Thin Capitalization and Interest Deduction Rules: A ...corit-academic.org/wp-content/uploads/2011/12/60TI0683-Webber.pdf · Thin Capitalization and Interest Deduction Rules: A Worldwide

Thin Capitalization and InterestDeduction Rules: A WorldwideSurvey

by Stuart Webber

Reprinted from Tax Notes Int’l, November 29, 2010, p. 683

Volume 60, Number 9 November 29, 2010

(C)

TaxA

nalysts2010.A

llrightsreserved.

TaxA

nalystsdoes

notclaim

copyrightin

anypublic

domain

orthird

partycontent.

Thin Capitalization and Interest Deduction Rules:A Worldwide Surveyby Stuart Webber

The United States faces budget deficits that areamong the largest in its history. According to the

Congressional Budget Office (2009), the current year’sdeficit will total $1.6 trillion, which is 11.2 percent ofGDP, the highest percentage since World War II (p. 1).Budget deficits are expected to remain large long intothe future. According to CBO projections, governmentspending will exceed revenue every year over the nextdecade. Rising healthcare costs and an aging popula-tion will put further pressure on budget deficits, andthis debt will reduce economic growth. According tothe CBO summary, ‘‘[o]ver the long term (beyond the10-year baseline projection period), the budget remainson an unsustainable path’’ (p. 4). The summary alsostates, ‘‘Putting the nation on a sustainable fiscalcourse will require some combination of lower spend-ing and higher revenues than the amounts now pro-jected’’ (p. 1).

Earlier this year the Obama administration proposedinternational tax laws designed to overhaul the way inwhich U.S.-based multinational enterprises are taxedand to generate additional tax revenue. While the 2009proposal was recently withdrawn, the administration isreportedly proposing a comprehensive overhaul ofinternational tax laws next year.1 The 2009 proposalwould have tightened restrictions on interest deductibil-ity, but it would apply only in very limited situations.

In contrast, a number of other countries have recentlyenacted more comprehensive changes to rules govern-ing interest deductions. For example, Germany andItaly have recently overhauled their interest deductionrules, and other EU countries are also consideringmodifications. As Nadal (2008) writes, ‘‘Countriesaround the world, concerned with earnings stripping,have been tightening their thin capitalization regimes’’(p. 1). She adds, ‘‘The question becomes whether theU.S. thin cap rules are tight enough, or whether thereare loopholes that can be closed.’’

This article analyzes international tax laws thatregulate excessively leveraged financing structures.These tax laws are designed to combat thinly capital-ized financing structures and are important both togovernments and MNEs. From a government’s per-spective, they affect both tax revenue and the country’seconomic competitiveness. From the MNE’s perspec-tive, they determine the firm’s tax expense and mayshape where it conducts business. This article analyzesapproaches countries use to combat these tax minimi-zation strategies and to recommend a strategy that ismost likely to achieve the intended objectives.

Thin capitalization is a financing strategy MNEs useto make foreign direct investment (FDI). When anMNE initiates business activities in another country, itfrequently forms a local subsidiary to conduct business.

1For a discussion of its decision to withdraw its 2009 tax pro-posals, see ‘‘Business Fends Off Tax Hit: Obama AdministrationShelves Plan to Change How U.S. Treats Overseas Profits’’ TheWall Street Journal, Oct. 13, 2009, p. A1. According to the article,

‘‘Obama aides say the administration has set the idea aside fornow, but may return to it as part of a broader tax overhaulsometime next year.’’

Stuart Webber is a professor and head of the Business Leadership and Management Department atTrinity Lutheran College in Everett, Washington, a PhD candidate at the Copenhagen Business School,and a member of the Copenhagen Research Group on International Taxation.

(Footnote continued in next column.)

TAX NOTES INTERNATIONAL NOVEMBER 29, 2010 • 683

(C) T

ax Analysts 2010. A

ll rights reserved. Tax A

nalysts does not claim copyright in any public dom

ain or third party content.

These investments need to be funded to support busi-ness expansion. The cash is supplied as equity or debt.Debt creates an opportunity to lower income taxes, asinterest expenses are tax deductible, while dividendsare not. When an investment in a high-tax country isfunded with intercompany debt extended from a low-tax country, profit is shifted to the country imposinglower taxes. Thus, the MNE reduces its worldwide taxrate without incurring additional trade expenses. Thiscan motivate MNEs to fund overseas investments inhigh-tax jurisdictions with a high debt-to-equity ratio.

Farrar and Mawani (2008) write: ‘‘A business is saidto be thinly capitalized if it is financed with a highproportion of debt relative to equity. The rules thatlimit the amount of interest deductions in those situa-tions are known as thin capitalization rules’’ (p. 3).Some analysts prefer to focus on how income is shiftedfrom one jurisdiction to another, and use the terms‘‘interest stripping’’ or ‘‘earnings stripping.’’ In describ-ing how income is shifted out of the U.S., Isenbergh(2005) writes, ‘‘This maneuver is known in the tax lexi-con as ‘interest stripping’ or ‘earnings-stripping’ be-cause taxable income is stripped from the U.S. tax en-vironment by interest deductions’’ (p. 33). Whateverterm is used, the evidence demonstrates this is not atheoretical concern; it happens in practice. Haufler andRunkel (2008) write, ‘‘Recent empirical research pro-vide conclusive evidence that international tax differen-tials affect multinationals’ financing structures in a waythat is consistent with overall tax minimization’’ (p. 1).Countries imposing high income tax rates are con-cerned with these funding strategies, contending theincome was earned in their country and profits shouldbe taxed there. To limit this activity, countries have en-acted a number of regulatory strategies. Thin capitali-zation rules limit a firm’s debt-to-equity ratio to controlhighly leveraged financing structures. Interest deductionregulations directly limit the tax-deductible interest ex-pense a firm can recognize. Some countries employeither thin capitalization rules or interest deductionlimitations, but many countries use a combination ofregulations to combat excessive financial leverage.

Banks, insurance companies, and investment banksrely on significantly more debt than non-financial-services firms, such as manufacturing organizationsand retail firms. Thus, financial services firms havehigher debt-to-equity ratios compared with other indus-tries, and some countries establish separate thin capi-talization policies for them. This article does not ad-dress thin capitalization/interest deduction limitationsin that business sector. It does focus on rules applyingto corporate entities, rather than partnerships and otherbusiness forms.

This article assumes no major changes to the exist-ing paradigm of international business taxation; it istaken for granted that each country separately taxes theprofits earned by businesses operating within its bor-

ders, and that governments do not coordinate their ac-tivities when enacting and enforcing tax laws.2

Tax Principles

To evaluate the effectiveness of thin capitalizationand interest deduction rules, it is useful to identify thecriteria by which these laws should be judged. It maybe impossible to develop a comprehensive list of taxprinciples to which all would agree. Nonetheless,economists and tax experts have identified general prin-ciples by which tax laws should be evaluated. As Mus-grave and Musgrave (1976) write, ‘‘Ideas as to whatconstitutes a ‘good’ tax system have had their influ-ence. Economists and social philosophers, from AdamSmith on, have propounded what such requirementsshould be’’ (p. 210). For the purposes of this article,we will focus on those principles that may be relevantto an analysis of thin capitalization and interest deduc-tion tax regulations.

It is generally agreed that tax obligations should beclearly stated and identified with as little ambiguity aspossible. Both the taxpayer and tax collector benefitfrom knowing precisely the amount owed and whenfunds are due. Businesses need this information to pre-pare accurate financial statements and financial fore-casts. And government agencies need this informationto prepare their financial plans. The European Com-mission states that certainty is an important tax prin-ciple, emphasizing both the taxpayer’s and govern-ment’s need for predictability. The commission (2004)has written, ‘‘Certainty is desirable to assist businessplanning, but also to provide a degree of revenue cer-tainty for administration; for example, if the rules gov-erning loss-offset are unclear then neither business norgovernment can predict tax payments and revenue’’ (p.4). For the purposes of this article, this will be calledthe certainty principle.

Efficiency is another important principle that is gen-erally supported. To be efficient, a tax system shouldcollect revenue with as little expense as possible. Fundsspent collecting taxes reduce the earnings of businessesand individuals and add nothing to public welfare.Musgrave and Musgrave (1976) write: ‘‘Administrationand compliance cost should be as low as possible com-patible with other objectives’’ (p. 211). The EuropeanCommission also supports the efficiency principle, writ-ing, ‘‘The simpler a tax base is the lower the adminis-trative or compliance costs should be, for both adminis-trations and business’’ (p. 5). Further, ‘‘[t]he rules of a

2Several articles have proposed fundamental changes to theexisting paradigm of international taxation. See, e.g., R. Avi-Yonah and K. Clausing, ‘‘Reforming Corporate Taxation in aGlobal Economy: A Proposal to Adopt Formulary Apportion-ment,’’ in: J. Furman and J.E. Bordoff (eds.), Path to Prosperity:Hamilton Project Ideas on Income Security, Education, and Taxes,Washington: Brookings Institution Press, 2008, pp. 319-344.

SPECIAL REPORTS

684 • NOVEMBER 29, 2010 TAX NOTES INTERNATIONAL

(C) T

ax Analysts 2010. A




tax base must be easy to enforce as an unenforceabletax is unlikely to be equitable or neutral’’ (p. 5).

The commission’s comments identify another effi-ciency characteristic, which is the efficient functioningof markets. Most economists believe that when mar-kets are operating efficiently, tax motivations shouldplay a minimal role in shaping business and consumerdecisions. Taxes can distort markets and impose a wel-fare loss on an economy. Musgrave and Musgrave(1976) write, ‘‘Taxes should be chosen so as to mini-mize interference with economic decisions in otherwiseefficient markets’’ (p. 210). Ideally, taxes should play anegligible role in shaping economic decisions.

However, taxes can play an important role in cor-recting market inefficiencies or in addressing externali-ties. As Musgrave and Musgrave (1976) write, ‘‘At thesame time, taxes may be used to correct inefficienciesin the private sector, provided they are a suitable in-strument for doing so’’ (p. 210). Similarly, the Euro-pean Commission (2004) writes, ‘‘Taxation policy maybe used to correct ‘market failures’ whereby distortionsor inefficiencies in a particular market economy can be‘corrected’ by the use of specific tax incentives’’ (p. 4).While it may not be easy to discern whether marketsare operating efficiently, most economists and tax ex-perts would agree that taxes should play a role in ad-dressing externalities.

Probably all parties agree taxes should be ‘‘fair,’’ butdefining fairness with any specificity is difficult. Ac-cording to Jones (2006), a ‘‘standard by which toevaluate a tax is whether the tax is fair to the peoplewho must pay it. While no economist, social scientist,or politician would ever argue against fairness as anorm, there is precious little agreement as to the exactnature of tax equity’’ (p. 34). Nonetheless, taxpayersand regulators expect tax laws to be rational and logi-cal, and they should not be random or arbitrary. Gen-erally, most economists, tax experts, and taxpayers ex-pect tax laws to be reasonable, coherent, and just.Moreover, they should not unduly impact business op-erations without good cause.

Some experts have taken the general concept of fair-ness and tried to describe it more precisely. Two fur-ther fairness definitions have been suggested, and whileneither is a comprehensive definition, both identifywhat many taxpayers expect. One is the benefit prin-ciple, which argues a taxpayer’s obligations should berelated to the value of services received from the gov-ernment. A second is the ability-to-pay principle, whichsays taxes should be related to the taxpayer’s capacityto meet the obligation. At a minimum, it makes nosense to assess taxes that cannot be paid.

