Creating Interest Expense Out of Nothing at All—Policy Options to Cap Deductions to 'Real' Interest Expense

It is well recognised that interest deductions are often used by multinational enterprises (“MNEs”) to minimise their tax liabilities. Despite the significant effort devoted by the OECD and the participating countries in the Base Erosion Profit Shifting project, research has shown that the recommendations of Action 4 – which aimed at strengthening interest limitation regimes – are not as effective as could have been hoped for. One of the key issues with the best practice approach recommended in Action 4 is its failure to prevent interest deductions from exceeding a MNE's net third party interest expense, or the “real” interest expense. This outcome is ironic as the OECD has repeatedly emphasised that an important objective of Action 4 was to recommend policy options to prevent interest deduction from exceeding the “real” interest expense (“the guiding policy objective”). This begs the tax policy question: what are the policy options that can achieve the guiding policy objective?The article aims to answer this question. It first provides a review of the policy rationale underlying the guiding policy objective, paving the way for the analysis of alternative policy options to achieve that outcome. The article concludes by arguing that, although the debt cap rule is not the ideal solution in theory, it may be the second best solution that is a pragmatic model to achieve the guiding policy objective within a country, and is especially effective to deal with lowly geared MNEs