Direct Tax Laws & International Taxation · Fundamentals of BEPS

BEPS Action Plans: CFC, Interest Deductions and Harmful Tax

Updated 5 October 2026 · Fact-checked

Actions 3, 4 and 5 of the OECD/G20 BEPS project deal with profit shifting through foreign subsidiaries, interest payments and preferential tax regimes. Action 3 designs CFC rules, Action 4 limits net interest deductions to a fixed ratio of EBITDA, and Action 5 tests preferential regimes using substantial activity and the nexus approach. Solve questions by naming the action, its rule, then applying it to the facts.

Understand BEPS Action Plans: CFC, Interest Deductions and Harmful Tax

BEPS means Base Erosion and Profit Shifting. Groups use gaps between countries' tax rules to move profit to low-tax places, where little real activity exists. The OECD/G20 project has 15 Actions. Actions 3, 4 and 5 are three of them, and each closes a different gap.

Action 3: Controlled Foreign Company (CFC) rules. A group parks passive income, such as interest, royalty or dividends, in a subsidiary in a low-tax country and does not bring it home. CFC rules let the parent's country tax that income currently, even though it has not been distributed. The Action 3 report is a set of recommendations (best practices) for building such rules, not a minimum standard. It covers six building blocks: definition of a CFC, CFC exemptions and threshold requirements, definition of CFC income, rules for computing income, rules for attributing income, and rules to prevent or eliminate double taxation.

Action 4: Interest deductions. A group can load debt into a high-tax entity, which then pays interest to a group lender in a low-tax country. The interest is deducted in the high-tax country and taxed lightly elsewhere. Action 4 recommends a fixed ratio rule: a company's net interest deduction is limited to a percentage of its tax-EBITDA. The recommended corridor is 10% to 30%. A country may add a group ratio rule, which lets an entity deduct more, up to the group's net third-party interest to EBITDA ratio. A de minimis threshold can exempt small entities. Carry forward of disallowed interest is also an option.

Action 5: Harmful tax practices. Countries compete by offering preferential regimes, for example low tax on income from intellectual property (IP). Action 5 is a minimum standard, so Inclusive Framework members must comply, and compliance is peer reviewed. It has two main parts. First, the substantial activity requirement: a preferential regime must give benefits only to income from activities with real substance. Second, transparency: members must spontaneously exchange information on certain rulings.

For IP regimes, substantial activity is tested by the nexus approach. Benefits are given only to the extent the taxpayer itself incurred qualifying research and development (R&D) expenditure. Outsourcing to related parties does not qualify. This links the tax benefit to real spending.

In short: Action 3 taxes the parent on parked income, Action 4 caps interest, and Action 5 forces regimes to have real substance. Remember which is a minimum standard: only Action 5 among these three. Action 3 is a set of recommendations (best practices), and Action 4 is a best practice (common approach) recommendation. Neither Action 3 nor Action 4 is a minimum standard.

Key rules to remember

Fixed ratio rule (Action 4): Allowed net interest deduction = Fixed % × tax-EBITDA; Recommended percentage lies in a corridor of 10% to 30%. Net interest means interest expense minus interest income.
Tax-EBITDA: Tax-EBITDA = Taxable income + Net interest expense + Depreciation and amortisation (all as per tax rules); Computed from tax figures, not accounting profit. Exempt income is excluded.
Group ratio rule (Action 4): Group ratio = Group net third-party interest expense ÷ Group EBITDA; Optional addition to the fixed ratio. An entity may deduct net interest up to its EBITDA × group ratio, where permitted.
Nexus approach (Action 5): Qualifying income = Overall income from IP × [(Qualifying expenditure + Uplift) ÷ Overall expenditure]; Uplift = lower of (30% × Qualifying expenditure) and (Acquisition cost + Related-party outsourcing); Qualifying expenditure is R&D incurred by the taxpayer itself, including outsourcing to unrelated parties. Related-party outsourcing and acquisition costs are excluded from it, but they are in overall expenditure and can support the uplift. The fraction cannot exceed 100%.
CFC building blocks (Action 3): Definition of CFC; exemptions and thresholds; definition of CFC income; computation rules; attribution rules; prevention or elimination of double taxation; Six recommendations. Write all six in theory answers.
Action 5 core tests: Substantial activity requirement + Transparency framework (spontaneous exchange of rulings); Action 5 is a minimum standard under peer review.

How to solve BEPS Action Plans: CFC, Interest Deductions and Harmful Tax questions

Use this method for theory and case questions on Actions 3, 4 and 5. Always tie the rule to the facts given.

1Identify the action from the facts: parked passive income abroad points to Action 3, heavy intra-group interest points to Action 4, a preferential IP or similar regime points to Action 5.
2State the BEPS problem in one line, such as deferral of tax, interest stripping or harmful competition.
3State the OECD recommendation or standard, and say whether it is a minimum standard or a best practice recommendation.
4For a numerical question on Action 4, compute tax-EBITDA first, then apply the fixed percentage to get the cap.
5Compare the cap with the net interest actually claimed. Disallow or carry forward the excess, as the question allows.
6For Action 5 numerical questions, apply the nexus fraction (including the uplift, if the question covers it) to overall IP income to get qualifying income.
7Conclude in a sentence on the effect on the group, and mention that India's own law is separate where relevant.
8Write the answer in provision, facts, conclusion form.

Quickest way: Three-line action tag method

When to use it: Use this when the question asks which action applies, or asks for a short note in limited time.

Tag the action: 3 is CFC, 4 is interest, 5 is harmful tax practices.
Write the one-line rule: attribute CFC income to the parent, cap net interest at a share of EBITDA, or require substantial activity with the nexus approach.
Add the status: Action 5 is a minimum standard, the others are recommendations.
For numbers, do only two calculations: EBITDA × percentage for Action 4, or income × qualifying fraction for Action 5.

