On 5 October 2015, the OECD released its final report on recommended limitations on interest expense deductions ("Action 4") under its Action Plan on Base Erosion and Profit Shifting (BEPS). Action 4 is focused on the use of third party, related party and intragroup debt to achieve excessive interest deductions or to finance the production of exempt or deferred income. A best practice approach to tackling these issues should apply to all forms of interest and payments equivalent to interest, to ensure that groups in an equivalent position are treated consistently and to reduce the risk of a rule being avoided by a group structuring its borrowings into a different legal form.
A best practice rule to address base erosion and profit shifting using interest expense should therefore apply to: (i) interest on all forms of debt; (ii) payments economically equivalent to interest; and (iii) expenses incurred in connection with the raising of finance (such as payments under profit participating loans or guarantee fees with respect to financing arrangements, to name a few).The best practice approach does not apply to payments which are not interest, economically equivalent to interest, or incurred in connection with the raising of finance. However, any payment may be subject to limitation under the best practice approach when they are used as part of an arrangement which, taken as a whole, gives rise to amounts that are economically equivalent to interest. One of the aims of the best practice approach is to link the amount of interest deductions in an entity to the level of its taxable economic activity. A rule that limits the level of debt in an entity will not necessarily address base erosion and profit shifting risks, when an excessive rate of interest is applied to a loan. Therefore, such a rule would need to establish further mechanisms to identify the maximum interest on the permitted level of debt.
A key question is whether a general interest limitation rule should apply to the interest an entity incurs on its borrowings without any offset for interest income (gross interest expense), or after offsetting the interest income it receives (net interest expense).A gross interest rule has the benefit of simplicity and is also likely to be more difficult for groups to avoid through planning. However, a gross interest rule could lead to double taxation, where each entity is subject to tax on its full gross interest income, but part of its gross interest expense is disallowed. A net interest rule would reduce the risk of double taxation, as an entity's interest income would be set against its interest expense before the interest limitation is applied. It would also allow an entity to raise third party debt and on-lend borrowed funds within its group, without the entity incurring a disallowance of part of its gross interest expense. Taking into account these considerations, the general interest limitation rules will apply to an entity's net interest expense paid to third parties, related parties and intragroup, after offsetting interest income.
Based on the above, from an economic, commercial and transfer pricing angle, it is reasonable to argue that when dealing with limitation interest expense rules, corporates should firstly have net interest expenses and secondly, said net interest expenses should arise as a consequence of entering a raising of finance arrangement. Otherwise, only an arm's length test could apply as best practice approach. The OECD Transfer Pricing Guidelines specify the following two categories of transfer pricing methods that multinationals can use to test the arm's length character of their related party transactions:
- Traditional transaction methods, regarded as the most direct methods, which require the use of prices of gross margins agreed by third parties as the basis of testing the arm's length character of related party prices.
- Transactional profit methods, which test the profit results earned by related parties, relative to the profit results earned by comparable third parties.
Based on the above, the taxpayer should seek to apply the most appropriate method to demonstrate that the outcome of its taxable transactions falls within the range (prices or margins) that independent parties would achieve in comparable circumstances.
To this end, in the context of determining arm's length interest expense deductions, Baker McKenzie Luxembourg has developed a two-step methodology, looking at: (i) the minimum return allocation; and (ii) residual income allocation of the financing debt instrument, which is in line with the methods sanctioned by the OECD Transfer Pricing Guidelines.
Our two-step methodology
(i) Minimum return allocation
Firstly, we considered the Transactional Net Margin Method ("TNMM") as the most reliable method to establish the minimum arm's length return on the debt instrument.
(ii) Residual income allocation
Secondly, Baker McKenzie considered the profit split method as the most appropriate method to be applied to test a fair and balanced split regarding the residual investment income received by the issuer of the debt instrument. When using this method, the residual investment income is respectively assigned to the debt instrument and equity invested / instruments issued by the tested party entity, in line with economic indicators and financial ratios, linked to independent parties under similar terms, conditions, and circumstances.
