Purpose and Policy Considerations for Implementing Rules

Pinetz/Schaffer (Eds), Limiting Base Erosion 341
Purpose and Policy Considerations for
Implementing Rules
LunardiPurpose and Policy Considerations for Implementing Rules
Lino Lunardi
1. Introductory remarks
2. Difficulties in the compulsory nature of the current provisions: between
current practice and comparative policy analysis
3. Multiple approaches and scopes on limiting interest deductibility
3.1. Key considerations for setting the interest rate
3.2. Withholding taxes, a unilateral implementation
3.3. Reclassification/re-characterization of debt as equity in certain circum-
stances: switch-over clauses evolution
3.4. Thin cap provisions, a re-structuring approach: effectiveness of the new
measures to countering thin capitalization
4. Comparative international overview with reference to recent new rules
4.1. The developing countries’ perspective
4.2. American and Canadian positions and reactions to Action 4’s recom-
mended approach; the Economic Substance Doctrine in the US
perspective and evolution
5. Conclusion and recommendations
fb-limiting-base-erosion.book Seite 341 Montag, 29. Mai 2017 10:38 10

Purpose and Policy Considerations for Implementing Rules
Pinetz/Schaffer (Eds), Limiting Base Erosion342
1. Introductory remarks
Tax competition is one way to realize European tax integration. The historical
purpose of rules on interest deductibility is to ensure a taxation of net profit while
avoiding double economic taxation of the same income in the hands of both the
lender and the borrower, or in schemes implemented in double or multiple de-
duction or non-taxation situations. The OECD Report “Addressing Base Erosion
and Profit Shifting” notes that
From a Government perspective, globalization means that domestic policies, including
tax policy, cannot be designed in isolation, i.e. without taking into account the effects
on other countries policies and the effects of other countries’ policies on its own ones.1
The OECD’s report under Action 4 of the BEPS Project sets out best practice rec-
ommendations for countering this but does not introduce any strategic elements
apart from the suggestions and the reasoning debated previously in the OECD
discussions regarding interest deductibility.2
It addresses the use of deductible in-
terest payments by MNEs to achieve double-non taxation in both inbound and
outbound transactions (“interest stripping”):3
these transactions are perhaps the
easiest way for an MNE to erode the tax base of a source country. The Action
highlighted options for best practices (the Group Wide Rules and the Combined
Approaches), discussed them in detail and rejected some of the current ap-
proaches. It excluded from its discussion not just thin cap rules but also the with-
holding tax regime, applied across the board, and the arm’s length tests, applied
on a case-by-case basis.
The Discussion Draft commented extensively on fixed ratio rules as a best prac-
tice, contrasting with its treatment and generally hesitating on thin cap rules too.
It avoided recommending them as a best practice and specified that they do not
directly affect the level of interest expense. The combined approaches, instead,
would allow entities with lower levels of interest expenses to apply a simple fixed
ratio test, while more highly leveraged groups would apply a more complex
group-wide test. This would reduce competitiveness distortions of capital-rich
groups that could otherwise deduct less interest expense than groups that rely
more on external funding.
Reading the Action, there is no ideal solution, either from a theoretical or from a
practical or political perspective. It neither explicitly addresses nor makes a rec-
1 OECD Report 12 February, 2013, n. 1, at 28.
2 See, ‘Public Discussion Draft – BEPS Action 4: Interest deductions and other financial payments’, 18
December 2014; “Comments received on Public Discussion Draft – BEPS Action 4: Interest deductions
and other financial payments” Part 1, Part 2 and Part 3; Gagal Kumar, ‘OECD instruments are merely
a policy consideration?’, International Taxation (2015) Volume 13, p. 329.
3 Ajay Gupta, ‘BEPS Action 4: Keeping Formulary Apportionment at Bay’, Tax Notes International
(2015) p. 847.

Lunardi
ommendation on competitiveness. Economists prefer to avoid using the word
“competitiveness” because this concept, as applied to countries, is not well-de-
fined.4
Talking about tax competition, countries not only introduced specific na-
tional tax incentives, but they also used their domestic legislation in connection
with their tax treaty networks to attract investments. For too long, they seemed
more interested in tax competition than in tax coordination. Since all countries
use or are affected by tax treaties, the BEPS project’s tax treaty consequences
would have universal implications.
The present contribution will unfortunately underline that despite a debate of
decades about the above-mentioned common considerations, countries continue
to implement unilateral measures in conflict with “the need for an approach that
provides an effective solution”.5
Any restriction on the deductibility of interest
may potentially be in conflict with fundamental principles of taxation with risk of
distortions. It recaps that a comprehensive solution, in order to address BEPS,
cannot be developed without an internationally coordinated approach (a global
solution), including participation from countries that are not OECD members.
2. Difficulties in the compulsory nature of the current
provisions: between current practice and comparative
policy analysis
The preferred option in the Discussion Draft seems to be the group-wide rule but
its application would be extremely complex, given the significant differences in
tax and accounting principles applicable in different countries. Even the mere
definition of interest may vary amongst them.6
Countries believe that their cur-
rent interest deductibility rules are fit for their purpose. So, the uncoordinated
implementation of a group-wide rule would be another source of double taxation
and/or distortions in the competitiveness. However, even within the same corpo-
rate group, individual entities may be financed in different ways. Hence, its me-
chanical application could restrict the freedom of business to structure the fi-
nancing function of the group, with considerable effects on business activities and
financial market transactions.
Considering also the objective data that there is actually no major OECD country
that applies a group-wide test as a main rule, it is easy to imagine that such a rule
would not be supported by countries around the globe. From this perspective, at-
tention has to move towards a worldwide approach, more flexible than a fixed ra-
4 Rosanne Altshuler, ‘Inter-Nation Competitiveness: A Discussion Paper on Base Erosion and Profit
Shifting’, Bulletin for International Taxation (2014) p. 361.
5 Action 4 – 2015 Final Report, p. 25.
6 Oliver R.Hoor/Keith O’Donnell, “BEPS Action 4: When Theory Meets Practice”, Tax Notes Interna-
tional (2015) pp. 643–652.