However, the benefit principle and the ability-to-payprinciple may direct tax laws in different directions.First, it may be difficult to measure and value the gov-ernment benefits taxpayers receive. How does onevalue the benefit of police protection or public parks?As Schön (2009) writes, ‘‘There is simply no conceiv-able way to measure the ‘price’ of public services for

the individual private actor’’ (p. 76). Beyond this, manypublic services are specifically designed to aid a soci-ety’s neediest citizens, those with the least ability topay. The benefits they receive may far exceed the taxesthey can pay. And others may have the capacity to paysubstantial taxes, but have little or no need for manygovernment programs. Liberals and conservatives arelikely to have different perspectives on which principlebest represents fairness. Conservatives may favor thebenefit principle, which advocates paying only for whatis received. Liberals are likely to favor the ability-to-payprinciple, which may support income redistribution. AsMusgrave (1986) writes, ‘‘Contrasted with the conserva-tive appeal of the benefit doctrine, the ability to payapproach was favoured by liberal writers who were notaverse to income redistribution’’ (p. 321).

Probably all parties agreetaxes should be ‘fair,’ butdefining fairness with anyspecificity is difficult.

Musgrave and Musgrave (1976) describe the benefitprinciple this way: ‘‘One approach rests on the so-called benefit principle. According to the theory, datingback to Adam Smith and earlier writers, an equitabletax system is one under which each taxpayer contrib-utes in line with the benefits which he receives frompublic services’’ (p. 211). In international tax, this isalso used to support taxing profits where they aresourced. Schön (2009) writes, ‘‘The benefit principle ismeant to justify income taxation with respect to thesupport granted by a country to the generation of in-come in its territory. This principle is in particular in-voked by source countries to legitimate taxation in ju-risdictions where the taxpayer is not resident butcarries on all or part of his income-generating opera-tions’’ (p. 75). Governments may cite the benefit prin-ciple to support thin capitalization/interest deductionregulations, arguing that intercompany loans are ex-tended to shift income from where it is earned, andwhere government services are provided, to low-taxjurisdictions that provide minimal government support.

Musgrave and Musgrave (1976) describe the otherfairness principle this way: ‘‘The other strand, also ofdistinguished ancestry, rests on the ‘ability-to-pay’ prin-ciple. Under this approach, the tax problem is viewedby itself, independent of expenditure determination’’(p. 211). Thus, tax obligations are not necessarilylinked to benefits received. Schön (2009) notes that theability-to-pay principle rests on liberal values of sharedsacrifice, writing, ‘‘The ability-to-pay principle is deeplyrooted in the Western tradition of being a citizen’s

SPECIAL REPORTS


(C) T

ax Analysts 2010. A




contribution to the common good by reason of solidar-ity among the members of a society. It is meant to ad-dress the different consumption power of different tax-payers in order to enforce a politically defined financialsacrifice’’ (p. 71). Musgrave and Musgrave said thatwhile market-oriented economists may take issue withthe ability-to-pay principle, it remains an importantstandard by which taxes are frequently evaluated. Theywrite that a ‘‘given total revenue is needed and eachtaxpayer is asked to contribute in line with his abilityto pay. This approach leaves the expenditure side ofthe public sector dangling, and is thus less satisfactoryfrom the economist’s point of view. Yet, actual taxpolicy is largely determined independently of the ex-penditure side and an equity rule is needed to provideguidance. The ability-to-pay principle is widely ac-cepted as this guide’’ (pp. 211-212).

Most experts believe taxes should be neutral, that is,they should not discriminate in favor or against certaintaxpayers and investors, in the absence of externalities.Musgrave and Musgrave (1976) say, ‘‘Taxes should bechosen so as to minimize interference with economicdecisions in otherwise efficient markets’’ (p. 210).Doernberg (2008) writes, ‘‘From an efficiency point ofview, the aspirational goal for a tax system in general,or for the U.S. rules governing international transac-tions specifically, is the implementation of a tax-neutralset of rules that neither discourage nor encourage par-ticular activity. The tax system should remain in thebackground, and business, investment, and consump-tion decisions should be made for non-tax reasons’’(pp. 3-4).

In general, there are two aspects to neutrality. Oneis capital-export neutrality, and the second is capital-import neutrality. Concerning the former, Doernberg(2008) writes: ‘‘A tax system meets the standard ofcapital-export neutrality if a taxpayer’s choice betweeninvesting capital at home or abroad is not affected bytaxation’’ (p. 4). Schön (2009) describes it similarly,writing that capital-export neutrality ‘‘requires that —from the position of the investor — the tax burden forforeign and domestic investment is equal and thereforedoes not distort the decision of whether to invest hereor there’’ (p. 79). While many believe this is still aworthwhile objective, in practice capital-export neutral-ity does not exist today, because of international taxcompetition and laws that encourage countries to taxincome where it is sourced, or earned. Schön arguesthat capital-export neutrality would be ‘‘most easilyachieved when the country of residence of the investortaxes his or her worldwide income while the country ofsource fully waives its jurisdiction over income con-nected with its territory’’ (p. 79). However, source-based taxation is more frequent than residence-basedtaxation, and few countries would be willing to forgotaxing profits earned (or sourced) in their country.

Capital-import neutrality has played an importantrole in the development of thin capitalization laws.Schön (2009) writes, ‘‘The concept of capital import

neutrality starts from the perspective of the host coun-try of an investment and compares the tax burden fordomestic and foreign investors’’ (p. 80). Doernberg(2008) says, ‘‘This standard is satisfied when all firmsdoing business in a market are taxed at the same rate’’(p. 5). To encourage FDI and support internationaltrade, many international agreements require that do-mestic firms and overseas investments are taxed equit-ably, and countries violating these rules can be subjectto trade sanctions and penalties. To attract or limitFDI, countries may be tempted to use the tax systemto either subsidize or penalize overseas investors, whichis considered an unfair trade practice. Thus, manytrade agreements and international tax standards man-date consistent tax rates and regulations, so companiescompete on a level playing field. Some jurisdictionssupport this standard with a freedom of establishmentclause. As will be explained later, several thin capitali-zation rules have violated this standard, as judged bythe EC Treaty’s freedom of establishment clause.

Finally, we should consider whether thincapitalization/earnings stripping rules achieve theirintended objective. As Musgrave and Musgrave (1976)write, it is appropriate to use taxes to correct marketinefficiencies (p. 210). In this case, the inefficiency taxauthorities wish to address is the shifting of earningsfrom high-tax jurisdictions in which they are earned tolow-tax jurisdictions. Is a thin capitalization rule effec-tive at achieving this? Or is it so lax that it does notrestrict abuse? How easy is it to evade the tax laws andmove profits? Is the law so restrictive that it constrainsfirms from financing FDI in ways inconsistent withtheir business models? In short, do the laws achieve thegoals of funding government services while promotinga prosperous economy? An effective thin capitalizationlaw should constrain firms from incurring excessiveintercompany debt solely for the purpose of reducingtaxes. But it should also allow firms to incur debt —and take a tax deduction — when such debt is a nor-mal part of a firm’s business model.

International Tax LawsInternational laws govern how business transactions

are treated for income tax purposes and frequently re-flect the tax principles cited. These tax laws are morespecific than tax principles, and they may be inter-preted differently from country to country. Nonetheless,they govern how nations tax MNEs. Also, unlike thetax principles mentioned above, these international taxlaws may be the source of litigation between taxpayersand tax authorities in various nations.

Most economists and tax experts believe businesstransactions should not be motivated solely by tax re-duction goals. This is the business purpose doctrine.This doctrine says a business transaction should havesome purpose other than tax minimization. Jones(2006) says that in the United States, ‘‘a transactionshould not be effective for tax purposes unless it has agenuine business purpose other than tax avoidance.

SPECIAL REPORTS


(C) T

ax Analysts 2010. A




The lack of any business purpose by the participantscan render a transaction meaningless, at least from theperspective of the IRS, even if the transaction literallycomplies with the law’’ (p. 85).3 Many other countrieshave similar regulations to prevent taxpayers and ad-visers from structuring elaborate tax transactions thatserve no business purpose other than reducing tax obli-gations.

Concerning the business purpose doctrine, most taxauthorities believe tax obligations should be determinedby the underlying business substance, rather than thelegal structuring of a transaction. This is known as thesubstance-over-form doctrine.4 In many situations it ispossible to structure a business transaction so it literallycomplies with the law, but the net result of the transac-tion conflicts with the law’s intention. As Lessambo(2009) writes, ‘‘The substance over form doctrine reliesupon the underpinning that the tax results of an ar-rangement are better determined based on the underly-ing substance rather than its mere formal structuring.Therefore, the IRS has the ability to challenge a giventransaction according to its underlying substance’’ (p.207). This doctrine is frequently relevant in thin capi-talization regulations. For example, to shift incomefrom one country to another, an MNE may extend anintercompany loan from one legal entity to another.Tax regulations might try to prevent this by specificallylimiting intercompany debt. In response, the MNEmight structure a loan so it is literally extended from athird party, but in substance the parent guarantees thedebt or initiates a back-to-back loan that culminates inthe third-party loan. Tax authorities may argue thatwhile the loan was formally extended from a thirdparty, in substance it was an intercompany loan.5Courts frequently look through the legal agreementsand focus on the net business substance of transac-tions.

Another important legal concept is the arm’s-lengthstandard, which governs how related entities valuesales of products and services. When an MNE oper-ates in more than one country, it typically creates anew legal entity to facilitate legal operations in thatjurisdiction. That entity may need to buy or sell prod-

ucts from other legal entities within the same MNE.According to Jones (2006), ‘‘An important presumptionabout market transactions is that the parties are negoti-ating at arm’s-length. In other words, each party isdealing in its own economic self-interest, trying to ob-tain the most advantageous terms possible from theother party’’ (p. 62). The OECD’s Transfer PricingGuidelines for Multinational Enterprises and Tax Administra-tions (2010) cite the arm’s-length standard (pp. 31-32).U.S. Treas. reg. section 1.482(1)(b)(1) also supports thearm’s-length standard, stating, ‘‘In determining the truetaxable income of a controlled taxpayer, the standardto be applied in every case is that of a taxpayer dealingat arm’s length with an uncontrolled taxpayer.’’

Overview of Thin Capitalization Rules

To understand thin capitalization rules, a brief over-view of this issue follows, as does a more detailed ex-amination of the regulations in several key countries.Rules in all G-7 countries plus Denmark, the Nether-lands, and New Zealand will be reviewed in some de-tail, as rules in those countries illustrate many of thechallenges and complexities of drafting effective thincapitalization/interest deduction rules. These rules willbe contrasted with regulations in a number of smallerEuropean countries.

In 1969 the United States enacted IRC section 385,which gave tax authorities the power to determine ifintercompany loans were, in substance, equity invest-ments. Tax authorities believed then that characterizingintercompany loans as equity would resolve the thincapitalization issue. If the IRS could deem intercom-pany loans to be investments, it could treat the interestpayments as dividends, which are not tax deductible.However, tax authorities eventually determined thatthese tools were inadequate and that additional toolswere necessary. According to Lessambo (2009), ‘‘In1989, Congress enacted section 163(j) for excessive in-terest payments paid abroad’’ (p. 10). Many othercountries began to develop similar rules around thistime. According to von Brocke and Perez (2009), ‘‘Inthe late 1990s most developed countries began to intro-duce thin capitalization rules in order to restrict theimplementation of abusive financing structures whichmight lead to the transfer of profits to another jurisdic-tion where the profits were taxed at a lower rate’’ (p.29).

