may not be subjected to the interest limitation. By the same token, an interest expense to an affiliated party can be turned into tax-exemption, or that affiliated party enjoys the low tax rate regimes.^[134]

 

The last sets of targeting rules are supplementary definitions to aid the implementation of the aforementioned rules, where the terminologies on related parties and structured arrangements are being enucleated. Related parties, as per the recommendation of OECD, are members of the same group.^[135] However, should that not be the case, the determination test thereof is to be defined as either (i) one entity has effective control over the other entity, in terms of capital, voting rights or similar items, or (ii) two entities are effectively controlled by a third entity, or (iii) one entity has at least 25% stake in another entity and the third entity hold at least 25% stake in the first entity. On the other hand, the meaning of what might constitute a structured arrangement is defined rather limited.^[136] A structured arrangement is deemed as any corporate structure that allows an entity, its group, and related parties to not bear the entire cost of the interest payment. An example for this is a triangular case, where one party is a third party acting as an intermediary for the interest payment conducted intragroup, where the pay out from the third party might be different from interest. The existence of such structured arrangement will be disregarded and be treated as if the corporations operated in normal circumstances, i.e., the relevant authority would ignore such arrangement and apply the interest limitation accordingly.

 

3.3.6  Special rules for banking and insurance sectors

 

As the name suggests, the rationale for the introduction of special rules is that the financial sector requires financial assets and liabilities as an indispensable part of its day-to-day business model. Moreover, this industry is also subject to heavy regulation on their capital structure, where some leverage ratios are implemented to avert the financial crisis similar to the one has happened in 2008, for example, under Basel III Accord^[137] for bankers or EU Directive Solvency II^[138] for insurers. Therefore, a rigid regulation on interest limitation in this sector would be counterproductive.

 

On the other hand, it must be borne in mind that banks and insurance might also be utilised as a tax planning tool. BEPS practices vis-à-vis the involvement of banking and insurance entities can take a wide array of forms, for example, the inclusion of the bank with regulatory debt interest to offset the total ordinary debt. Therefore, it is stressed that the best practice as introduced above may not be fully effective.^[139] However, the OECD did not give any specific proposal for this particular sector, which may still leave some room for aggressive tax planning practices to occur.