tio rule, multilateral in concept and able to eliminate quite a large capacity for tax-
motivated debt creation and debt shifting, thereby better following the outcomes
of the BEPS project.7
Action 4 is strictly focused on the characterization (interest versus dividend or
vice versa) of instruments (in the form of hybrid arrangements), their income and
tax treatment of the (transparent or non-transparent entity) borrower. It devel-
oped a complicated method to calculate a company’s earnings and recommended
that interest deductions should be limited to between 10–30% of the EBITDA.
The Member country will put this fixed limit on the amount of interest that the
company can deduct and will tax the remainder of the payments. This should
make it less attractive for companies to artificially shift debt in order to minimize
their taxes, discouraging them from creating artificial debt arrangements de-
signed to minimize taxes. The EU Member States are in principle free to deter-
mine the rules under which interest is deductible but taxation rules are not har-
monized at the EU level. In designing rules limiting interest deductibility, na-
tional legislators must test the compatibility of the rules, firstly with the
fundamental freedoms laid down in the Treaty on the Functioning of the Euro-
pean Union (TFEU)8
and secondly with the scope of work conducted by the Code
of Conduct Group (at the political level). Of no lesser importance is the check test
of the rules with respect to the State Aid issue if the domestic provision could be
considered to grant a selective advantage to certain taxpayers.
Almost all developed countries have measures to counter cross-border tax plan-
ning using financing structures.9
However, the recent broader restrictions and
specific measures, applied also to third-party debt, are characterized by the diver-
sity of regimes, constantly changing and highly complex. Failing in bilateral co-
operation means taking the risk of double non-taxation: a type of damage that
may be mitigated by the adoption of a domestic exchange of information provi-
sions.
3. Multiple approaches and scopes on limiting interest
deductibility
3.1. Key considerations for setting the interest rate
General interest barriers seem to be suitable instruments for countering abuse but
they can have a discriminatory and distortive effect on taxpayers as a result of
7 Eduardo Traversa, ‘Interest Deductibility and the BEPS Action Plan: nihil novi sub sole?’, British Tax
Review (2013) No. 5, p. 607.
8 ITC, ‘Materials 2015/2016 on International & EU Tax Law’ (Leiden, 2015).
9 Thin capitalization rules were the classic prevailing instrument with respect to related-party debt.
George Zehetmayer, ‘Thin capitalization rules as an instrument to counter abuse’ in Karin Simader/
Elisabeth Titz (eds.) Limits to Tax Planning (Vienna: Linde, 2013) pp. 256–257.

Lunardi
their particular features, disallowing the deductibility of interest from the purpose
of the loan. Whatever national approach is adopted, international coordination is
necessary to avoid distortions caused by the uncoordinated coexistence of differ-
ent concepts: double taxation or double non-taxation due to inconsistent national
strategies. Neutrality and stability should be the key guidelines for a coordinated
best practice which should also not be compromised by over-complex rules,
highly complicated rules or a constant alteration of exiting legislation. Ambigui-
ties in the interpretation of the rules and overreaching effects may discourage in-
ward foreign direct investments. Taxpayers need rules that they can comply with
and tax authorities should be aware of the practical aspects of enforcement: policy
and legislative cost of reform are determined by the elasticity of the legal frame-
work. A significant opportunity in this direction is the role of treaty law: any lim-
itation on the deduction of interest expenditure at the level of the debtor in the
source country should correspond to a correlative exemption of interest at the
level of the creditor in his residence country, to avoid double taxation.
There are at least two fundamental uncertainties to general interest barrier rules.
Firstly, too general interest limitations are inherently complex, as the rules are not
aimed at tax avoidance: national legislators try to prevent economic negative far-
reaching effects arising as a result of the exceptions and counter-exceptions of in-
terest expenditure. Secondly, looking at the effect of general interest barriers, as
the deduction of interest cannot be completely excluded, the question of the allo-
cation to tax jurisdictions of profits and expenses cannot be totally resolved. Pol-
icy options available to counter borderline international tax planning using debt
instruments should be the following:
 removal of differences in the treatment of debt and equity in domestic tax sys-
tems;
 regarding the political process, drawing solutions that would have to be
adopted uniformly, thanks to an international coordination, as opposed to
solutions that could be adopted on a national level;
 rules covering either inbound or outbound cases uniformly by way of a gen-
eral interest deduction, avoiding differentiated treatments of inbound and
outbound investments; a uniform rule applying equally to intra-group debt
and to external debt, both to related-party and third-party debt;10
 in the perspective of the Member State, legislation designed to apply not only
to cross-border cases but also to purely domestic ones, should also be in line
with anti-discrimination clauses in tax treaties as well;
 rule-based and standard-based solutions would have to be distinguished. Fol-
lowing a standard-based approach, for example, the applications of the arm’s
10 See Yifan Yuan, ‘Stopping base erosion: a look at interest deductibility’, Tax Notes International
(2015) p. 255.