Common mistakes in BEPS Action Plans: CFC, Interest Deductions and Harmful Tax

Calling all three actions minimum standards.
Students remember that BEPS has some minimum standards and apply the label to every action.
Fix: Remember that among these three, only Action 5 is a minimum standard. Action 3 is a set of recommendations (best practices), and Action 4 is a best practice (common approach). Neither is a minimum standard.
Applying the Action 4 percentage to gross interest or to accounting profit.
The word EBITDA is read as accounting EBITDA and interest is not netted.
Fix: Use tax-EBITDA and net interest expense, meaning interest expense less interest income.
Stating the Action 4 ratio as exactly 30%.
Many countries adopt the top of the range, so it is remembered as the rule.
Fix: Say the recommended corridor is 10% to 30%, and that each country picks its own percentage.
Counting related-party outsourcing and acquisition cost as qualifying expenditure in the nexus fraction.
Students treat any R&D spend as qualifying.
Fix: Only the taxpayer's own R&D and outsourcing to unrelated parties qualify. Related-party outsourcing and acquisition costs sit in overall expenditure only, and can support the uplift.
Saying CFC rules tax the foreign company directly.
The word company suggests the tax falls on the CFC.
Fix: CFC rules attribute the CFC's income to the resident shareholders, who are taxed in the parent's country.
Leaving out the transparency part of Action 5.
Students focus on the nexus approach alone.
Fix: Always give both limbs: substantial activity and spontaneous exchange of information on relevant rulings.

Worked examples

Example 1

Alpha Ltd is the Indian arm of a foreign group. For the year, its tax-EBITDA is ₹50,00,000. It paid interest of ₹22,00,000 to group lenders and earned interest income of ₹2,00,000. Country X applies a fixed ratio rule at 30% of tax-EBITDA with no group ratio rule. Apply the Action 4 approach to find the deductible net interest and the excess.

Show the solution

Net interest expense = ₹22,00,000 − ₹2,00,000 = ₹20,00,000.
Cap = 30% × ₹50,00,000 = ₹15,00,000.
Compare: net interest of ₹20,00,000 is more than the cap of ₹15,00,000.
Deductible net interest = ₹15,00,000.
Excess = ₹20,00,000 − ₹15,00,000 = ₹5,00,000, which is disallowed in the year. Under Action 4 a country may allow it to be carried forward.

Answer: Deductible net interest is ₹15,00,000 and ₹5,00,000 is disallowed, subject to any carry-forward the country allows.

Example 2

Beta Co's country offers a preferential rate on income from patents. Beta earned overall patent income of ₹80 lakh. Its overall expenditure on the patent was ₹100 lakh, made up of: own R&D ₹50 lakh, R&D outsourced to unrelated parties ₹20 lakh, R&D outsourced to a related group company ₹20 lakh, and acquisition cost of the patent ₹10 lakh. The regime applies the nexus approach with the 30% uplift. Find the income that may get the benefit.

Show the solution

Qualifying expenditure = own R&D + unrelated party outsourcing = ₹50 lakh + ₹20 lakh = ₹70 lakh.
Overall expenditure = ₹50 + ₹20 + ₹20 + ₹10 = ₹100 lakh.
Uplift = lower of (30% × ₹70 lakh = ₹21 lakh) and (related-party outsourcing ₹20 lakh + acquisition cost ₹10 lakh = ₹30 lakh) = ₹21 lakh.
Nexus fraction = (₹70 lakh + ₹21 lakh) ÷ ₹100 lakh = 0.91. This is below 100%, so no cap applies.
Qualifying income = ₹80 lakh × 0.91 = ₹72.80 lakh = ₹72,80,000.
The remaining ₹7.20 lakh (₹80 lakh − ₹72.80 lakh) = ₹7,20,000 does not get the preferential rate and is taxed at the normal rate.
This shows the Action 5 principle that benefit follows the taxpayer's own real R&D activity.

Answer: ₹72,80,000 of the patent income qualifies for the preferential rate and ₹7,20,000 is taxed normally.

Exam tips

Write the six CFC building blocks in order when asked for a note on Action 3. They are easy marks.
In Action 4 numericals, show net interest, cap and excess as three separate lines so partial marks are safe.
For Action 5, always name the nexus approach and the substantial activity requirement, and say it is a minimum standard.
In case scenario MCQs, look for the trigger fact: parked passive income, intra-group loans, or a preferential IP regime. Pick the action from that.
Do not quote Indian section numbers for these actions unless the question gives them. Keep the answer to the OECD framework.

Practice questions from Fundamentals of BEPS

BEPS Action Plans: CFC, Interest Deductions and Harmful Tax: frequently asked questions

What is BEPS Action 3 in simple words?

It is the OECD recommendation for CFC rules. These let a parent's country tax the passive income of a low-taxed foreign subsidiary in the parent's hands, without waiting for a dividend.

What is the BEPS Action 4 interest limitation?

It limits a company's net interest deduction to a fixed percentage of its tax-EBITDA. The recommended corridor is 10% to 30%. A group ratio rule can allow more for entities in groups with high third-party debt.

What is the nexus approach under Action 5?

It links the benefit of an IP regime to the R&D the taxpayer itself carried out. Income gets the benefit in proportion to qualifying expenditure (plus a limited uplift) over overall expenditure.

Which of these actions is a minimum standard?

Action 5 on harmful tax practices is a minimum standard, so Inclusive Framework members must meet it and are peer reviewed. Action 3 is a set of best-practice recommendations and Action 4 is a best practice (common approach). Neither is a minimum standard, and countries may adopt them in their own way.