BEPS: The impact of the interest limitation rule on investment

OVERSEAS investment by Thai companies has been surging in recent years and this trend is almost certain to continue.

One of the questions frequently asked by Thai investors when seeking to acquire foreign operating companies or establish overseas subsidiaries is what type of funding structure would be the most tax efficient.

Funding by debt is a more flexible structure than equity and carries a lower cost of capital. Debt has other advantages over equity since it helps to keep the profit within a company and increases the return on equity for the owners.

From the tax perspective, funding by debt helps lower a company’s taxes because of the allowable interest deductions. Dividends paid to shareholders are not tax deductible and must be derived from after-tax income.

Tax savings help further reduce a company’s debt-financing cost, which is an advantage that equity financing lacks.

Using interest is one of the simplest ways of shifting profits out of a company. This is a very common technique used in international tax planning. For example, debt push-down is commonly used in cross-border acquisitions, where the interest cost on funds raised by borrowing for an acquisition is offset against taxable income in the newly acquired entity. The use of intra-group loans to generate tax deductible expenses in high-tax jurisdictions brings taxable profits down, while the interest received by the lending company would be in a low-tax jurisdiction.

The level of debt pushed down to operating companies may bear no relation to the level of earnings or net assets of those companies. It would relate to how much debt the investors can inject into high-tax jurisdictions to reduce tax liabilities.

The level of interest expense in an entity would be viewed as profit shifting using the interest as a tax-driven channel. Tax planning strategies that exploit gaps and mismatches in tax rules to artificially shift profits to low or zero tax locations where there is little or no economic activity, resulting in little or no tax being paid, have come under the scrutiny of the OECD.

In 2012, the G-20 called on the OECD to analyse the problems created by such strategies, which came to known as base erosion and profit shifting (BEPS), and develop an action plan to address issues of concern in the following year.

One of the approaches proposed to tackle the issue of interest deductibility is to set general limitation rules on the amount of interest that an entity can deduct.

This may be accomplished by reference to the position of the group as a whole or as a fixed ratio, since the use of a debt push-down structure may come under the scrutiny of the tax authorities of various countries when considering whether the structure is driven by tax planning rather than commercial reasons.

Examples of the options proposed are the group-wide interest allocation rule and the group fixed-ratio rule.

Under the interest allocation rule, the deemed interest expenses allocated to each entity would be permitted for tax deduction where such allocation is linked to either the earnings of the group or the asset values. Under the group ratio rule, the interest would be linked to the financial ratio of each entity.

If these options are adopted, the tax deductible interest in each country would be based on the financial ratio of each entity or the earnings of the group as a whole and not on the amount of the actual borrowing.

However, if these rules came into force, a compliance burden would be imposed on every company required to prepare supporting documents to submit to the tax authority in each country. Where Thai investors have invested in a number of companies in different locations, the level of compliance will result in a significant amount of time and cost being required to obtain the necessary information from the overseas operating companies.

This would not only place a burden on the tax-paying company but also on the tax authorities.

If the Revenue Department adopted this approach for local intra-group funding, a legal amendment would be required. The Revenue Department would also need to ensure that it is ready for the additional administrative burden in obtaining and scrutinising the supporting documentation to verify the correctness of the tax deductions for interest.

Orawan Phanitpojjamarn is tax director at PricewaterhouseCoopers Legal & Tax Consultants.