length principle would allow greater flexibility, but at the expense of higher le-
gal uncertainty.11
Some tax regimes have adopted a fixed ratio (based, for instance, on the ratio of
debt to equity) or a variable ratio (following complicated domestic and worldwide
calculations). The most common fixed ratio seems to be 3:1. Such a standard ratio
does not seem in general to be based on any economic rationale. Firstly, generally
speaking it does not take into consideration the differences in debt capacities of
the different companies of a group and it could lead to relevant distortions in in-
terest expenses deduction in the case of alternative investments.12
Due to the rigid
character of this kind of anti-avoidance rule, economic double taxation can arise
if the residence state of the lender does not provide corresponding relief for the
corporate taxes paid on the non-deductible interest in the residence state of the
borrower.
3.2. Withholding taxes, a unilateral implementation
Ensuring a fair allocation of profits and expenses among the countries involved is
independent of tax rate differentials. Any such rule should not fundamentally
change the present allocation of revenue, meaning that business profit is taxed in
the source country and interest is taxed in the residence country. Loan interest
withholding tax is a key point for both foreign lenders and national borrowers, as
to which country has the right to tax the profits and which must allow the deduc-
tion of expenditure.13
Group financing companies in low-tax jurisdictions could
be deterred by a withholding tax on interest paid to jurisdictions reluctant to ex-
change information or by applying a lower corporate income tax rate than the
source country.
It is not the intention of the OECD to change the allocation of income between
source and residence country but rather primarily to assure the present allocation
of taxing rights. Tax competition has the result that countries are prompted to
11 Although the BEPS Action 4 Discussion Draft said arm’s length tests would not be part of the consul-
tation process, support for that standard was a recurring theme in the over 1000 pages of comment
letters, received by the OECD. For some authors, global group-wide tests would create significant
complexity and difficulties for taxpayers and tax authorities. The comments from business and in-
dustry representatives, almost universally denounced a group-wide approach and bemoaned the dis-
owning of arm’s length test and argued that group-wide allocation would engender complexity and
difficulties for both taxpayers and tax administration. They pointed to the temporal volatility in earn-
ings, the unique circumstances of individual constituent entities, and the proposal’s perverse incen-
tive for increasing indebtedness. See also Amanda Athanasiou and David D.Stewart, ‘OECD Action 4
Draft Focuses on Fixed Ratios’, Tax Notes International (2015) p. 655.
12 See Pascal Hinny, Brussel (Belgium) “General Report” in IFA (eds.) ‘New Tendencies in tax treat-
ment of cross-border interest of corporations’, Cahiers de Droit Fiscal International, Vol. 93b (2008)
p. 33.
13 See Michele Gusmeroli, ‘Withholding Tax Exemption for Interest on Medium and Long-Term
Loans’, European Taxation (2015) p. 352.

Lunardi
waive given taxation rights to promote domestic economic activity, particularly
capital investments. This can be seen clearly in taxation of interest where to re-
duce or to abolish of withholding tax increase the attractiveness of the investment
for the foreign investor (debt). The fact that countries unilaterally or bilaterally
waive the levying of any substantive withholding tax on out-flowing interest is
fundamentally due to the interest of the source state in not confronting its domes-
tic private and public debtors with the possibility of the creditor “grossing up” the
additional tax burden (in so far as this cannot be deducted in the state of resi-
dence) to the required interest payments. When creditors receive their interest on
that portion of profits it will not be taxed in the country of origin (this is the case
in most industrialized states). A double non-taxation effect may occur as once
these funds leave the country as payments they can be moved to states without
taxation implications. Great amounts of profit can be moved without undergoing
taxation in the country of origin, sending the funds to tax havens. In order to
avoid such evasion an adequate flat withholding tax could be applied on all inter-
est to be paid to domestic and foreign creditors.14
New policies are not easy to transform into national tax law because the actual
collection of taxes remains in the hands of national tax authorities, which are of-
ten reluctant to change (or limit) their traditional instruments. Implementation
of the (re)introduction of withholding taxes requires tax treaty amendments. To
find consensus among the participating countries on a simultaneous change to all
relevant tax treaties, Action 15 could provide for a multilateral instrument to be
devised in order to adjust tax treaties.
3.3. Reclassification/re-characterization of debt as equity
in certain circumstances: switch-over clauses evolution
Financing decisions are an economic issue and the deductibility of financing cost
for debt financing is crucial. In general, a shareholder has the choice of financing
its company with equity, debt (loan) or by a combination of equity and debt. In
free market economies, there are almost no limitations on financing, except po-
tentially of minimum equity requirements, which tend to address to use debt fi-
nancing as the preferred way of financing. There is no financial neutrality be-
tween taxation of interest and taxation of dividends as interest is a tax-deductible
expense with the borrower while dividends are paid from the taxed profit without
influencing the taxable profit of the distributor. Furthermore, interest barrier
rules are legislated with the objective of giving incentives to increase the amount
of equity, replacing debt.15
The reason for giving preference to debt financing
14 Gustav M. Obermair/Lorenz Jarass, ‘Unilateral Withholding Tax To Counteract Base Erosion and
Profit Shifting’, European Taxation (2015) p. 509.
15 Wolfgang Ender, ‘Interest barrier rules and similar rules as instruments to counter abuse’ in: Karin
Simader/Elisabeth Titz (eds.) Limits to Tax Planning (Vienna: Linde, 2013) pp. 281–306.

