On January 28, 2016 the European Commission published its so-called Anti Tax Avoidance Package. One of the items of this Anti Tax Avoidance Package is the proposal for a Council Directive laying down rules against tax avoidance practices that according to the European Commission directly affect the functioning of the internal market.
The proposed Directive sets out six key anti tax avoidance measures, which all Member States should apply. These are:
· Interest limitation rule
· Exit taxation
· Switch-over clause
· General anti-abuse rule
· Controlled foreign company legislation
· Hybrid mismatches
This article is the first in a series of articles we intend to publish with respect to the so called Anti Tax Avoidance Directive. In each article we intend provide you with some additional remarks with respect to one of these proposed anti tax avoidance measures from the Anti Tax Avoidance Directive. This article will focus on the interest limitation rule.
First of all it should be noted that the proposed Directive arranges that the anti tax avoidance measures laid down in the Directive are minimal measures. In this respect Article 3 of the proposed Directive arranges that the Directive shall not preclude the application of domestic or agreement-based provisions aimed at safeguarding a higher level of protection for domestic corporate tax bases.
Interest limitation rule
It should be noted that the limitation of the deductibility of borrowing costs as arranged for in this Directive does not apply to so-called financial undertakings. The definition of a financial undertaking is provided by Article 2, Paragraph 4 of the proposed Directive.
The proposed provisions with respect to the so-called interest limitation rule are laid down in Article 4 of the proposed Directive.
The interest limitation rule as proposed does not only limit the deductibility of borrowing costs due over intra-group loans. It also applies to borrowing costs due to unrelated third parties. Furthermore it should be noted that the interest limitation rule does not only apply to borrowing costs due to lenders that are (tax) residents of so-called low tax countries, but to all borrowing costs.
The title ‘Interest limitation rule’ is somewhat misleading since the applicability of the provisions laid down in Article 4 of the proposed Directive is not limited to interest as such. The provisions of Article 4 of the proposed Directive do apply to what are called exceeding borrowing costs, which is a term that next to interest as such also covers other sort of costs incurred in connection of the borrowing of funds.
Article 2, Paragraph 1 of the proposed Directive defines borrowing costs as interest expenses and other equivalent costs that a taxpayer incurs in connection with the borrowing of funds, including any difference between the borrowed funds and the maturity amount, the interest element in a leasing contract where the economic owner is entitled to deduct such interest and expenses incurred in connection with the raising of finance.
Article 4, Paragraph 1 of the proposed Directive arranges that borrowing costs are fully deductible to the extent that the taxpayer receives interest or other taxable revenues from financial assets. The limitation of deductibility only comes into play with respect to the so-called exceeding borrowing costs (which are defined by Article 2, Paragraph 2, of the proposed Directive as the amount by which the borrowing costs of a taxpayer exceed interest revenues and other equivalent taxable revenues from financial assets that the taxpayer receives).
The actual interest limitation rule is laid down in Article 4, Paragraph 2 of the proposed Directive. This paragraph arranges that exceeding borrowing costs shall be deductible in the tax year in which they are incurred only up to 30 percent of the taxpayer's earnings before interest, tax, depreciation and amortization (EBITDA) or up to an amount of EUR 1,000,000, whichever is higher. It subsequently arranges that the EBITDA shall be calculated by adding back to taxable income the tax-adjusted amounts for net interest expenses and other costs equivalent to interest as well as the tax-adjusted amounts for depreciation and amortization.
Paragraph 3 of Article 4 subsequently arranges that if certain conditions are met by derogation from paragraph 2, the taxpayer may be given the right to fully deduct exceeding borrowing costs if the taxpayer can demonstrate that the ratio of its equity over its total assets is equal to or higher than the equivalent ratio of the group. Although several conditions have to be met, there is one condition we would like to highlight and that is the condition that payments to associated enterprises do not exceed 10 percent of the group’s total net interest expense.
Article 4, Paragraph 5 of the proposed Directive allows a Member State to arrange that borrowing costs that cannot be deducted in a certain year because of the interest limitation rule, can be carry forward to later years of which the exceeding borrowing costs do not amount to 30% of the adjusted EBITDA. Needless to say that also in such later years the total of the deductible exceeding borrowing costs (the exceeding borrowing costs incurred in that year and the non-deducted borrowing costs carried forward from a previous year or years) cannot exceed 30% of the adjusted EBITDA. It should be noted however that Paragraph 5 does not mention the threshold of EUR 1,000,000.
Article 4, Paragraph 4 of the proposed Directive allows a Member State to arrange that the part of the EBITDA that has not been used to absorb borrowing costs can be carried forward to future years in order to absorb exceeding borrowing costs of those future years.
If in the future the proposed Directive is adopted as it is, it will be important for tax departments to give financing structures constant attention. Reasons here for are a.o.:
· The interest limitation rule does not only apply to exceeding borrowing costs due on intra-group financing, but also to exceeding borrowing costs due on third party financing. Therefore the costs of non-deductibility can be high;
· In order to be able to fully use the carry forward possibilities of the non-deducted borrowing costs one should set up a good system that keeps track of these non-deducted borrowing costs;
· In order to be able to fully use the possibilities of carrying forward that the part of the EBITDA that has not been used to absorb (exceeding) borrowing costs, one should set-up a good system to keep track of this non-used EBITDA. It is important to start keeping track of this unused EBITDA as soon as countries have implemented the proposed Directive in their local legislation (and included this possibility to carry forward in their local legislation).
Alain Thielemans
The next article in this series which discusses exit taxation can be found here.
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