From inception, thin capitalization rules generallyevaluated the firm’s balance sheet to determine if thecontrolled foreign corporation’s financing structure wasexcessively leveraged. Von Brocke and Perez (2009)write, ‘‘In a first stage, the majority of these thin capi-talization rules established the existence of safe har-bours (e.g., debt-to-equity ratios) in order to force re-lated companies to apply normal market conditions intheir intra-group transactions’’ (p. 29). Lund, Kors-gaard, and Albertsen (2008) agree, writing, ‘‘Specific

3The business purpose doctrine was first articulated in theUnited States in Gregory v. Helvering, 293 U.S. 465 (1935).

4Within the United States, this doctrine was articulated inCommissioner v. Danielson, 378 F.2d 771 (CA-3, 1967).

5A closely related and overlapping tax standard is the steptransaction doctrine. Lessambo (2009) writes, ‘‘Under the steptransaction doctrine a series of formally separate transactionswill be integrated if they show to be interdependent, and part ofa sole picture’’ (p. 209). For example, if an MNE lent money toa bank, and that bank lent the funds back to the MNE’s sub-sidiary, tax authorities might collapse the two transactions to-gether to demonstrate the loan should be viewed as related-partydebt. Thus, both the substance-over-form principle and the steptransaction doctrine could be used to treat the series of transac-tions as a related-party loan.

SPECIAL REPORTS


(C) T

ax Analysts 2010. A




rules aimed to discourage thin capitalization often re-quire that the debt-to-equity ratio meet a specific ratioin order for the company to be allowed to deduct inter-est expenses’’ (p. 283).

However, since that time, several countries haveshifted their approach to combat these financing strate-gies. Lund, Korsgaard, and Albertsen (2008) write, ‘‘Inrecent years, there has been a tendency for some coun-tries to base their rules on a company’s operations, andmore and more countries are introducing so-called in-terest limitation rules and earnings stripping rules’’ (p.283).

Germany and Italy have recently adopted this ap-proach. Von Brocke and Perez (2009) believe debt-to-equity rules were ineffective, writing, ‘‘It was verysimple for companies to circumvent the limit estab-lished by debt-to-equity ratio by increasing the equityof the financed subsidiary in a manner sufficient topush down as much debt as necessary’’ (p. 29). In ad-dition, several countries found that their rules were in-consistent with the capital-import neutrality principle,which also motivated those countries to develop alter-native regulatory approaches.

Governments do not sharetax return informationwithout taxpayeragreement, creating aninformation asymmetrythat benefits the MNE.

The United Kingdom began by limiting the debt-to-equity ratio and now relies exclusively on the arm’s-length standard. The U.K. does not give taxpayers anyfirm financial guidelines or ratios, which may make itdifficult for taxpayers to comply with the standard andfor regulators to enforce it. Developments in theUnited Kingdom will be discussed in more detail later.

There are several other facets to thin capitalizationrules that merit attention. One is that countries moni-tor thin capitalization rules in other countries whendeveloping their own policies. Van Saparoea (2009)writes that a ‘‘Netherlands legislator has been investi-gating the possibility of introducing new legislationthat is similar to that applying in Germany’’ (p. 7).Von Brocke and Perez (2009) state, ‘‘With the 2008Budget law, the Italian parliament introduced new in-terest limitation rules inspired by the new Germanrules, and repealed thin capitalization rules which havebeen in place since 2003’’ (p. 33). This is partly drivenby the search for more effective ways to regulate thisactivity, but it may also be motivated by tax competi-tion.

Several countries have altered their rules many timesin the past decade. Von Brocke and Perez (2009) write,‘‘The United Kingdom modified its thin capitalizationrules three times between 1994 and 2004’’ (p. 29).They also explain that Germany had thin capitalizationrules that were changed in 2000, 2003, and 2007 (pp.30-33). Van Saparoea’s article, ‘‘Optimizing the InterestDeduction Rules — A Never-Ending Story,’’ describesdevelopments in Germany, the Netherlands, and theUnited Kingdom (p. 3). Frequent changes suggest ithas been difficult to craft these rules successfully. Sev-eral governments have monitored these rules regularlyand have modified them to improve effectiveness. How-ever, other countries have developed more stable thincapitalization rules, for reasons to be discussed later.

Impact of Tax CompetitionOne of the driving forces behind international tax

laws is tax competition. Because MNEs must satisfyshareholders, they seek to maximize net income, whichmotivates them to reduce income taxes. Gresik (2001)notes that MNEs can transfer operations from onecountry to another. He writes, ‘‘This flexibility not onlyhelps transnationals minimize the cost of taxes andregulations imposed by national governments; it canalso aid them in pitting one government against an-other’’ (p. 800). Because MNEs can move business op-erations easily, they have a negotiating advantage overtaxing authorities.

Gresik argues that tax competition deprives somecountries of needed tax revenue. He writes, ‘‘It is clearthat one country’s choice of tax policy can impose fis-cal externalities on another country’’ (p. 820). Beyondthis, MNEs manage the information they provide totaxing authorities. Governments do not share tax re-turn information without taxpayer agreement, creatingan information asymmetry that benefits the MNE. AsGresik writes, ‘‘In the absence of shared information,the usual global efficiency losses arise because eachcountry’s tax policies still impose negative externalitieson the other’’ (p. 833).

Similarly, governments aim to develop tax policiesthat maximize a nation’s well-being. However, the taskconfronting tax authorities and legislators can be chal-lenging. While it is clear MNEs increase profitsthrough lower tax rates, it is less clear whether govern-ments benefit from increasing or decreasing income taxrates. Lowering tax rates may reduce tax revenues, atleast initially. But lower taxes may also attract FDI,create jobs, and make businesses more competitive.Increasing tax rates might immediately raise tax rev-enue but discourage FDI. Schön (2009) writes, ‘‘Gov-ernments know that a simple extension of the tax baseor a raise of the tax rate might not have the aspiredrevenue effect once mobile taxpayers relocated theirresidence or their activity/investment to another juris-diction. There might be a fall in revenue, while a low-ering of the tax base or rate might induce more invest-ment, increasing both domestic welfare and the

SPECIAL REPORTS


(C) T

ax Analysts 2010. A




government budget’’ (p. 70). Some small countries,such as Singapore and Ireland, have adopted low-taxstrategies to attract investment. It is not entirely certainwhat the best economic strategy is, and countriesshould balance prospects of attracting new investmentagainst the immediate impact on tax revenue. So notonly do MNEs have an information advantage overgovernments, but they also have clearer objectives.

Van Saparoea (2009) describes the government’s di-lemma: ‘‘Anti-abuse legislation has over time become achallenging issue for tax authorities, which try to bal-ance tax opportunities, on the one hand, and tax re-strictions, on the other, within the constraints of retain-ing a competitive advantage, compared to otherjurisdictions’’ (p. 3). In the absence of coordinatedinternational tax policies, this clearly gives MNEs anadvantage. In a global economy with mobile capital,one country can gain an advantage by offering lowerincome tax rates or less restrictive tax policies, at leastin the short run. This pressures other countries to fol-low suit and match the tax rate cuts or to enact per-missive tax regulations.

Evidence of Earnings StrippingWhile it is clear that MNEs could reduce their tax

rate by leveraging debt on subsidiaries in high-tax juris-dictions, for some time no study conclusively demon-strated firms were doing so. Desai, Foley, and Hines(2004) comment that ‘‘estimating the sensitivity ofcapital structure to tax incentives has proven remark-ably difficult, due in part to measurement problems.Consequently, it is not surprising that several studiesfind no effect or unexpected relationships between taxincentives and the use of debt’’ (p. 2454).

However, in recent years several studies have shownthat firms leverage more debt on subsidiaries operatingin countries imposing high income taxes. As Hauflerand Runkel (2008) write, the evidence that high incometax rates motivate additional debt is ‘‘conclusive’’ (p.1). In addition, the studies also demonstrate that mostof the additional debt is extended from related entitieswithin the MNE, which allows the company to reduceits tax rate without incurring additional trade expenses.

Desai, Foley, and Hines (2004) studied the leverageof 3,680 MNEs owning 32,342 related corporationsduring 1982, 1989, and 1994. The study focuses onU.S. firms investing abroad. They concluded that thesefirms increased debt in response to high tax rates. Theywrite: ‘‘First, there is strong evidence that affiliates ofmultinational firms alter the overall level of composi-tion of debt in response to tax incentives. The esti-mates imply that 10 percent higher tax rates are associ-ated with 2.8 percent greater affiliate debt as a fractionof assets, internal finance being particularly sensitive totax differences. While the estimated elasticity of exter-nal borrowing with respect to the tax rate is 0.19, theestimated tax elasticity of borrowing from parent com-panies is 0.35’’ (p. 2452). In other words, when operat-ing in high-tax jurisdictions, MNEs increased both

trade and intercompany debt, but intercompany debtwas more responsive to high income tax rates.

They also compared debt-to-equity levels in severalcountries. Desai, Foley, and Hines write:

Affiliates in high-tax countries generally makegreater use of debt to finance their assets than doaffiliates in low-tax countries. Affiliates in taxhavens such as Barbados have aggregate leverageratios of 0.30 or less, while affiliates in high-taxcountries such Japan and Italy have aggregateleverage ratios that exceed 0.53. [p. 2462.]

A study of German companies reached similar con-clusions. Mintz and Weichenrieder (2005) conducted astudy of the outbound investments of 13,758 German-owned subsidiaries between 1996 and 2002. They alsoconcluded there was a strong relationship between highincome tax rates and subsidiary debt. They write, ‘‘Wefind that the tax rate in the host country has a sizeableand significantly positive effect on leverage’’ (p. 1).

Mintz and Weichenrieder said their results weresimilar to those in the study by Desai, Foley, andHines, writing, ‘‘Our estimates are largely in line withresults derived from U.S.-owned subsidiaries’’ (p. 17).However, they did find some differences in the behav-ior of German firms, as compared with U.S.-basedMNEs. They concluded German firms used very littlethird-party debt to achieve higher leverage, writing,‘‘German-owned subsidiaries rely almost exclusively onintra-company loans, while in U.S. studies the marginaleffect of a tax change has turned out to be larger forthird-party debt’’ (p. 17). In short, the German firmsused little trade debt to achieve financial leverage.

Mintz and Weichenrieder also analyzed the debtratios of wholly owned versus partially owned sub-sidiaries. They write, ‘‘While wholly-owned firms expe-rience a significant tax effect on their financial lever-age, this is not the case for German subsidiaries thatare less than 100 percent owned affiliates’’ (p. 17).They believed that minority shareholder interests com-plicated the process of extending related-party debt.

Seida and Wempe (2004) analyzed the impact of 12corporate inversions, contrasting results with 24 similarcorporations, in similar industries and with comparableannual revenue figures. They found that inverted cor-porations (ICs) realized substantial reductions in theireffective tax rate (ETR) as a result of the corporateinversion. The pre-inversion tax rate fell from 32.01percent to 20.44 percent after the inversion (p. 806).They write, ‘‘The 11.57 percentage point reduction inmean ETR for the inversion sample is significantlygreater than the mean ETR reduction for the controlsample (approximately four percentage points)’’ (p.806).