over equity financing is instead directly related to reducing the taxable base in the
jurisdiction of the borrower’s residence.
National and international debates for new rules or approaches are focused on in-
congruity in the definitions of debt and equity in domestic law. It is a crucial rea-
son why payments in cross-border transactions could be subject to either multi-
ple- or non-taxation in many states, giving opportunities for tax arbitrage with
hybrid instruments. For this reason the debt to equity ratio should not be consid-
ered an attempt to set the best capital structure but, rather, as a political compro-
mise with respect to revenue sharing between source and residence countries.
Each country has developed its own understanding of the two concepts, often
leading to a double non-taxation situation, in which payments could be consid-
ered a deductible interest in the payer’s country of residence and an exempt divi-
dend in the beneficiary’s country of residence.16
These rules create an obvious
bias towards debt financing, particularly when this is combined with low taxation
at the level of the recipient. An essential objection both to this ratio and to an as-
set-related ratio is their predisposition to manipulation. Thus, the classic distinc-
tion between equity and debt in international tax law is absolutely not obsolete
due to new developments and its consequences and the influence of a variety of
legislative policy concerns.
From a tax policy point of view, to minimize the economic domestic difference in
the tax burden between earnings from equity and from debt, the source state can
capture returns on debt by levying of withholding tax on out-flowing interest in
Article 11 of the OECD Model and the limitation on the deductibility of interest.
Especially in the first circumstance, global tax policies are quite varied. Develop-
ing and emerging economies continuously try to subject domestically-generated
earnings to substantial taxation by withholding taxes. In contrast, large western
industrialized economies have moved away from levying withholding taxes in do-
mestic tax law.17
Nevertheless, withholding taxes on dividends have continued to
be largely applied, in any case for payments on portfolio shareholdings. The final
result is that the total tax burden on out-flowing returns on equity is significantly
higher than the total tax burden on out-flowing returns on debt.
The simultaneous presence of completely different provisions for shareholder
debt finance, interest caps and re-classification of payments, could generate the
final result of double taxation of interest on shareholder loans. Because of classifi-
cation conflicts one can find that, in both double non-taxation and double taxa-
tion, unilateral unfair competition in the source state may be avoided only
through a harmonization of the criteria, at the double taxation treaty level neces-
16 Boston (USA) “General Report” in IFA (eds.) ‘Debt-equity conundrum’, Cahiers de Droit Fiscal Inter-
national, Vol. 97B (2012).
17 Not only on double tax treaties but also with unilateral legislation in many states: Germany, UK, US,
France, Switzerland.

Lunardi
sarily, in the introduction of limited source taxation or a limitation on deductions
of interest.
3.4. Thin cap provisions, a re-structuring approach:
effectiveness of the new measures to countering
thin capitalization
Restrictive practices may normally be justified as a way to protect the integrity of
the domestic tax base, against erosion through undue or excessive deductions
among members of an associated group. The variety of national thin capitaliza-
tion regimes has negative economic effects on foreign investments. Numerous
conflicting thin capitalization concepts, design of rules that differ widely and
rules subject to constant amendment indicate that there are no easy solutions to
the problem (or possibly no solution at all) unless the lack of tax neutrality be-
tween debt and equity is removed.
In 1982, the IFA Congress work underlined that a taxpayer should have the right
to demonstrate that its debt-to-equity ratio is suitable even if it exceeds a given
fixed ratio.18
In addition, the congress debates suggested an approach to deter
thin capitalization practices, based on a combination of the “flexible” arm’s length
approach and a “rigid” fixed ratio approach.19
In 1986, the OECD Council
adopted the Committee’s Thin Capitalization report, which focused on the exces-
sive use of loan financing. If we compare this Report with the Action, the first one
focuses on the compatibility of domestic (anti-avoidance) thin capitalization
rules with the treaty based on the 1977 OECD Model Convention and did not
take any firm position on the way in which the thin capitalization problem should
be addressed. It emphasized that the domestic rules should be applied in accord-
ance with the arm’s length principle. In 1996, the panelists of the IFA Congress
adopted a resolution to the effect that thin capitalization falls within the scope of
Article 9(1). Under those premises, thin capitalization rules should be as specific
as possible and operate in order to create legal certainty.20
However, if the domes-
tic thin capitalization rules go beyond the arm’s length principle, such legislation
would be in conflict with tax treaties.21
In 2008, the IFA Congress panelists in
Brussels (Belgium) considered the “New tendencies in tax treatment of cross-bor-
18 Montreal (Canada) 1982, ‘The tax treatment of interest in international economic transactions’.
19 This is referred to as “hidden capitalization” in the OECD Report on “Thin Capitalization”, adopted
by the OECD Committee on Fiscal Affair on 26 November 1986. See, Craig Elliffe, ‘Unfinished Busi-
ness: Domestic Thin Capitalization Rules and the Non-Discrimination Article in the OECD Model’,
Bulletin for International Taxation (2013) p. 26.
20 Geneva (Switzerland) 1996, ‘International aspects of thin capitalization’, Subject II ‘International as-
pects of thin capitalization’, in IFA Yearbook, p. 72. Therefore, it is fair to say that the IFA resolution
supports the OECD position.
21 Andreas Fross, ‘Earnings Stripping and Thin Cap Rules: Maintaining an Arm’s Length Distance’, Eu-
ropean Taxation (2013) p. 507.

