Interest deductions and tax avoidance – will BEPS solve the problem?

New rules to prevent corporations using debt and interest payments to lower their taxbills have been one of the outcomes of the OECD BEPS programme. However, how effective are these rules? And is the new debt cap proposed by the OECD likely to have any impact at all?

Earnings stripping and interest payments

Corporation tax is a tax on profits. Interest payments are counted as a business expense in corporate accounts and so any interest paid by a company is deducted from profits before tax is paid. The more interest a company pays, the lower the profits, the lower the tax bill. This is sometimes called the debt shield.

Using debt has been a well known and widely practiced form of tax avoidance. Multinationals can set up finance companies in tax havens to loan money to their operating companies around the world. The debt shield also encourages companies to take on debt as it makes debt a cheaper form of financing.

BEPS and the interest rate deduction

The OECD, under the BEPS programme, has proposed that countries limit the amount of debt that can be deducted from profits before corporation tax is paid. The OECD have suggested a cap on interest of between 10% to 30% of Earnings before Interest Taxation, Depreciation and Amortisation (EBITDA), sometimes referred to as operating profit. The cap takes into account all loans, whether intra-company loans or commercial loans from an external source.

These rules have been carried forward into the EU’s Anti Tax Avoidance Directive, which mandate the lowest cap of 30%.

The cap in practice

I decided to run some numbers to understand what that cap means in practice. Take a notional company Dodgyco. Dodgyco has an income of $300,000,000. It makes a profit on its operations of 30%, which leaves it with $100,000,000 before interest and tax.

Under the OECD rules the company is allowed to deduct $30,000,000 in interest payments a year from its taxable profit.

If we assume that dodgyco can borrow at an interest rate of 5% then an interest payment of $30,000,000 implies a debt of $600,000,000.

Lets say that dodgyco is valued at ten times its earnings – $1,000,000,000. This implies that the company will have a financial leverage of 60% before the cap bites.

In today’s low interest world a 5% interest rate is generous. Currently $ denominated investment grade corporate bonds are yielding 3.5% on average. European bonds see even lower yields.

Once the interest rate hits 3%, then a $30,000,000 interest payment represents a debt of $1,000,000,000.

These ratios are very high. Currently the average debt to equity ratio of the Standard and Poor’s 500 is 50%, which has led to fears that US companies are over-leveraged. The historic average is just 14%, suggesting that when interest rates start to increase, leverage will decrease too.

Exceptions for exceptionally high interest

It seems then that most companies will have little to worry about from the new rules from the OECD.

But one area where companies have much higher levels of leverage is infrastructure, particularly in cases where a company has been subject to a leveraged buyout. Infrastructure projects generally have very stable and sometimes government backed revenue streams. This allows companies to sustain very high levels of debt, as there is greater certainty that the money will be there to make the interest payments.

Heathrow, the UK’s largest airport, is just one example. In recent years the company has sustained a ratio of over 90%. In 2016, interest payments accounted for 91% of EBITDA, well over the OECD’s proposed upper limit of 30%.

But even in these cases, it appears that companies could have a get out. The EU’s Anti Avoidance Directive allows a get out from the interest cap for loans used to invest in “infrastructure” for the public benefit. How this will be interpreted will be an important issue for many companies, and is likely to have a serious impact on tax revenues too.

Real solutions

Clearly the OECD guidance, of a 30% cap on interest payments, is far too high, and the infrastructure exemption in the EU directive leaves a giant loophole for the most highly leveraged companies. So what would a more effective solution look like?

A hard cap on interest deductions that takes into account commercial loans is desirable because it discourages companies from over-leveraging. Within the OECD proposals countries are free to implement a cap of 10% EBITDA and should be encouraged to do so.

But why not disallow all tax deductions on loans that originate from related companies? By removing the tax incentive for firms to borrow from their parent companies or shareholders, we remove a major source of profit shifting.

From the point of view of the firm, a loan which comes from a related party can’t be considered to carry the same risk that a commercial loan carries. Why then, should they expect to be treated equally?