Further, the study concluded that the ETR de-creased because of a substantial decline in U.S.-sourceincome, primarily due to earnings stripping. They writethat ‘‘despite managers’ claims that inversion is neces-sary to avoid U.S. tax on foreign earnings, most of the

SPECIAL REPORTS


(C) T

ax Analysts 2010. A




observed inversion-related tax reduction is likely due toavoidance of U.S. tax on U.S. earnings through in-creased stripping of U.S. earnings to lower-tax foreigncountries’’ (p. 825).

All three studies demonstrated that MNEs transferearnings from high-tax jurisdictions by leveraging sub-sidiaries with debt. Each of the three studies also con-cluded that the debt was lent by related entities, ratherthan third parties.

U.S. Rules

U.S. corporate income taxes are among the highestin the world, rivaled only by Japan’s 40 percent rate.The federal income tax rate is 35 percent, and moststates also levy corporate income taxes, so the com-bined rate is approximately the same as Japan’s.6Given these high income tax rates and the size of theU.S. economy, the federal government should be alertto potential inbound thin capitalization activities.

U.S. thin capitalization rules were first implementedin 1989 when IRC section 163(j) was enacted. Section163(j)(2)(A)(ii) applies when ‘‘the ratio of debt to equityof such corporation as of the close of such taxableyears (or any other day during the taxable year as theSecretary may by regulations prescribe) exceeds 1.5 to1.’’ When that condition is met, and the interest ex-pense is greater than 50 percent of the adjusted taxableincome of the business, that portion above 50 percentis not tax deductible. Thus, both conditions must bemet before tax-deductible interest expenses are limited.Adjusted taxable income is calculated by adding backnet interest expense, depreciation, amortization, de-pletion, and a net operating loss deduction to taxableincome (Department of Treasury 2007, p. 9). The ex-cess interest is not deductible that year, but can be car-ried forward into future years. The initial rules appliedonly to debt extended from related parties, but in 1993the law was expanded to include debt extended fromunrelated parties, if guaranteed by a foreign or tax-exempt entity (Department of Treasury 2007, p. 9).

The U.S. 1.5-1 debt-to-equity figure is a safe harborrule. When the debt-to-equity ratio is below that figure,the IRS will not question whether the debt is excessive.If it is above the 1.5-1 ratio, the IRS may or may notdetermine the debt is excessive, based on an examina-tion of all relevant facts and circumstances. To describerules in several other countries the Department ofTreasury (2007) wrote, ‘‘A debt-to-equity ratio is oftenused, but sometimes it is a strict limit (e.g. interest onany debt that exceeds the ratio is disallowed) ratherthan only a safe harbor as it is in the United States’’(pp. 10-11).

While the U.S. debt-to-equity ratio is lower than thatimposed in other nations, this does not necessarilydemonstrate the rules are effective at achieving theirobjective. If the limitations are ineffective, firms canstill shift income overseas through excessive debt. TheU.S. Congress became concerned that earnings strip-ping was depriving the U.S. Treasury of needed taxrevenue, and in 2004 directed the Treasury Departmentto study the impact of thin capitalization on tax rev-enue.

To analyze this issue, the Treasury conducted twostudies. The first compared the profitability of foreigncontrolled domestic corporations (FCDCs), which areowned 50 percent or more by foreign parties, and do-mestically controlled corporations (DCCs). If FCDCswere less profitable than DCCs, this might indicateearnings were being stripped out of the U.S. But thestudy did not reach a conclusion on that question.

The Treasury study analyzed the 2004 tax returnsfor more than 76,000 corporations, and determinedthat DCCs were significantly more profitable thanFCDCs.7 DCC profit levels averaged 4.3 percent ofrevenue, while FCDCs averaged 2.9 percent of revenue(Department of Treasury 2007, p. 13). However, thestudy suggested this may be explained by the fact ‘‘thatDCCs receive a substantial amount of income in theform of dividends and royalties, mainly from subsidiar-ies abroad’’ (Department of Treasury 2007, p. 14).Comparisons of operating income, which exclude divi-dends, royalties, interest revenue and expenses, anddepreciation and amortization, demonstrate thatFCDCs are actually more profitable than DCCs, regis-tering profits at 6.3 percent of revenue, versus 5.5 per-cent of revenue for DCCs (p. 15). Further, comparisonsof interest paid/cash flow demonstrated that interestexpenses for DCCs and FCDCs were roughly compa-rable (p. 18). Thus, the study ‘‘did not find conclusiveevidence that FCDCs have very high interest expenserelative to cash flow compared to DCCs’’ (p. 21).Given these results, the Treasury Department reachedno conclusion on earnings stripping but determined itneeded to gather more information.

To analyze this topic further, in February 2009 theIRS released new Form 8926, ‘‘Disqualified CorporateInterest Expense Disallowed Under Section 163(j) andRelated Information.’’ The purpose of the form is tocollect more information to determine whether someFCDCs might be engaged in earnings stripping activi-ties. According to IRS Bulletin 2007-50, ‘‘Form 8926solicits information relating to the determination andcomputation of a corporate taxpayer’s 163(j) limita-tion, including the determination of the taxpayer’s

6See Table 1 of this article for income tax rates in the G-7countries.

7Partnerships, real estate investment trusts, and S-Cos (smalldomestic corporations) were excluded from the study to facilitateconsistent comparisons, though the Treasury Department ac-knowledged that these entities could sometimes be financedthrough excessive debt.

SPECIAL REPORTS


(C) T

ax Analysts 2010. A




debt-to-equity ratio, net interest expense, adjusted tax-able income, excess interest expense, total disqualifiedinterest for the tax year and the amount of interest de-duction disallowed under section 163(j), as well as cer-tain information with respect to the related personsreceiving disqualified interest.’’ The IRS plans to usethis information to determine if earnings strippingfrom the United States is occurring.

In the second study, the Treasury analyzed the be-havior of ICs to determine if they were engaged inearnings stripping activities. An IC is an MNE thatshifts its corporate headquarters from one country toanother. A U.S. IC is relieved of the burden of the U.S.tax on worldwide earnings. In principle, taxes on U.S.-source income should not change. However, the studydetermined that ‘‘data on ICs strongly suggest thatthese corporations are shifting substantially all of theirincome out of the United States, primarily though in-terest payments’’ (p. 21). Rules to combat thin capitali-zation were ineffective at controlling this activity. Thestudy relied primarily on the previously cited analysisby Seida and Wempe (2004), which analyzed the taximpact of corporate inversions.

As mentioned, Seida and Wempe determined thatICs substantially reduced their effective tax rate byshifting their corporate headquarters abroad, leveragingthe U.S. entity with substantial debt, and transferringearnings to low-tax jurisdictions. Over the course ofthe study they found ICs reduced their ETR by 11.57points, while comparable firms reduced their tax rateby approximately four points. Seida and Wempe did adetailed analysis of four firms and concluded the ETRreduction was ‘‘attributable to the stripping of U.S.earnings via intercompany interest payments’’ (p. 825).They found that all four firms substantially increasedtotal and long-term intercompany debt after the inver-sion, much of it incurred by the U.S.-based entity (p.816-817). Further, they found that thin capitalizationrules were not effective in limiting earnings stripping.Seida and Wempe analyzed publicly available informa-tion, and did not have access to the firms’ tax returns.However, they concluded that at least three of thefirms, and possibly all four, had U.S. debt-to-equity ra-tios less than 1.5 to 1, the thin capitalization limit inthe United States (p. 821). They found the debt-to-equity ratio for the fourth firm may or may not be be-low 1.5 to 1, depending on how the firm consolidatedits financial results for tax purposes. That firm’s debt-to-equity ratio may have been as low as 0.9 to 1, if its‘‘other subsidiaries’’ were consolidated into the parent’stax return.8 Seida and Wempe (2004) did not specifi-cally analyze whether the firm’s interest expenses ex-

ceeded 50 percent of earnings before interest, taxes,depreciation, and amortization (EBITDA). However,that limitation does not take effect if the debt-to-equityratio is less than 1.5 to 1. Thus, it is possible to stripall earnings from the U.S. as long as the debt-to-equityratio is not exceeded.

Congress passed the American Jobs Creation Act of2004, which included provisions addressing corporateinversions. It was specifically aimed at ICs in which‘‘the former shareholders of the U.S. corporation hold(by reason of holding stock in the U.S. corporation) 80percent or more (by vote or value) of the stock of theforeign-incorporated entity after the transaction’’ (JointCommittee on Taxation 2009, p. 58). IRC section 7874has significantly reduced this activity in the UnitedStates. According to Nadal (2008), ‘‘Under section7874, inversions are disregarded when a foreign corpo-ration acquires substantially all the assets of a domesticentity such that after the transaction, at least 80 percentof the foreign corporation’s shares are owned byformer shareholders of the domestic entity and the ex-panded affiliate group does not have substantial com-mercial activities in the foreign corporation’s countryof incorporation’’ (p. 3). When those conditions aremet, the firm continues to be treated as a U.S. corpora-tion for tax purposes.

Earlier this year the Obama administration intro-duced proposals to change international tax rules in avariety of ways, including the tax deductibility of inter-est expenses in limited situations. Because the Treasurystudy did not provide evidence that overseas firms withdomestic CFCs were stripping earnings outside theU.S., no changes were proposed to those rules. How-ever, as the Seida and Wempe (2004) study demon-strated, ICs were stripping earnings from the U.S.Congress-enacted IRC section 7874, which taxes ICs asdomestic entities. But that section only taxed ICs asdomestic entities when the 80 percent ownershipthreshold was met. Thus, the Obama administrationproposed to lower this threshold to situations in which60 percent of the stock in the new entity is owned byformer shareholders of that corporation (JCT 2009, p.58). As mentioned, the entire international proposalwas withdrawn in October 2009, including the addi-tional tax rules governing those ICs.

The details of the withdrawn IC rules merit review,as they reflect the administration’s thinking on thincapitalization regulations and thus may shape futureproposals. According to the JCT (2009) proposal, the

8Seida and Wempe (2004) specifically focused on ICs, butnote that other MNEs may be motivated to strip earnings fromthe U.S. as well. However, they believe the incentives may not beas strong, writing, ‘‘Foreign-domiciled firms (whose foreign dom-icile was not established via an inversion) with tax rates less than

the U.S. rate have incentives to strip U.S. earnings. U.S.-domi-ciled firms also have incentives to strip U.S. earnings. However,their ability to do so is severely limited by statutory interest ex-pense allocation rules . . . U.S.-domiciled firms achieve only de-ferral of income when U.S. earnings are stripped; foreign-domiciled firms (including inverted firms) achieve permanentexclusion of income stripped from the U.S.’’ (p. 806) (emphasisadded).

SPECIAL REPORTS

(Footnote continued in next column.)


(C) T

ax Analysts 2010. A




1.5-1 debt-to-equity safe harbor would have been elimi-nated, and ICs would be able to deduct interest onlyup to 25 percent of adjusted taxable income, versus 50percent today (JCT, 2009, p. 59). However, the ruleswould only have applied on interest paid to related par-ties. The interest cap remained at 50 percent of ad-justed taxable income for interest paid to third-parties,when the debt is guaranteed by a related party. TheJCT summarized the proposal by stating, ‘‘By eliminat-ing the debt-equity safe harbor, reducing the adjustedtaxable income threshold from 50 percent to 25 percentfor interest on related-party debt, limiting the carryfor-ward of disallowed interest to 10 years, and eliminatingthe carryforward of excess limitation, the proposal sig-nificantly strengthens rules that appear ineffective inpreventing certain recent earnings stripping arrange-ments in the context of corporate inversion transac-tions’’ (p. 61).