der interest of corporations”. The event renewed the question of whether or not
there was anything to add to the debate.22
The domestic rules limiting interest de-
duction in the international environment have to be analyzed by looking at their
compatibility with the existing double taxation conventions, in particular in the
provisions of Articles 9, 10, 11, 23, 24 and 25 of the OECD Model Convention.
After such a long process, in 2017 Action 4 does not provide any guidelines con-
cerning the type of measures that the OECD would like to recommend to its
members in order to avoid profit shifting through deduction of interest. “…
[A]ctions are not directly aimed at changing the existing international standards
on the allocation of taxing rights on cross-border income.”.23
Many states have al-
ready enacted various measures to limit profit shifting through payments of de-
ductible interest to foreign companies, generally referred to as thin capitalization
rules and very different in their nature and their effects. Whereas some countries
would like simply to limit the amount of deductible interest without reclassifica-
tion, other regimes reclassify the payment in another category of income (for ex-
ample, dividend) or the debt instrument (according to their economic substance).
4. Comparative international overview with reference
to recent new rules
4.1. The developing countries’ perspective
Action 4 presents a variety of choices and leaves restrictions up to the prerogative
of individual countries. The most important measures adopted by countries
started substantially in 201324
but despite the formal and explicit hope of the
OECD by the G20 to reach common solutions, some of them, for domestic rea-
sons, may prefer to act unilaterally.25
Many emerging economies are becoming
both capital exporters as well as importers and developing countries are con-
scious that, in order to grow their economies, they need to work effectively on a
global level if they want to employ their already scarce resources by combating il-
licit financial flows and reducing the effect of tax havens. This requires actions in
multiple directions.
On a basic level, poor countries simply lack the resources and capacity to build ef-
fective tax collection systems by themselves, due to their low-skilled public sec-
tors. This makes it difficult for the state to grant a better business environment.
Earning stripping rules are a complex piece of tax legislation which requires both
time and the financial resources of taxpayers for compliance. Thus, with more
complex rules the enforcement authorities need to expend additional resources
22 Johanna Hey, ‘Base Erosion and Profit Shifting and Interest Expenditure’, Bulletin for International
Taxation (2014) p. 332.
23 See fn. 1, 11 and 17.

Lunardi
for ensuring proper application and the staff of the tax administration needs
training and continuous updates. To make use of a minimum threshold, a busi-
ness could be split up into several ones and a tax planning strategy could be to
split the debt capital over more than one group entity. From the above brief con-
siderations, it is clear that the Action does not reflect the interests of developing
countries properly.26
Actual international tax standards facilitate non-taxation of multinationals be-
cause they are mostly residence-based. Their profits are taxable exclusively in the
residence state, unless there is a substantial presence, based on a permanent es-
tablishment, in the states in which they operate. The source states’ ability to im-
pose withholding taxes on interest paid to the foreign owners of capital is often
24 For a comparative international overview on the recently introduced concepts about the deductibil-
ity of interest, under the Austrian corporate taxation system see Flora Matkovits/Barbara Polster,
‘Recommendations of the OECD for Restrictions on Interest Deduction – Impact on Austria’,
Steuer&Wirtschaft International (2016) p. 2; Hermann Peyerl, ‘Deductibility of Interest and Royal-
ties Restricted: Is Austria a BEPS Role Model?’,European Taxation (2014) p. 572; Andreas Baumann/
Karin Simader, ‘Debt-Financed Acquisitions of Inter-Company Shareholdings – Recent Develop-
ment’, European Taxation (2013) p. 55; under the Finnish see Seppo Penttilä/Martti Nieminen, ‘In-
terest Deduction Limitation Rules Introduced’, European Taxation (2013) p. 237; under the French
context see Pauline Curt/Eric Robert, ‘The New Limitation on the Deduction of Financial Expenses’,
European Taxation (2013) p. 286; under the Portuguese side see Antonio Martins, “Corporate Fi-
nancing, Interest Deduction and Tax Controversies”, Intertax , Volume 41 (2013) p. 462; regarding
Scandinavian Countries in general see Rainer Zielke, ‘Anti-avoidance Legislation of Scandinavian
Countries with Reference to the 2014 Corporate Income Tax Burden of the Thirty-Four OECD
Member States: Denmark, Finland, Norway and Sweden Compared’, Intertax (2013), Volume 41, Is-
sue 2, p. 682; Christian Carneborn, ‘Swedish Interest Deductions – Quo Vadis?’, Tax Notes Interna-
tional (2015) p. 987; regarding the Belgian side see Werner Jeyvaert, ‘Belgium makes its notional in-
terest deduction regime compliant with EU law’, Tax Planning International Review (2014) p. 4, and
Bob Michel/Pieter Van Den Berghe, ‘Fairly Odd: Belgium’s New Fairness Tax’, European Taxation
(2014) p. 223; under the Australian side see Richard Vann, ‘Corporate Tax Reform in Australia:
Lucky Escape for Lucky Country?’, British Tax Review (2013) No. 1, p. 59; Developments Report,
‘Australia – Budget for 2013/14’, Asia-Pacific Tax Bulletin (2013) p. 270; under the Dutch side see
Norbert Vis, ‘Restriction on Interest Deductibility for Dutch Holding Companies’, European Taxa-
tion (2013) p. 295; Patrick T.F. Schrievers/Joost Vogel, ‘The Netherlands Has Not Turned a Blind Eye
towards the International Debate Regarding Tax Planning’, European Taxation (2014) p. 198; under
the German side see Christian Kahlenberg, ‘The Tax Treatment of Hybrid Financial Instruments’,
European Taxation (2015) p. 264; Martin Weiss, ‘The Tax Treatment of Shareholder Loans in Ger-
many’, European Taxation (2015) p. 179; under the Indonesian side see NazlySiregar/Eddy Utama-
Tambunan, ‘Thin Capitalization and Secondary Adjustments’, Asia-Pacific Tax Bulletin (2013)
p. 340; under the South African perspective see Annet Wanyana Oguttu, ‘Curbing Thin Capitaliza-
tion: A Comparative Overview with reference to South Africa’s Approach – Challenges Posed by the
Amended Section 31 of the Income Tax Act 1962’, Bulletin for International Taxation (2013) p. 311;
under the Japanese perspective see Developments Report, ‘Japan’, Asia-Pacific Tax Bulletin (2013)
p. 160; under the Chinese side see Matthew Mui/Hai Yan/Alexis I. Meyere, ‘China’s first official po-
sition on BEPS release by Jiangsu Tax Bureau’, Tax Planning International Review (2014) p. 14.
25 Brazil is an example of how a reviewed tax system could be an alternative to the OECD’s future pro-
posals, playing a role of guide especially for non-OECD members. João Victor Guedes Santos, ‘Bra-
zilian Interest on Equity Under Tax Treaties’, Tax Notes International (2015) p. 87.
26 Shee Boon Law, ‘Base Erosion and Profit Shifting – An Action Plan for Developing Countries’, Bul-
leting for International Taxation (2014) p. 41.

