Changes to interest deduction limitation rules

The EU Anti-Tax Avoidance Directive (ATAD), contains five legally binding anti-abuse measures, which all EU member states are required to apply against common forms of aggressive tax planning. The Directive includes an exit tax, a general anti-abuse rule, controlled foreign company rules, measures to tackle hybrid mismatch arrangements, in addition to an interest limitation rule. We will look at this last measure mentioned and the impact for member states.  

Firstly, what is the Interest Limitation Rule? 

The interest limitation rule, Article 4 of the ATAD, in short, requires EU member states to put in place anti-avoidance tax rules that set a limit on the amount of interest a company can deduct for corporation tax purposes. Therefore, limit the ability of companies to deduct substantial borrowing costs and reduce their taxable profits. 

To limit excessive interest deductions, the ATAD takes a ratio-based approach. This stipulates that only a certain percentage of “exceeding borrowing costs” are deductible in the tax period in which they are incurred. “Exceeding borrowing costs” is defined as the amount by which the deductible borrowing costs of a taxpayer exceeds taxable interest receipts and other economically equivalent taxable revenues.  The Directive allows member states to set this ratio up to a maximum of 30% of the taxpayer’s earnings before interest, tax, depreciation and amortisation (EBITDA). Borrowing costs and the EBITDA may be calculated at the level of the group. Excess borrowing costs may also be available to be carried forward to future years and potentially carried back for a period of three years. Taxpayers may be allowed to deduct exceeding borrowing costs up to €3million per period. This limit shall be considered for the entire group. 

Some Exemptions 

The Directive has also provided for some exemptions when calculating the ILR. Standalone entities in a member state, being an entity not a member of a worldwide group, has no associated enterprises, and does not have a permanent establishment in a territory other than the State are permitted to fully deduct exceeding borrowing costs. Exclusions in relation to loans obtained to fund a long-term public infrastructure project where the project provides, upgrades, operates and/or maintains a large-scale asset that is considered in the general public interest of that particular member state. Certain ‘financial undertakings’ may be excluded from the ILR rules. 

As many domestic and multinational companies claim interest relief, all companies will need to pay close attention to the new rules which will represent significant changes to Ireland’s rules, as they will have significant ramifications for many companies. Even though the Directive allows for certain financial undertakings to be excluded, for example banking and insurance sectors, all financial services industries will need analyse the new rules. Many banks often have legal entities which would not form part of the exemption. 

When should it be enacted by? 

Member states were required to transpose the interest limitation rules by 1 January 2019. However, countries with “equally effective” rules in place were allowed until 1 January 2024, to ensure these are aligned with the ATAD. 

For example, Ireland’s interest limitation rules differ in structure from the Directive in that they utilise purpose-based tests, designed to limit certain borrowings, as opposed to the ratio-based approach the ATAD takes. In Ireland, a tax deduction for interest is only available where the relevant borrowings are used for certain limited qualifying purposes.  The strict qualification criteria are supplemented by extensive anti-avoidance provisions relating to connected party transactions. 

Nevertheless, despite these differences, Ireland’s Government argued that the country’s rules remain “equally effective”, allowing it to postpone transposition of the interest limitation element of the ATAD until 2024. The European Commission took a different view, however, and in July 2018, served a formal notice on Ireland asking that interest limitation rules be transposed into law sooner than the planned date in 2024. The European Commission launched infringement procedures against 10 other EU member states for failure to fully implement the Directive.   

According to the Irish Government, it was their opinion, supported by case study data, that Ireland’s existing interest limitation rules are at least equally effective to the rules contained in the EU Directive and notified derogation requests under EU law. 

In December 2020, Ireland launched a Feedback Statement on the ATAD Implementation of Article 4 Interest Limitation and has stated that an Interest Limitation Ratio (ILR) will be transposed into law in their Finance Bill 2021, effective 1 January 2022. 

This Feedback Statement contains questions on technical and policy issues relevant to the ILR development. The Irish Department of Finance has noted that the views of stakeholders will be important in ensuring that Ireland’s ILR, while meeting the ATAD standard, is clear, operable and consistent with the long-standing focus on taxation of activities with substance in Ireland. 

We expect similar commentary/challenge from other countries as well.  What are you seeing in your geographies?