The purpose of the OECD’s Base Erosion and Profit Shifting (BEPS) project was to tackle tax avoidance on an international basis by encouraging jurisdictions to adopt a consistent approach in a number of areas. We are already seeing the effect of this in respect of interest deductions.

Last month the UK announced the introduction, from April 2017, of restrictions on deductions for interest expense in line with the OECD’s BEPS recommendations - a 30% net interest to tax-EBITDA ratio together with a group ratio rule to cater for groups with high external leverage. Germany, Italy and Spain already have equivalent rules and the draft EU anti-avoidance directive would require all EU member states to introduce something similar.

Against this background, the announcement of the proposed US earnings stripping rules last week looks even more controversial.

The US announcement was made in the context of the Treasury’s campaign to make US inversion transactions less attractive. One of the tax benefits that may be achieved if a US business ceases to be US owned is that interest that is deductible in the US can be paid to a non-US affiliate which is often paying significantly less tax on the interest than the benefit of the deduction at the US tax rate. Following an inversion or other foreign acquisition, a US subsidiary might, for example, issue its own debt to its foreign parent as a dividend distribution. Following the announcement, such debt would be treated as equity for US tax purposes and therefore not tax deductible. On the face of it, the proposed regulations apply only to debt issued to related parties, although there is a general anti-abuse rule for transactions structured to get around the rules.

The earnings stripping rules do not, however, affect only inversions. Most non-US groups will want to maintain an appropriate level of debt funding for their US operations, but these rules would potentially apply to a group that wants to re-leverage its US operations to an appropriate level.  

Non-US owned US businesses should be concerned that these rules put them at a competitive disadvantage to their US owned competitors. The rules are unlikely to prevent US owned businesses from paying debt funded dividends to maintain an appropriate debt to equity funding ratio. Over time, foreign owned US businesses could find themselves paying significantly more US tax than their US-owned rivals.

The US approach does also seem inconsistent with the BEPS recommendations, which are focused on the maximum level of deductible debt rather than how the debt is created. 

The US Treasury is clearly constrained with what it can do, given its difficulties in passing new tax legislation, but these proposals discriminate against non-US owned businesses and are inconsistent with the BEPS road map – non-US multinationals would be justified in raising objections.

Sara Luder is Head of the Tax practice at Slaughter and May.