limited or prohibited by tax treaties based on the residence model. The opportu-
nity is there now for developing countries to participate in the discussion arena to
influence international principles away from the residence-based model moving
them towards a consumption/source-based model, as OECD/G20 countries de-
mand a closer connection between where multinationals conduct their business
and where they pay their taxes. Disclosure rules can be both compliance-cost in-
tensive, for taxpayers, and resource intensive, for developing countries’ tax ad-
ministrations. These factors should be carefully considered when these countries
evaluate whether to adopt any of the recommendations proposed by OECD/G20
under the Action 4.
Since accomplishing the expected results of the Action program requires exten-
sive input from African countries and concrete global debates on the much-
needed reform of international tax policy, a crucial way is to ensure tax system
transparency and multilateral automatic exchange of tax information with non-
reciprocal exchange of information for low-capacity countries. Developing coun-
tries often have difficulties obtaining the information from MNEs for many rea-
sons: poor compliance with existing rules, limited capacity in enforcing rules, in-
adequate tools to capture and analyze data, inadequate staffing, not being as com-
petitive as employers of skilled staff working on international tax avoidance
issues, the moving of highly skilled manpower to the private sector. These diffi-
culties in implementing highly complex international rules leave discretion in
their application, for instance, on disputes with large taxpayers conducting com-
plex international transactions by negotiation and compromises between the tax
administration and the taxpayer.
Many countries grant tax incentives to attract foreign investments, eroding the
tax base of developing countries, but they often find it difficult to assess whether
intra-group international payments are for real value received or whether they are
excessive or unwarranted, particularly for payments relating to interest. The Ac-
tion offers developing countries an opportunity to develop their limitation rules
for interest and related financial payments, taking into account both international
developments and their own economic environment.
4.2. American and Canadian positions and reactions to
Action 4’s recommended approach; the Economic Sub-
stance Doctrine in the US perspective and evolution
Canada was one of the first countries to adopt interest deductibility restrictions.
But examining the differences between Canada’s earnings stripping and thin cap-
italization rules and the Action 4 Report’s recommended approach (best prac-
tices) one may observe that the BEPS interest restriction is not a priority for Can-
ada. Canada’s thin capitalization rules restrict the amount of interest-deductible

Lunardi
debt owed to related non-residents that a Canadian corporation can incur, so as
to limit the potential for cross-border intragroup interest stripping.27
This can
create an incentive for multinational groups to thinly capitalize their Canadian
operations, with high levels of interest generating debt and low equity. The Can-
ada Revenue Agency (CRA)28
underlines this favorable thin capitalization rules
application, confirming that although Canadian authorities are taking the BEPS
project seriously, implementation of BEPS recommendations do not seem to be a
priority. The Canadian concrete approach appears more focused on taking uni-
lateral action to protect the integrity of its tax treaties network, preserving a busi-
ness tax territory to attract foreign investments.29
Also the US Treasury officially expressed dismay over their engagement with the
OECD.30
So the possibilities of significant change in international tax rules result-
ing from the Action run head on against nationalist interests. In addition, the
complexity and lack of clarity in the OECD proposed guidance and the OECD’s
lack of attention to clarity and ability to administer in writing international tax
rules, explain the vague rules that may provide tax administrations with signifi-
cant discretion to pursue taxpayers. This, in summary, is the explanation of how
the US Treasury, despite the fact that the multilateral instrument is a critical part
of the Action, justified the United States’ refusal to participate in developing some
action items, in other words, to participate in a project that would happen any-
way.31
As part of its 2015 fiscal Budget, the Obama Administration proposed a
new rule limiting the ability of multinationals to shift interest deductions. Noting
that adjusting the mix of debt and equity is one of the simplest techniques availa-
ble to multinational groups for shifting profits to lower tax jurisdictions, the
Treasury explained that under the proposal, the interest expense of a US member
of a multinational group could not exceed that member’s proportionate share of
the group’s worldwide interest expense.32
27 Duff D.G., ‘Action 4 of the OECD Action Plan on Base Erosion and Profit Shifting initiative: interest
and base-eroding payments – insights from the Canadian experience’, Bulletin for International Tax-
ation (2015) Volume 69, No. 6/7, pp. 350–354.
28 The interpretation line was explicitly confirmed by the CRA at the CRA Round Table at the Cana-
dian Tax Foundation annual conference in Montreal on November 24, 2015. See, Steve Suarez, ‘Ca-
nadian Thin Capitalization developments for foreign currency debt’, Tax Notes International (2015)
p. 947.
29 See Tim Wach, ‘BEPS, treaty shopping and the Canadian response’, Tax Planning International Re-
view (2014) p. 28.
30 OECD International Tax Conference in Washington, 10–11 June, 2015. See, Mindy Herzfeld, ‘The
U.S. Treasury and the BEPS Mess’, Tax Notes International (2015) p. 1067.
31 See H. David Rosenbloom/Joseph p. Brothers, ‘Reflections on the Intersection of U.S. Tax Treaty
Policy, U.S. Tax Reform, and BEPS’, Tax Notes International (2015) p. 759; Robert Feinschreiber/
Margaret Kent, ‘Targeted US Attacks Challenge BEPS Projects’, International Taxation (2015) Vol-
ume 13, Issue 3, p. 219.
32 Martin A. Sullivan, ‘OECD Interest Deduction Draft Echoes Treasury Proposal’, Tax Notes Interna-
tional (2015) p. 17.