As mentioned previously, one way MNEs can avoiddebt-to-equity constraints is by injecting both equityand debt into a subsidiary. If the MNE aims to reducetaxes, it can first calculate how much debt it wants toleverage on the subsidiary to strip earnings and thencalculate how much equity must be invested to complywith debt-to-equity limitations. While the worldwideenterprise’s external debt-to-equity ratio may be deter-mined by the firm’s objective to balance shareholderrisk and return, this is not necessarily the motivationfor each internally funded subsidiary. The optimal debtstructure for a worldwide enterprise may not be theoptimal debt structure for a subsidiary, particularly ifthat CFC operates in a country that imposes high in-come taxes.

Given these facts, it seems the United States may betoo cautious in regulating earnings stripping activities.The relationship between high income tax rates anddebt has been demonstrated several times, and the U.S.corporate tax rates are among the highest in the world.Its current rules do not effectively limit earnings strip-ping, as the Seida and Wempe (2004) study showed.Many other industrialized countries have taken moreaggressive steps to control earnings stripping, as latersections in this article will demonstrate. As the UnitedStates looks to raise additional sources of tax revenue,it should aim to tighten existing rules, which do notadequately control tax-motivated intercompany debt.

German RulesGermany initially implemented debt-to-equity limita-

tions to control excessive financial leverage. Germany’stax-deductible debt-to-equity limit ratio was 1.5 to 1 inmost situations; however, it was 3 to 1 for holdingcompanies (Strunin 2003, p. 52). The rules were spe-cifically aimed at combating situations in which a re-lated party in another country extended loans to shiftearnings from Germany. ‘‘The thin capitalization rulesapplicable until fiscal year 2003 were focused specifi-cally on the avoidance of abusive financing strategiesin which the lender was a foreign shareholder or re-

lated party’’ (von Brocke and Perez 2009, p. 30). How-ever, Germany’s approach prompted legal challenges inthe European Court of Justice.

In the 2002 Lankhorst-Hohorst (C-324/00) case, theECJ determined that German antiabuse rules violatedthe freedom of establishment standard in article 43 ofthe EC Treaty. (For the ECJ judgment in Lankhorst-Hohorst, see Doc 2002-27361 or 2002 WTD 241-23.) Inthat case a Dutch firm lent €1.5 million to its Germansubsidiary, Lankhorst-Hohorst GmbH, in which itowned 100 percent of the shares. As part of the loan,the parent wrote a letter of support that waived theright to repayment in the event third-party creditorsmade claims against the German subsidiary. This loanenabled the subsidiary to reduce its bank borrowingand its interest expense. German tax authorities deniedthe interest deduction and deemed the interest pay-ments to the Dutch owner a dividend distribution, rea-soning that a third party would not have made a loanunder the same conditions, given the firm’s high levelof indebtedness and the parent’s agreement to waiverepayment in favor of other creditors (von Brocke andPerez 2009, p. 30).

The United States may betoo cautious in regulatingearnings strippingactivities.

However, the ECJ determined that the German taxrules treated domestic and international firms inequi-tably. It rejected arguments from German, Danish, andU.K. tax authorities, as well as the European Commis-sion, supporting the German law. German tax authori-ties had characterized the interest payments as divi-dends, and German tax law treated dividend paymentsto German and international firms differently. If a Ger-man resident corporation had extended the loan and itwas deemed a dividend distribution, the parent wouldhave been entitled to claim a tax credit for additionaltaxes due. However, if a nonresident corporation ex-tended the loan, and it were deemed a dividend distri-bution, the additional income would be taxed at a 30percent rate. No tax credits would apply. Thus, domes-tic and international firms were treated differently, giv-ing tax preferential treatment to domestically ownedGerman companies.

In response, the German government modified itsarticle 8A by expanding its scope so that it applied toall lending transactions, including German residentparent companies. Nonetheless, new German rules didnot fully eliminate differences in treatment of domesticand international owners of German firms. Von Brockeand Perez write, ‘‘The deemed dividends appreciated inrelation to German parent companies were 95 percent

SPECIAL REPORTS


(C) T

ax Analysts 2010. A




tax exempt, while if the lender were a foreign com-pany, the deemed dividend would be subject to a with-holding tax at the rate of 25 percent’’ unless a taxtreaty offered a lower rate (p. 31). These rules againmay not have complied with article 43 of the ECTreaty freedom of establishment clause, necessitatingchanges. In short, it appears that once the thin capitali-zation rules determined interest expenses should betreated as dividends, domestic and international parentcompanies were again taxed differently.

In addition, Germany sought to create a more at-tractive investment environment, and thus lowered in-come tax rates and simplified tax regulations. VanSaparoea (2009) writes, ‘‘Germany has attempted tocreate an attractive tax jurisdiction by widening its taxbase in the Corporate Tax Reform Act of 2008’’ (p. 6).This has been part of a longer-term German strategyto make that country more attractive to investors.Becker, Fuest, and Hemmelgarn (2006) write: ‘‘Themain goals of the German Tax Reform 2000 were toimprove the competitiveness of firms in Germany, tofoster investment, to increase Germany’s attractivenessto foreign investors and to adapt the corporate tax sys-tem to the rules of the EC common market’’ (p. 6). Aspart of this longer-term strategy, Germany has over-hauled its tax legislation on thin capitalization, and hasshifted from focusing on debt-to-equity ratios to an em-phasis on limiting interest expense deductions. An ad-vantage of these rules is that they directly limit interestdeductions, and thus sidestep the complexities of char-acterizing interest expenses as dividends.

Germany recently passed a general interest disallow-ance rule, which was phased in during 2007 and 2008.The rule does not reference balance sheet debt, and itlimits the net interest expense of a corporation to 30percent of the taxable income before EBITDA ex-penses. Net interest expense is defined as interest rev-enue less interest expense. Bagel and Huning (2008)write, ‘‘The scope of the new rules is far broader thanformer thin capitalization rules, as any third-party debtfinancing (whether or not there is back-to-back financ-ing) is included’’ (p. 310). The interest deduction rulesapply when the business is part of a controlled group,which is defined as an enterprise that is or may be in-cluded in consolidated financial statements, preparedaccording to international financial reporting standards,U.S. generally accepted accounting principles, or Ger-man GAAP standards. When interest expenses are dis-allowed, they can be carried forward indefinitely.

The German rules offer three exceptions to theseinterest limitation rules. First, to be administrativelyefficient, a de minimis rule states that the interest limi-tation does not apply when firms incur net interest ex-penses less than €1 million per year. Second, a ‘‘stand-alone clause’’ provides an exception if the relevantbusiness is not fully consolidated into the worldwideenterprise’s results, for either financial or business con-trol reasons. Third, an exception is granted if the busi-ness belongs to a worldwide enterprise, and the ratio of

equity to assets for the subsidiary is greater than orcomes with 1 percentage point of the equity-to-assetsratio of the worldwide enterprise. In other words, ifthe subsidiary is less leveraged than the worldwide en-terprise, or is no more than 1 percent more leveragedthan the worldwide business, the firm is not con-strained by the interest limitation rule (van Saparoea2009, p. 6).

The new German rules appear to have several ad-vantages over the prior regulations. First, these rulesmay in part avoid the foreign neutrality problems in-herent in their other laws. Limiting interest expensedeductions may circumvent complexities in recharacter-izing interest payments as dividends. Second, debt-to-equity ratio limitations may not always prevent earn-ings stripping. A related party might extend substantialdebt and equity, comply with debt-to-equity ratio limi-tations, and still generate enough interest expense tostrip earnings from one jurisdiction to another. Limit-ing interest deductions appears to be more effective bydirectly addressing the real concern of tax authorities:reduced tax receipts. Finally, the rules avoid the issueof whether one debt-to-equity ratio is correct for allbusinesses. Some industries rely on more debt to fundoperations than do other firms, and the same debt-to-equity ratio limit for all firms may appear arbitrary.

While the interest limitation approach appears toresolve a number of the issues associated with thincapitalization rules, it is not clear that the 30 percentinterest expense limitation is the correct figure for allbusinesses. The third escape clause, which exemptsCFCs that are less leveraged than the worldwide enter-prise, may resolve part of this concern. If the consoli-dated firm is funded with substantial debt, and theCFC has a higher equity-to-assets ratio (or within 1percentage point), the escape clause exempts that firm.However, there is an alternative scenario to consider. Ifthe worldwide enterprise incurred minimal debt andrecognized low interest expenses, the 30 percent ofEBITDA cap may permit the enterprise to fund sub-sidiaries with a far greater portion of debt than the en-terprise would incur. This may permit the MNE tostrip earnings from high-tax jurisdictions in ways in-consistent with the enterprise’s funding strategy.

In addition, the new German rules may not avoidall challenges based on the freedom of establishmentclause in the EC Treaty. Von Brocke and Perez (2009)write that the rules ‘‘may also contravene the freedomof establishment and the free movement of capital byway of a hidden discrimination’’ (p. 34). If a Germanparent owns a German subsidiary, it can be treated asone business under its tax laws, and thus could be ex-empted from the rules under the previously mentionedstand-alone clause. This opportunity is not open toGerman firms owned by a foreign parent, so the rulescould again be challenged. The German government islikely to argue these rules are within its authority, andit is not certain how the ECJ will rule.

SPECIAL REPORTS


(C) T

ax Analysts 2010. A




U.K. Rules

U.K. tax regulators have struggled with the samechallenge encountered by German tax authorities. Tominimize earnings stripping, their regulations haveaimed to prevent MNEs from leveraging businesseswith excessive debt extended from related foreign enti-ties. But the rules also need to comply with require-ments to treat domestic and internationally ownedfirms equally. Achieving both objectives has been diffi-cult.

The United Kingdom has regulated highly leveragedfinancing structures since the 1990s. Von Brocke andPerez (2009) write, ‘‘The United Kingdom modified itsthin capitalization rules three times between 1994 and2004, in order to introduce the arms-length principleand to guarantee an equal treatment of UK residentcompanies, and companies resident in an EU MemberState’’ (p. 29). U.K. thin capitalization rules were chal-lenged in the ECJ in Test Claimants in the Thin Cap GroupLitigation.9 (See Doc 2007-6302 or 2007 WTD 50-9.) Asthe regulations were modified several times, the court’srulings addressed the different regulations in effect overthat period. According to von Brocke and Perez (2009),‘‘The ECJ concluded that even prior to 1995 and, inany case, between 1995 and 2004, when interest waspaid by a resident company in respect of a loangranted by a related non-resident company, the tax po-sition of the former company was less advantageousthan that of a resident borrowing company which hadbeen granted a loan by a related resident company’’ (p.31). When interest expenses were recharacterized asdistributions, the U.K. rules provided more favorabletax treatment when the lender was also subject to U.K.tax rules. Thus, U.K.-owned enterprises had an advan-tage over internationally owned businesses. As such,the ECJ determined that ‘‘the U.K. thin capitalizationrules contravened the freedom of establishment clausein Article 43 of the EC Treaty’’ (von Brocke and Perez2009, p. 31).

