To tackle this, the OECD has proposed two solutions. The first is what is called a fixed ratio rule. Under this rule a set percentage of the EBITDA is allowed to be tax deductible by way of interest expense. So, say a company had earnings of €1 million and under a 30 percent fixed ratio rule it would be able to deduct €300,000 from that €1 million, regardless of whether the company is actually paying more, say €500,000 in interest. This is particularly a problem for real estate because it is a very capital intensive industry and relies on a lot of debt capital to make deals stack up commercially, says Ion Fletcher, director of policy (finance) at real estate lobby group the British Property Federation. This proposal effectively makes debt more expensive by limiting its deductibility and increases the cost of capital for businesses.
The other approach is slightly more nuanced but still problematic. It is called the group allocation method and it takes into account the total external interest cost that a group or a company incurs, which is then shared among the different group companies by reference to the proportion of the group’s earnings or assets each company makes up. So, if you take a company constitutes 30 percent of the group’s earnings, then that company is entitled to 30 percent of the group’s interest as an interest deduction. Fletcher says this method is administratively impossible to manage as you need perfect information about what each entity’s earnings are and what proportion of the total group’s earnings they constitute. Often groups will have different entities in different countries reporting from different accounting rules, and earnings figures might not be directly comparable; some entities may report to March 30 while others may report to December 31.
Fletcher, and the industry as a whole, feel very strongly there is already a good system in place to prevent the type of abuse the OECD and politicians wish to quash: the arm’s length principle which says when you have two related parties that are transacting with each other, they can only recognize that agreement for tax purposes if the agreement could have been made on comparable terms with a third party.
The argument against the status quo is that the arm’s length principle can be difficult for individual tax authorities to understand, especially where those tax authorities don’t have much experience dealing with financial instruments or financial transactions. Data availability also might be poor or the tax authority might lack the resources to check comparable data that the taxpayer delivers.
But, with the OECD reporting its work on the topic to the G20 in September, time is running out for lobby groups and industry participants to put forward the case for real estate. The fear is that an incredibly comprehensive review of taxation avoidance has taken place in a short time frame, and the proposals are not as well-targeted as they could be. This means that tough rules designed to tackle the worst of the avoidance might end up applying to everyday commercial transactions, causing “collateral damage.” Watch this space.