One reason for tension within the OECD BEPS discussion is the issue of how
much discretion tax administrators should have in enforcing the rules. In this de-
bate, one interesting starting point could be the US “economic substance doc-
trine”,33
which provides that a taxpayer’s characterization of a transaction may be
disregarded when the transaction lacks economic substance. The doctrine, as an
anti-abuse rule generally applied to highly structured artificial transactions to re-
move the element of risk and profit, could be considered a cautionary lesson in
the OECD work, as it considers incorporating a broad anti-abuse rule into the
current transfer pricing guidelines. For a long time, the “debt-equity distinction”
distorted corporate financing decisions, encouraging excess borrowing and tax-
avoidance behavior, as the US tax code favored “corporate debt” over “corporate
equity”.
Particularly interesting are the suggestions focusing on the fact that studies dis-
cuss contemporary policy issues, but none support their explanation with pri-
mary historical evidence.34
Reflecting on the past, the disparate treatment of debt
and equity was never a conscious policy goal, but was rather the unintended out-
come of an extended series of short-term political decisions, the expression of an-
swers to temporary historical contingencies, but with consequences clearly per-
sisting to the present day. Historical evidence demonstrates how lobbying by fi-
nancial companies may explain the existence of interest deductibility. In other
words, interest deductibility may be viewed as the result of lobbying more gener-
ally, with the tacit approval of the taxpaying public. In this perspective, the debt-
equity distinction could be portrayed as an aggravating factor of the 2008 finan-
cial crisis, considering the fact that interest deductibility encourages excessive lev-
erage.
This brief reasoning argues, for instance, that the debt-equity distinction is the
consequence of an extended series of reactive short-term political decisions,
rather than the intentional realization of a policy goal. Decisions made to react to
specific historical circumstances are difficult to change. The US history of the
debt-equity distinction offers practical lessons regarding tax reform and shows
how relevant steps in the tax law evolution was an ad hoc response to the imme-
diate historical context and tax policy outcomes are not the result of rational tech-
nocratic processes, but neither are they sufficiently explained in simple terms of
special-interest politics. Tax policy is often the result of reactive, context-driven
decision making, whereby short-term political issues come to dictate long-term
policy outcomes.
33 See Mindy Herzfeld, ‘The Economic Substance Doctrine: Lessons for BEPS’, Tax Notes International
(2015) p. 503.
34 See Camden Hutchison, ‘The Historical Origins of the Debt-Equity Distinction’, Florida Tax Review
(2015) Volume 18, No. 3.

Lunardi
Nowadays, looking for the possible benefits from the Action 4 initiative, the light
should likely shine on coordination. Distortions are caused by uncoordinated ac-
tions of national legislators. Thus, taking into consideration the conflicts of inter-
est in this area, harmonization seems to be an unrealistic objective.
5. Conclusion and recommendations
Looking for solutions in which tax systems can be revised to minimize their effect
on long-term growth has long been a preoccupation of policy makers. In 2010,
the OECD set out some guidelines on how governments could achieve pro-
growth tax reforms and the Discussion Draft did not define excessive interest de-
ductions, which is a sensitive BEPS concern.35
International tax competition sees
a large number of states to attract private businesses to make investments. In this
environment, countries are free to keep their existing rules or to adopt the OECD
recommendations in their domestic tax law. But the Action proposals may be
taken into consideration also from a constitutional law perspective in many coun-
tries, as they foresee limitations to the net income principle.
A best practice recommendation should be studied to have minimal impact both
on investments and competition,36
avoiding double taxation and high compliance
costs.37
A prerequisite for restricting the deductibility of interest is that economic
double taxation of interest must be avoided to the extent possible. For instance,
following the worldwide debt allocation rule means that a disallowance of an in-
terest deduction at the level of a thinly capitalized group company should be off-
set by a corresponding extra deduction of interest at the level of an overcapital-
ized group company. In multilateral sharing, economic double taxation of inter-
est is avoided. In other terms, a fair interest deduction restriction should allow
deductions of interest on loans used to finance assets through which a taxpayer
generates income that is taxable in the state where these assets are used.38
On the
taxpayers’ side, rules limiting the debt financing of companies should find a bal-
35 OECD, Tax Policy Reform and Economic Growth 2010 (OECD 2010). Jeffrey Owens, ‘Trend and
Challenges in the Tax Arena’, Bulletin for International Taxation (2012) p. 685.
36 I.M. de Groot, ‘Interest Deduction and the CCCTB: A Walk in the Park for Tax Advisors?’, Intertax,
Volume 41 (2013) p. 571. Tax competition, whether harmful or harmless, will exist as long as the
global maze of different tax systems exists. The only way to ban harmful tax competition is to intro-
duce a global tax system: something that remains in the realm of the impossible. Something slightly
less unattainable, although equally politically sensitive, would be the implementation of a tax system
for the European Union (EU): the Common Consolidated Corporate Tax Base (CCCTB). Following
the critical evaluations of De Groot, the CCCTB Directive Proposal (published on 25 April 2012)
does not provide for a specific interest deduction limitation that applies to situations within the EU
because of that does nota rise within the CCCTB group.
37 Jakob Bungaard, ‘Debt-flavoured Equity Instruments in International Tax Law’, Intertax, Volume 42
(2013) p. 416.
38 Jan Vleggeert, ‘Interest Deduction Based on the Allocation of Worldwide Debt’, Bulletin for Interna-
tional Taxation (2014) p. 103.