The U.K. now relies on the arm’s-length principle toregulate excessively leveraged financing structures. Ac-cording to HM Revenue & Customs, ‘‘in tax terms aUK company (which may be part of a group) may besaid to be thinly capitalized when it has excessive debtin relation to its arm’s length borrowing capacity, lead-ing to the possibility of excessive interest deduc-tions.’’10 Further: ‘‘The arm’s length borrowing capac-ity of a UK company is the amount of debt which itcould and would have taken from an independentlender as a stand alone entity rather than as part of amultinational group.’’11

The U.K. rules then specify the process regulatorsshould use to determine whether a firm is thinly capi-talized. First, it is necessary to ‘‘ascertain how muchthe company or companies would have been able toborrow from an independent lender.’’12 This figuremust be compared with ‘‘the amounts actually bor-rowed from group companies or with backing of groupcompanies.’’13 The regulations then deny tax deduc-tions for interest expenses that exceed a firm’s arm’s-length debt capacity.

These transfer pricing rules apply when one entitylends funds to another organization it controls, orwhen both organizations are controlled by the sameparty (Kyte 2008, p. 348). According to HMRC, ‘‘Theborrowing capacity of a UK company must be assessedon a stand alone basis, disregarding any relationshipwith other group companies.’’14 Thus, it is a hypotheti-cal debt capacity. As a result, firms may be motivatedto determine the maximum amount they could borrow,whether or not they would actually do so. In otherwords, the more firms can use the arm’s-lengthstandard to demonstrate they could borrow large sumsof money, the more earnings they can strip to anotherjurisdiction. According to HMRC:

It follows that in establishing the arm’s lengthborrowing capacity of a particular borrower, it isnecessary to hypothesise that the borrower is aseparate entity from the larger group of which itis part.15

The U.K. legislation also applies when the entitiesengage in a series of related lending transactions, cul-minating in a third-party loan. In short, the rules spe-cifically state they intend to apply the substance-over-form doctrine. The rules do not include any safeharbors, exceptions, or sourcing rules for interest ex-penses. They also exclude debt borrowed for an unde-fined ‘‘unallowable purpose’’ (van Saparoea 2009, p.7).

One key question with the U.K.’s approach iswhether it gives taxpayers sufficient guidance to deter-mine whether their debts or interest expenses are exces-sive. To comply with the U.K.’s requirements, tax-payers may need more specific direction concerninghow much debt violates the arm’s-length standard. Fur-ther, it can be difficult to determine the CFC’s stand-alone debt capacity, as this is a hypothetical exercise.CFCs have little experience doing this, and lendershave no incentive to evaluate the organization’s hypo-thetical, stand-alone debt capacity. Lending rules ofthumb may be helpful in determining a range of debt

9ECJ, Case C-524/04, Mar. 13, 2007, ECR (2007) 2107.10See HMRC INTM 541010 — Introduction to thin capitali-

zation (legislation and principles).11Id.

12See INTM 541020 — Introduction to thin capitalization(legislation and principles).

13Id.14See HMRC INTM 56100 — Thin capitalization: FA 2004

legislation — main changes to the thin capitalization legislation.15See supra note 10.

SPECIAL REPORTS


(C) T

ax Analysts 2010. A




capacities, but actual loan agreements are often theresult of detailed discussions between lender and bor-rower, in which trade-offs among debt limits, collateral,and loan covenants are negotiated. The U.K.’s ap-proach gives taxpayers little guidance and conflictswith the certainty principle. The absence of clear regu-lations also increases the likelihood of costly litigation.This can also make enforcing rules very inefficient.This may be why no other major country has chosenthis approach.

Further, many companies can incur more debt thanthey actually choose to accept. Firms may consciouslychoose to minimize debt because they do not wish toincur the additional risks, interest expenses, or operat-ing restrictions that may accompany debt. Some busi-nesses believe avoiding debt gives them more freedomto manage their operations without intrusive loan cov-enants. A subsidiary may have the arm’s-length capac-ity to incur more debt, but this does not mean addi-tional debt is consistent with the enterprise’s businessstrategy. If an MNE’s strategy includes keeping debtlevels low, it may not make sense to permit subsidiariesto leverage themselves with intercompany debt to re-duce the firm’s worldwide tax expense.

A number of studies have demonstrated that manyfirms incur substantially less debt than they could bor-row. Allen’s study (2000) of Australian, British, andJapanese firms demonstrated that firms in those coun-tries have spare debt capacity. Allen defined spare bor-rowing capacity as ‘‘mobile uncommitted pool of capi-tal resources that a company possesses’’ (p. 300). Hewrote that it ‘‘may take the form of committed or un-committed lines of credit and bank loans, or a level ofcurrent borrowing which is substantially below the up-per limit that the company’s management, bankers andcreditors regard as being prudent’’ (p. 30).

Allen (2000) was not seeking to determine whetherfirms have spare debt capacity, as that had been dem-onstrated in a number of prior studies.16 However, it isone of the most recent studies. Allen believed sparedebt capacity was a signaling tool firms used to com-municate to investors they had financial resourcesavailable. Because Japanese firms frequently are mem-bers of a keiretsu, in which firms have developed closeand long-term banking relationships, Allen believedfewer Japanese firms would need to signal spare debtcapacity to investors. He believed investors in Japanesefirms understood that those firms had banking relation-ships that could be counted on for financial support,should the need arise.

Allen (2000) said prior studies indicated that spareborrowing capacity was often maintained to signal toinvestors that the firm could tap into financial re-sources immediately should they need to. Allen sur-veyed Australian, British, and Japanese firms to deter-mine if they maintained spare borrowing capacity.They were asked how much spare borrowing capacitythey kept, the reasons for maintaining unused lines ofcredit or spare borrowing capacity, and whether theyhad a target debt ratio, or an upper limit. Allen re-ported that 56 percent of Australian firms, 88 percentof British firms, and 32 percent of Japanese firms hada policy of maintaining spare borrowing capacity (p.309). Firms reported they had a variety of unusedbank lines of credit to support their needs, as well asoverdraft facilities. Businesses reported a variety of rea-sons for spare borrowing capacity, including the desireto have funds available for special projects, reserves forcrises, acquisitions, and unplanned circumstances andopportunities. Further, Allen reported, ‘‘The larger thecompany, the more likely it is to have such a policy’’(p. 310). Allen also concluded that many firms couldborrow significantly more without facing higher inter-est rates: ‘‘Some 63 percent of the Australian respon-dents and 89 percent of the British ones consider thatthey could borrow 20 percent or more than existingborrowings without increasing their average borrowingcosts. The evidence suggests fairly extensive spare debtcapacity existed at the time of the survey’’ (p. 314).Allen concluded that ‘‘spare borrowing capacity is arelatively common policy’’ (p. 318).

Industrialist David Packard, co-founder of Hewlett-Packard Co., explained his reasoning for avoiding debt.He said HP eschewed long-term debt, in large part be-cause the founders feared loss of control to lenders.They also believed avoiding long-term debt imposedfinancial discipline on the firm. Packard (1995) writes,‘‘Bill [Hewlett] and I determined we would operate ourcompany on a pay-as-you-go basis, financing ourgrowth primarily out of earnings rather than by bor-rowing money’’ (p. 84). Commenting on proponents ofleveraged capital structures, Packard continues, ‘‘Theadvocates of this approach say you can make yourprofits go further by leveraging them. That may be, butat HP it was our firm policy to pay as we go and notincur substantial debt’’ (p. 85). The firm could incurdebt, but would not do so. If a business avoids com-mercial debt, should its subsidiaries be able to incurtax-deductible intercompany debt, simply because itssubsidiaries have the capacity to accept loans? If inter-company debt is incurred only to minimize taxes, itcould be argued this is inconsistent with the businesspurpose doctrine.

This information suggests that the U.K. approach ondebt capacity may be too lenient. Limiting a CFC’sdebt-to-equity ratio by referencing what the firm couldhave borrowed in external markets may sound logical,but Allen’s study showed that 88 percent of Britishfirms had spare borrowing capacity. Firms were ca-pable of borrowing more debt than they incurred. It

16In his literature review, Allen cited a number of prior stud-ies, including: G. Donaldson (1961), Corporate Debt Capacity, Har-vard University Press: Cambridge, Mass.; E.F. Fama (1990),‘‘Contract Costs and Financing Decisions,’’ Journal of Business,Vol. 63, 71-91; and H. Duan and S. Yoon (1993), ‘‘Loan Com-mitments, Investment Decisions, and the Signaling Equilibrium,’’Journal of Banking and Finance, Vol. 17, 645-661.

SPECIAL REPORTS


(C) T

ax Analysts 2010. A




may make more sense to limit debt by referencingwhat the worldwide enterprise actually chooses to bor-row, rather than by what a CFC theoretically could bor-row.

In a related development, in 2009 the U.K. passedtax legislation that in some situations may limit the taxdeductibility of interest expenses there. The legislation,commonly called the worldwide debt cap, became ef-fective January 1, 2010. The legislation is aimed at lim-iting tax deductible interest expense for companies thatincur the great majority of their debt in the U.K. It isspecifically aimed at large businesses and applies toboth U.K. and foreign headquartered firms, but Dod-well, Bird, Buck, and Richards (2009) say, ‘‘HMRCanticipates that the debt cap rules would apply to rela-tively few U.K. inbound groups’’ (p. 1).

The new proposal was first mentioned in a 2007discussion paper17 in which the U.K. government sug-gested it favored a new approach that van Saparoea(2009) said would limit debt ‘‘to the external borrow-ings of the group as a whole’’ (p. 7). According toDodwell, Bird, Buck, and Richards (2009), the U.K.tax authorities’ proposal ‘‘would be capped by refer-ence to the worldwide group’s net external borrowingcosts in its consolidated accounts’’ (p. 1). The rulesapply to companies that contain at least one U.K. firm(or a U.K. permanent establishment). ‘‘The rule is tar-geted at situations in which a UK group bears moredebt than is required for the worldwide group to oper-ate’’ (Dodwell, Bird, Buck, and Richards 2009, p. 1).

The worldwide debt cap legislation specifically tar-gets large businesses and excludes all businesses de-fined as ‘‘micro, small and medium-sized enterprises asdefined in the Annex to Commission Recommendation2003/361/EC’’ (HMRC draft bill 2009, p. 9). In short,HMRC believes it would not be cost-effective to applythe debt limitation to small firms. HMRC writes, ‘‘A deminimis limit is introduced for purposes of excludingamounts that the government does not consider ma-terial for purposes of the debt cap’’ (HMRC, ‘‘World-wide Debt Cap Current Thinking,’’ 2009, p. 1).

Two figures must be calculated to determine if theinterest limitations apply. Under the U.K. legislation,one figure is the tested amount and the second figure isthe available amount. According to HMRC, ‘‘World-wide Debt Cap Current Thinking’’ (2009), the testedamount is ‘‘the total intra-group finance expenses inthe UK’’ (p. 1). This must be compared with the avail-able amount, which is ‘‘the net external finance ex-pense of the worldwide group from consolidated ac-counts’’ (p. 1). The rule states that ‘‘any excess of thetested amount over the available amount is disallowed,but the worldwide group may reduce the amount ofUK taxable receipts to match the disallowance that

arises’’ (p. 1). In brief, the limits apply when the inter-nal finance costs of the U.K. firm exceed the externalfinance costs of the worldwide enterprise. If a subsid-iary bears only a small portion of a firm’s worldwidedebt, these rules would not apply.