The profit split methodology applied in this step was also based on the guidance included within the final report released by the OECD in October 2015, on aligning transfer pricing outcomes with value creation ("Action 8-10"), under its Action Plan on BEPS, which is detailed below.The transactional profit splits constitute a useful method, which has the potential to align profits with value creation, in accordance with the arm's length principle. Furthermore, it seems to be the most appropriate method, particularly in situations where the features of the transaction make the application of other transfer pricing methodologies problematic.
The current guidance on the application of the transactional profit split method in Chapter II, Part III, Section C of the OECD Transfer Pricing Guidelines1 indicates that the main strength of the method is that it can provide solutions for highly integrated operations, such as global trading of financial instruments , for which a one-sided method would not be suitable.
While the guidance on splitting profits provides a number of examples of potential allocation keys, it focuses on asset-based and cost-based allocation keys. There is a hesitant mention of an approach which splits profits, so that each party achieves the same return on capital (paragraph 2.145).
Chapter VI of the OECD Transfer Pricing Guidelines, Special Considerations for Intangibles, makes a number of references to the transactional profit split method and to situations where the current guidance on its application may need to be clarified. For example, the guidance suggests that:
- In some cases, profit splits or valuation techniques may be useful for evaluating arm's length allocations of profit in situations involving the outsourcing of important functions, where information on comparable uncontrolled transactions is unavailable.
- When no information on comparable uncontrolled transactions is available, a transactional profit split method may be useful in situations involving the pricing of transfers of intangibles. This may include the transfer of partially developed intangibles; or the transfer of all, or limited rights in a fully developed intangible.
Profit splitting factors, mentioned as possible mechanisms, are used in practice to various extents and include invested capital, costs, surveys of functional contributions, weighting of factors, as well as equalized expected rates of return. Moreover, Action 8-10 provides a scope of revisions of the current guidance on the transactional profit split method:The guidance on transactional profit splits and selecting the most appropriate method should emphasize the point made in paragraph 2.2 of the current OECD Transfer Pricing Guidelines that the nature of the transaction, determined in accordance with the guidance in Section D of Chapter I, is vital when selecting the most appropriate transfer pricing method, even in the absence of information on reliable, comparable uncontrolled transactions.
The sharing of profits or losses under a profit split may in some circumstances reflect a fundamentally different commercial relationship between the parties, in particular concerning risk allocation, to the paying of a fee for goods or services. In cases where the delineation of the actual transaction is such that a share of profits would be unlikely to represent an arm's length outcome, the revised guidance will emphasize the need to use and adjust the best available comparables, rather than selecting a profit split method. An appropriate method using inexact comparables is more likely to be reliable in such cases, than an inappropriate use of the transactional profit split method. As such, the guidance regarding methods to be applied in such difficult cases will be expanded. Selecting the most appropriate method is particularly acute when there is a lack of reliable comparables data, as is very often the case in developing countries.
With respect to the profit splitting factors, as previously mentioned, Action 8-10 stresses the need for a strong correlation between profit allocation factors and the creation of value, in order to ensure an outcome that is consistent with the arm's length principle. In addition, the sensitivities and practical application of the various mechanisms, including the capability to independently verify underlying data, should be compared so that guidance is provided about the appropriate application of the mechanisms. A transactional profit split method can be used to support results under a TNMM, or to determine royalty rates, or in other ways that are practical, that respect the form of the contractual arrangements and help simplify pricing outcomes.
In closing, for most entities a clear correlation between earnings and taxable income is expected. Therefore, measuring economic activity using earnings should be the most effective way to ensure that the ability to deduct net interest expense is matched with the activities that generate taxable income and drive value creation. Consequently, Baker McKenzie has determined the most reliable profit level indicators ("PLIs") at each level of the two-step methodology in order to establish the aforementioned correlation.