ance between free choice of source of financing and the legitimate interest of the
tax authorities of the country of the borrower to prevent abusive tax structures.
On the governmental side, states follow their peculiar economic and administra-
tive policies when they set rules for limiting interest deduction, but they cannot
act in isolation as they are also in competition with the tax systems of other states.
It is important to balance the needs of government with the needs of investors.39
A core function of the OECD is to encourage cooperation in removing barriers to
cross-border trade and investment and to promote cross-border trade and invest-
ment. The cost-benefit consideration for the Action is the risk and cost of unilat-
eral actions that would take place in projects far from the benefit of a coordinated
action. The OECD used to encourage uniformity although it is now offering op-
tions, which could lead to more non-uniformity among countries’ laws and
worsen the unilateral action problem. Because Action 4 is not an effort to harmo-
nize tax law, some level of competition is permitted.
Hence, the overriding question should be: “What is fair tax competition?” Fair
taxation does not require harmonized tax rates. It relies on Member States being
able to tax companies where they make their profits, in an effective way and in
line with their national rules, preventing tax avoidance through the well-target
corporate tax reforms and greater coordination between Member States. The
“nexus approach” poses the risk of worsening any adverse economic effects of tax
competition, as it creates an incentive for taxpayers to move people and activities
from high to low-tax jurisdictions.
Taxation could be called a scourge of the entire twentieth century, along with
world wars, pollution and over-population. Tax history provides many starling
conclusions. Many of the great events of history, certainly most revolutions, have
been rooted in taxation. It should be clear that taxation is a good barometer of a
social order. Nothing reflects a nation more faithfully than its tax system. It could
be noted, from the earliest records of civilization, the history of human liberty is
intertwined with the history of taxation.40
History shows that taxpayers’ consent, when expressed through representatives,
is seldom an effective check on taxation. Thinking about the English civil war,
what is most unique about the British experience with the excise is that the gov-
ernment could never obtain the consent of Parliament for a general excise, as was
in operation throughout Europe. The British government was well aware that
there was more to taxation by consent than lobbying a tax bill through Parlia-
ment. That state of affairs has continued, not only in Britain, but with the federal
government in the United States. Secession was the cause of the Civil War. Some
39 Amanda Athanasiou, ‘The Cost of BEPS: A Question of Balance’, Tax Notes International (2015)
p. 847.
40 Charles Adams, ‘For Good and Evil – The impact of taxes on the course of civilization’ (Madison
Books [1999], 2nd
edition) p. 267.

Lunardi
authors consider that taxation was the most significant factor on both sides. But
behind these acts of violence and secession itself was a tax issue neither side
would compromise. Freedom from oppressive taxation caused the American
Revolution, the French Revolution, and revolts and rebellions throughout history
too numerous to mention.
Many laws will be tolerated even if they are disliked and clumsy in operation, but
tax laws, when bad, will not be tolerated with ease. When citizens get mad about
taxation there is a good chance something will happen, sooner or later. There may
be violence, like the American Revolution, or simply evasion and flight to avoid
tax. Angry taxpayers often do not limit their discontent to grumbles, they are
prone to react in some direction for relief, using force and violence if necessary.
This is, unquestionably, tax history’s most important lesson. The most crucial
problem, seldom addressed by any tax reformers, is not the question of rates, but
it is the dangers created by the growing powers of spying and tough penal laws
used to enforce tax compliance. This, and not tax rates, may be the most signifi-
cant struggle of our age between government and citizen.
All governments must have a regard not only for what the people are able to bear
but what they are willing to pay, and the manner in which they are willing to pay,
without being provoked to a rebellion.41
41 Stephen Dowell, ‘A History of Taxation and Taxes in England’ (London, 1965, reprint of 184th
edi-
tion; vol. 4) p. 306.

Purpose and Policy Considerations for Implementing Rules

Recommended

Recommended

More Related Content

What's hot

What's hot (20)

Similar to Purpose and Policy Considerations for Implementing Rules

Similar to Purpose and Policy Considerations for Implementing Rules (20)

More from Lino Lunardi, LL.M, CPA, Tax advisor, Auditor

More from Lino Lunardi, LL.M, CPA, Tax advisor, Auditor (12)

Recently uploaded

Recently uploaded (20)

Purpose and Policy Considerations for Implementing Rules