However, comparing a subsidiary’s finance expensewith that of the worldwide enterprise is an idea thathas merit. As mentioned previously, Germany’s currentrules provide an exception for subsidiaries that are nomore leveraged than the worldwide enterprise. In addi-tion, Japan allows firms to measure their debt-to-equityratio against similar Japanese firms to determine ifthey are excessively leveraged. Comparing a sub-sidiary’s debt or interest expense with the worldwidebusiness, or to a similar enterprise, may be a fairer andmore efficient rule than uniform, somewhat arbitrary,limitations. Some industries and firms choose to incurmore debt than others as part of their funding strategy,and ‘‘fair’’ regulations should not penalize such firms.

Rules in Other G-7 CountriesAnalyses of rules in Germany, the United Kingdom,

and the United States illustrate many of the challengesinherent in drafting effective thin capitalization/earnings stripping tax legislation. However, rules in theother G-7 countries may help to demonstrate other dif-ficulties economically powerful nations face whendrafting these rules.

Italy’s approach is closely modeled after Germany’s.It also abandoned a debt-to-equity test in favor of in-come statement limitations, effective January 1, 2008.Von Brocke and Perez (2009) say that Italy’s rules were‘‘inspired by the new German rules’’ (p. 33). The rulesalso restrict net interest expense to 30 percent ofEBITDA, the same figure selected by German legisla-tors (p. 34). Like the German rules, they also apply tointerest paid to non-related parties, such as banks.

Italian legislators made several changes to the Ger-man law. According to Polombo (2008), the 30 percentinterest limitation applies to financial statements pre-pared according to Italian GAAP (p. 319), not taxableincome. Italian legislators also took additional steps toensure their laws regulated domestic and internationalfirms equitably. Von Brocke and Perez (2009) write,‘‘The Italian parliament has avoided one problem un-der the German rules by extending the benefits ofgroup relief . . . to foreign companies of a group, pro-vided that the foreign company meets all the condi-tions foreseen under Italian law for the formation of aconsolidated group except the residence requirement’’(p. 34). Italian legislators were concerned Germanregulations may be challenged once again under thefreedom of establishment clause. Polombo also notesthat disallowed interest deductions can be carried for-ward indefinitely into the future (p. 319).

France is the last G-7 European country currentlyrelying on the debt-to-equity ratio to limit excessivefinancial leverage. According to Galinier-Warrain

17HMRC, ‘‘Taxation of the Foreign Profits of Companies: ADiscussion Document’’ (June 21, 2007), Chapter 5.

SPECIAL REPORTS


(C) T

ax Analysts 2010. A




(2008), France modified its thin capitalization policies,effective January 1, 2007, and they are described as‘‘quite complex’’ (p. 307). The key elements toFrance’s thin capitalization/interest deduction rules arethat they cap the debt-to-equity ratio at 1.5 to 1, andinterest may be nondeductible when ‘‘the amount ofinterest exceeds 25 percent of the current pre-tax result,increased notably by intra-group loan interest and thedepreciation considered to determine this pre-tax re-sult’’ (p. 308).

Under France’s new law, the debt-to-equity ratio isnow calculated based on a firm’s net equity, ratherthan contributed capital. The firm can elect to useeither net equity at the beginning of the year or at theend. Debt now includes all debt extended from relatedparties, while prior rules included only loans extendedfrom direct shareholders. Firms can carry forward non-deductible interest expenses. However, after two years,the carryforwards are discounted by 5 percent per an-num. In general, France’s new rules tighten interestdeductibility restrictions.

Canada began to evaluate thin capitalization legisla-tion in 1969, when a white paper on tax reform pro-posed limiting interest deductibility when a nonresidentshareholder owns at least 25 percent of the Canadiancorporation and lends money to that corporation, andthe firm’s debt-to-equity ratio exceeds 3 to 1 (Nitikman2000, pp. 23-24). The rules were enacted in 1972 andare contained in subsections 18(4) to 18(6) of Canada’sIncome Tax Act.

The debt-to-equity ratio was reduced to 2 to 1 in2001. This change was apparently motivated by a Ca-nadian Department of Finance study, which stated thatother countries were reducing their debt-to-equity ratiobelow 3 to 1. Farrar and Mawani (2008) believe verylittle analysis went into the decision to change the ra-tio, writing, ‘‘No clear justification for this reductionappears to have been given. Perhaps the Department ofFinance relied on the recommendation from the MintzReport,18 which suggested a reduction because at thattime other (unidentified) countries had reduced theirratios to 2:1’’ (p. 6).

Farrar and Mawani (2008) conducted a study of3,715 Canadian firms in 64 industries to determinetheir debt-to-equity ratios. They found the mean debt-to-equity ratio for Canadian firms was 1.06 to 1, andthat four industries had debt-to-equity ratios that ex-ceeded 2 to 1 (pp. 16-17). Of the four, ‘‘only the realestate industry had a debt-equity ratio exceeding 2:1with statistical significance,’’ but 7.1 percent of indi-vidual firms had debt-to-equity ratios exceeding 2 to 1.While Farrar and Mawani concluded Canada’s 2-1 ra-tio ‘‘seems reasonable’’ (p. 2), the mean debt to equityduring 2001-2005 ranged from a high of 4.2 to 1 to a

low of 0.15 to 1 (p. 35), which might also suggest thatit is very difficult to determine one ratio that is fair andeffective for all firms and industries. It could be arguedthat the 2-1 ratio is too low for 7.1 percent of busi-nesses. But at the same time, it might be too high forthe remaining businesses. If the worldwide enterprisefirm chooses to keep its debt levels low, a 2-1 debt-to-equity ratio may encourage firms to incur intercom-pany debt for the sole purpose of reducing incometaxes.

France is the last G-7European countrycurrently relying on thedebt-to-equity ratio tolimit excessive financialleverage.

Japan’s first thin capitalization rules were intro-duced in 1992 and current rules have been in placesince 2006, according to Nakamura (2008, pp. 321-322). In most cases Japan’s thin capitalization rulesapply when a firm’s debt-to-equity ratio exceeds 3 to 1.They phase out interest deductions when the ratio of‘‘interest-bearing debt to foreign controlling share-holders and third parties in specified cases’’ (p. 323) isgreater than three times the firm’s equity. The rulesapply both to Japanese companies and foreign com-panies operating there. A 2-1 ratio applies in some situ-ations. If a company has engaged in large bond repur-chase transactions, this debt can be excluded from thecalculation, and the lower ratio applies.

Japanese thin capitalization rules also permit an al-ternative measure, in place of the debt-to-equity ratiosabove. Nakamura (2008) writes that ‘‘a company hasthe option to use the debt-to-equity ratio of a compa-rable Japanese company operating in the same busi-ness, and having similar characteristics as to size’’ (p.323). Thus, we see examples in Germany and Japan inwhich rules reference market debt-to-equity ratios.Such approaches may be a more effective approach toarrive at an appropriate debt-to-equity ratio for a CFC.Identifying one debt-to-equity ratio for all businesses isinherently problematic, and can be viewed as ‘‘unfair’’by businesses that tend to incur more debt, such as the7.1 percent of Canadian firms mentioned. However, aspointed out previously, any debt-to-equity ratio maynot be effective, as it does not limit the absolute levelof debt, and thus interest expenses. It would be moreeffective to adopt the approach Germany and Italyhave selected, and limit interest expenses to a percent-age of EBITDA.

18The Mintz Report was a 1998 Department of Finance re-port that suggested changes to Canada’s thin capitalization rules.

SPECIAL REPORTS


(C) T

ax Analysts 2010. A




Table 1 provides a brief summary of thincapitalization/interest deduction rules in each of theG-7 countries.

Limits in Other Key CountriesIn addition to the G-7 countries, there are a number

of other countries that are concerned with the tax im-pact of leveraged financing structures and that havedeveloped innovative regulations rules that deserve spe-cial attention. Three countries that have created ambi-tious thin capitalization/interest deduction limitationsare Denmark, the Netherlands, and New Zealand.Each country has a smaller economy and populationthan the G-7 countries, yet each is also a prosperous

nation that has developed advanced social programsdependent on generating tax revenue.

Denmark has developed sophisticated thin capitali-zation rules that are considered ‘‘very complicated anddetailed’’ (Lund and Korsgaard 2008, p. 302). Den-mark’s approach is to limit interest deductions by aseries of three limitations, each of which can succes-sively reduce tax-deductible interest expenses. The firstrestriction limits the deductibility of debts extendedfrom related parties. The second limitation establishesa limit based on the value of a firm’s qualifying assets.And the third limitation caps net financing expensesbased on the firm’s earnings before interest and taxes(EBIT).

Table 1. Summary of Thin Capitalization/Interest Deduction Policies in G-7 CountriesCountry/Max. 2009

Corp. Tax Ratea2006

Population(in millions)

Rules to LimitFinancial Leverage?

Approach to LimitAbuse

Financial Tests Comments

Canada/31.32% 32.6 Yes Balance sheet test Debt-to-equity ratio notto exceed 2 to 1

Original 3-1 ratio wasmodified in 2001.

France/34.43% 60.7 Yes Balance sheet andincome statement test

Debt-to-equity ratioshould not exceed 1.5to 1, and interestexpenses should notexceed 25% of pretaxincome, after interestand depreciation areadded back

Implemented new lawJanuary 1, 2007. Thelaw has a broaderdefinition of equity,and debt includes alldebt extended fromrelated parties, not onlyshareholders.

Germany/30.18% 82.7 Yes Income statement test Net interest expenselimited to 30% ofEBITDA

Rules changed in 2001,2003, and 2008. Mostrecent change shiftedfrom thin capitalizationtest to interestdeduction limits.

Italy/27.5% 58.1 Yes Income statement test Net interest expenselimited to 30% ofEBITDA

New laws implementedJanuary 1, 2008.Changed from thincapitalization test tointerest deductionlimits.

Japan/39.54% 128.2 Yes Balance sheet test Debt-to-equity ratio notto exceed 3 to 1

Firms have the optionof using thedebt-to-equity ratio of asimilar Japanese firm.

United Kingdom/28% 59.8 Yes Arm’s-length principle No specific financialtest or safe-harbor ratio

Rules changed threetimes between 1994and 2004.

United States/39.1%b 301.0 Yes Balance sheet test,which limits interestexpense deductibility

If debt-to-equity ratioexceeds 1.5 to 1,interest expenses >50% of EBITDA arenot deductible

The 1.5-1 debt-to-equityratio is a ‘‘safe harbor.’’The IRS will presumeratios below 1.5 to 1are not excessivelyleveraged, but ratiosabove 1.5 to 1 may ormay not be challenged.

aCorporate tax rates for all G-7 countries were obtained from the OECD Tax Database (http://www.oced.org/ctp/taxadatabase). See TableII.1.

bThe maximum U.S. federal statutory tax rate is 35 percent, but the great majority of U.S. states also impose income taxes, pushing thecombined rate to approximately 40 percent. It can be higher or lower than that figure depending on the states in which the business operates.

SPECIAL REPORTS


(C) T

ax Analysts 2010. A




According to Lund and Korsgaard (2008), under thefirst limitation, ‘‘interest expenses on controlled debtare not deductible to the extent that the debt-to-equityratio exceeds 4:1’’ (p. 302). The rules do not apply tointerest on debts less than DKK 10 million, or to loansextended by private individuals. If a company candocument that a similar loan could be obtained froman independent party, the 4-1 debt-to-equity limitationmay not apply. However, the rules apply both to loansextended by related parties and to loans extended bythird parties if they are collateralized by related-partyassets.

