4.3.5.2 Earnings stripping rule

The ATAD1 earnings stripping rule

In general, companies belonging to a group have a choice between two options for financing their activities: via debt or via equity. Tax systems normally favour debt financing over equity financing, as interest payments on debt are generally deductible, whereas equity returns are non-deductible. This can lead to excessive debt financing.1 The earnings stripping rule as included in ATAD1 aims to prevent base erosion and profit shifting through excessive interest payments.2 It is possible to exclude standalone entities from the measure. As a standalone entity is not part of any group, the base erosion and profit shifting risk posed is different than the risk posed by group entities.3

The earnings stripping rule concerns a generic interest deduction limitation that has been designed by means of a calculation rule. The balance of interest on third party and group loans is limited to 30% of taxable earnings before interest, taxes, depreciation and amortization (EBITDA). In addition, Member States can choose to implement a safe harbour rule, so that the net interest deductible is capped at a fixed amount of EUR 3 million if the resulting deduction exceeds the EBITDA ratio.4

The interest limitation rule provides for two optional, alternative group escapes.5 A requirement for both of the escapes is that the taxpayer should be part of a group which files statutory consolidated accounts.6 By taking into account the indebtedness of the overall group at worldwide level, a taxpayer may be entitled to deduct higher amounts of exceeding borrowing costs. The group escape thus provides for a potential benefit for taxpayers: due to the group situation more interest may be deductible. If the interest income at the level of the recipient is included in the taxable basis, limiting interest deduction in essence leads to a variant of economic double taxation.7 The group approach thus reduces the potential double taxation that can result from application of the earnings stripping rule.

Interest expense limitation rules & the OECD MTC

To what extent does the OECD MTC combat excessive interest deductions similar to the ATAD1 rule? A provision aimed at preventing excessive interest deductions in a group is not included in the OECD MTC. Tax treaties in principle do not deal with the answer to the question whether payments are deductible or not and whether they are effectively taxed or not.8 This is both governed by domestic law.

However, there are various OECD provisions that could potentially limit the application of domestic law restrictions on the deduction of interest or allow those restrictions.9 In the field of interest limitation rules, the question arises whether the domestic provisions aimed against thin capitalisation are allowed by art. 9, par. 1, OECD MTC and the non-discrimination article.10 According to the OECD Commentary, art. 9 OECD MTC does not hinder the application of domestic rules on thin capitalisation if their effect is to assimilate the profits of the borrower to correspond with the profits which would have been accrued in an arm’s length situation.11 Apart from that, the Commentary discusses the relationship between domestic thin capitalisation rules and the non-discrimination article and concludes that there should be no conflict with the non-discrimination article if the thin capitalisation rules are consistent with the arm’s length principle.12

It can be argued that the interest limitation rule as included in ATAD1 does not aim to assimilate the profits to an amount corresponding to an arm’s length profit. In this view the domestic implementation of the ATAD1 rule cannot be in conflict with art. 9, par. 1, OECD MTC, as it does not fall within its scope.13 Alternatively, it can be argued that, as the interest limitation rule can limit the deductibility of an arm’s length interest payment, it can conflict with a tax treaty. Depending on its scope, the rules could also be incompatible with art. 24, par. 4 or par. 5, OECD MTC.14 If the rules are applied irrespective of whether the interest is paid to residents or non-residents, they do not seem to be restricted by tax treaties.15 In any case, if the application of the interest limitation rule would be fully or partially incompatible with tax treaties,16 this would mean that the scope of application of the rule would be limited. This would mean that combatting tax avoidance via the interest limitation rule would be restricted via the application of tax treaties.

Would it be desirable to include rules for the deductibility of interest expenses at the level of tax treaties? As the deductibility of payments is in general not covered by the OECD MTC, a specific anti-base erosion rule for interest expenses does not seem logical in the current structure of the model. The computation of the tax base as such should after all be determined by the national laws of the Contracting States. A fact is, however, that the tax avoidance opportunities that exist within a multinational group due to the possibility of debt financing are not in concurrence with the goals of the OECD MTC. As loans within groups of companies in essence do not add economic value, in an ideal situation there should be no loans between entities belonging to the same group. Changing the approach to reflect the fact that intra-group financing activities have no economic reality would require a drastic change in approach. To make this possible, the group as such should be seen as the taxpayer, both from a domestic as well as from a tax treaty perspective. I will elaborate on this point of view in the following chapters.