Under the second limitation, ‘‘companies may de-duct net financing expenses only to the extent that theexpense does not exceed a standard rate of inter-est . . . on certain qualifying assets’’ (Lund and Kors-gaard 2008, p. 302). In 2009 that interest rate was 6.5percent (Bundgaard and Tell 2010, p. 7). The interestrate is applied on the tax value of assets at year-end todetermine the interest ceiling limitation. Fixed assetsare valued net of accumulated depreciation; nondepre-ciable assets are valued at cost plus the cost of any im-provements; internally developed intangible assets arenot valued unless the costs are capitalized for tax pur-poses; and inventory, work-in-process, and receivablesare valued net of any reserves. That figure is comparedwith net financing expenses, which are defined as thesum of taxable interest income less deductible interestexpenses, excluding interest on trade accounts payableand trade receivables, trading losses, loan losses, andgains and losses on foreign exchange gains and losses.The rules apply to debts extended from both relatedand third parties. Interest expenses above the limitationare not deductible and cannot be carried forward. Therules apply only when net financing expenses exceedDKK 21.3 million (Bundgaard and Tell 2010, p. 9).This de minimis figure is adjusted annually.

Finally, a third Danish interest limitation rule re-stricts interest to a percentage of EBIT. Kaserer (2008)writes, ‘‘Most prominently, Denmark extended its thincapitalization rule by an interest stripping rule restrict-ing a firm’s interest deductions to 80 percent of EBIT’’(p. 3). Kaserer notes that similar rules were adopted inGermany and Italy, but those rules limit interest ex-penses to 30 percent of EBITDA. The U.S. limits inter-est expenses to 50 percent of adjusted taxable income,but only if the 1.5-1 debt-to-equity ratio is exceeded.

Similar to the G-7 countries, the Netherlands at-tempts to balance the competing goals of raising taxrevenue and creating an attractive investment environ-ment. Van Saparoea (2009) comments, ‘‘For Asian andAmerican companies in particular, the Netherlands haslong been one of the preferred jurisdictions in Europein which to develop a base. Numerous internationaloperations have derived significant tax benefits fromusing the Netherlands as an international base; therebycontributing to a reduction in their worldwide tax bur-den’’ (p. 5). Not only do MNEs reduce their tax rate,

the Netherlands generates tax revenue from the MNEs,so its tax policies are mutually advantageous.

The current Dutch rules were implemented effectiveJanuary 1, 2004. These rules identify two tests to deter-mine whether interest expenses are tax deductible.Sporken (2008) says, ‘‘The first test concerns the debt-to-equity ratio of the taxable company itself, whichmay be 3:1 at a maximum’’ (p. 329). Debt is defined asaverage payables less average receivables, so the rulesmeasure net debt, rather than gross obligations. Thisfigure is compared with average equity for tax pur-poses. The rules also specify that firms must use anequity figure of at least €1, even if average equity isdetermined to be less than that figure. If the debt-to-equity ratio exceeds 3 to 1 and the excess is greaterthan €500,000, the associated interest expense is nottax deductible. However, ‘‘The amount of interest thatis not deductible cannot, however, be greater than theamount of interest on loans payable to entities that arerelated to the taxpayer less the amount of interest onloans payable by the entities to the taxpayer’’ (vanSaparoea 2009, p. 4).

The second option is to use the worldwide enter-prise’s debt-to-equity ratio. Van Saparoea (2009) writes,‘‘Specifically, if the taxpayer in its tax return opts forthis group ratio (the second ratio), its excess debt isheld to be the amount by which its average debt:equityratio exceeds the average debt:equity ratio of the groupto which it belongs’’ (p. 4). If the taxpayer belongs tomore than one group, the highest debt-to-equity ratioapplies. The taxpayer can select whether it wants the3-1 ratio or the worldwide enterprise’s debt-to-equityratio to apply, and firms are annually permitted to se-lect the measure by which its debts will be tested.

To prevent abuse and maintain tax revenue, theDutch rules also identify a number of specific cases inwhich interest is not tax deductible. According toSporken (2008), interest is deductible ‘‘unless the ex-pense cannot be considered a business expense orwhen specific anti-abuse rules apply’’ (p. 328). If aDutch corporation incurs debt to fund profit distribu-tions, fund investments in related entities, or acquire arelated entity, the associated interest expense may notbe tax deductible. However, the rules also provide twoexceptions to these limitations. If the loans are takenfor sound business reasons, or if the income is taxed ata reasonable level, which is generally defined as 10 per-cent of income, these rules do not apply (van Saparoea2009, p. 5).

In January 2008 the Netherlands amended theseregulations. Specifically, the exception that allowedfirms to incur debt, as long as the associated interestincome was taxed at 10 percent, was modified. Accord-ing to van Saparoea, legislators in the Netherlands‘‘feared that maintaining the second exception . . . with-out amendment would have adverse budgetary conse-quences’’ (p. 5). For example, since Cyprus’s incometax rate is 10 percent and the Netherlands’ is 25.5 per-cent, an MNE could establish a subsidiary in Cyprus,

SPECIAL REPORTS


(C) T

ax Analysts 2010. A




extend debt to a related entity in the Netherlands, andsubstantially reduce income taxes. Van Saparoea (2009)writes, ‘‘The amended law states that, in situations inwhich a taxpayer can sufficiently demonstrate that itsinterest income is taxable at a rate of at least 10 per-cent, it would nevertheless remain possible for a taxinspector to substantiate that either a debt itself or atransaction that corresponds to it lacks a sound busi-ness reason’’ (p. 5). In short, legislators wanted tomaintain the power to tax such income in the Nether-lands, even if the profits were shifted to a jurisdictiontaxing the income at 10 percent or more.

According to van Saparoea (2009), the Netherlandsis already considering changing this rule ‘‘because thecurrent rules could damage the attractiveness of theNetherlands as a business location’’ (p. 3). Van Sapa-roea says the amended rules have increased uncertaintyfor MNEs, as they do not know whether tax authori-ties will challenge interest deductions in many situa-tions. MNEs are also concerned that their profits couldbe taxed twice. Beyond this, three Netherlands tax pro-fessors have written that the amendment may not com-ply with the EC freedom of establishment clause.19

Thus, it is possible the 2008 amendment may be re-laxed, though no changes have been enacted at thistime.

New Zealand has also developed creative rules tolimit thin capitalization/earnings stripping activities.Smith and Dunmore (2003) write that New Zealand’srules were implemented in 1996, noting, ‘‘The reasonfor introducing the thin capitalization rules then was tocomplement the new transfer pricing rules being en-acted at the same time. It was believed that the absenceof any formal thin capitalization rules when the newtransfer pricing rules were being introduced could gen-erate opportunities for tax avoidance and create uncer-tainty in the minds of foreign investors as to NewZealand’s stance on thin capitalization. It was alsothought that clarity of the tax policy and of the taxregime was essential to promote foreign investment inNew Zealand’’ (p. 505). In short, they recognized thattaxpayers desire certainty when calculating tax obliga-tions.

New Zealand’s thin capitalization rules apply onlyto firms that meet an ownership test. They specificallyapply to taxpayers in three categories: nonresidents;New Zealand resident companies in which a nonresi-dent owns 50 percent or more of the firm; and trusteesof a non-qualifying trust, controlled 50 percent or moreby a nonresident (Smith and Dunmore 2003, pp. 505-506). If the taxpayer falls into one of those categoriesat any point during the year, the rules apply. Thus, the

rules do not apply to New Zealand residents, and theywould fail to meet the freedom of establishment clausein the EC Treaty, were New Zealand a member.

If the ownership test is met, two further tests areapplied to determine if the debt is excessive. The firstis a ‘‘safe-harbour debt percentage of 75 percent’’(Smith and Dunmore 2003, p. 505). In other words, ifa firm’s debt-to-equity ratio is less than 3 to 1, the debtis not considered excessive. According to Smith andDunmore, ‘‘The safe-harbour debt percentage is de-signed to reduce compliance costs of taxpayers whooperate with moderate levels of debt’’ (p. 506). Smithand Dunmore wrote that while this limit appearedsimilar to debt-to-equity ratio caps in other countries, itwas in fact more stringent: ‘‘While a 75 [percent] safe-harbour debt percentage appears comparable to thesafe-harbour debt/equity ratios adopted in the thincapitalization rules of Canada, Japan and Germany,the New Zealand debt percentage is effectively lowerbecause the ratios of those other countries take intoaccount only related-party interest-bearing debt, whileNew Zealand’s debt percentage takes into account allinterest-bearing debt’’ (p. 506).

New Zealand’s thincapitalization rules applyonly to firms that meet anownership test.

However, New Zealand’s rules also permit taxpayersto exceed the 3-1 ratio in some situations. If the world-wide business has a debt-to-equity ratio that exceeds 3to 1, the New Zealand entity is also permitted to havea higher debt ratio. Smith and Dunmore (2003) write,‘‘In addition, there is a provision allowing taxpayers tomaintain a debt percentage above 75 percent withoutsuffering a penalty under the rules if the worldwidegroup debt of which the New Zealand taxpayer is partalso has a debt percentage above 75 percent’’ (p. 505).If a New Zealand taxpayer’s debt ratio exceeds 3 to 1,it is permitted to have a debt percentage up to 110 per-cent of the worldwide enterprise’s debt percentage.Thus, the New Zealand entity can exceed the parentcompany’s debt-to-equity ratio. The 110 percent rulesapply to companies and trusts, but not individuals.

New Zealand’s approach requires it to define howthe worldwide enterprise’s group debt percentage iscalculated. Smith and Dunmore (2003) write, ‘‘A tax-payer’s ‘group debt percentage’ is defined as the pro-portion of the total interest-bearing debt to the totalassets of the taxpayer’s New Zealand group for theincome year. Thus, interest-free loans are excluded andare essentially treated as equity, as are accrual account-ing provisions, deferred tax, and other similar liabilitiesor provisions’’ (p. 506). New Zealand’s rules also allow

19F.A. Englen, H. Vording, and S. Weeghel, ‘‘Wijzinking vanbelastingwetten met het oog op het tegengaan van uitholling vande belastinggrondslag en het verbeteren van het fiscale vestiging-sklimaar,’’ Weekblad Fiscaal Recht 6777, Aug. 28, 2008.

SPECIAL REPORTS


(C) T

ax Analysts 2010. A




taxpayers to exclude debt for funds lent to non-relatedorganizations and individuals. The worldwide debt per-centage is calculated annually, at the end of the firm’sfiscal year.

A summary of thin capitalization/interest deductionregulations in Denmark, the Netherlands, and NewZealand is shown in Table 2.

Regulations in Small EU CountriesWhile all the G-7 countries may want to limit highly

leveraged financing structures, not all countries viewthin capitalization as a priority. As previously men-tioned, some countries view low income tax rates andmore lenient tax policies as an opportunity to attractFDI. In particular, small, less economically powerfulcountries may want to lower taxes to entice MNEs toset up operations there. Those countries may havefewer globally successful MNEs headquartered there,and thus low tax rates may have less impact on govern-ment finances. They may see the potential to attractFDI through lower income tax rates and more lenientthin capitalization and/or interest deduction regula-tions.

Haufler and Runkel (2008) explain this by saying,‘‘The country with the smaller population size not only

chooses the lower tax rate but also the more lenientthin capitalization rule. This is because the smallercountry faces the more elastic tax base for internation-ally mobile capital, but the same is not true for interna-tionally immobile capital’’ (pp. 3-4).

To illustrate this point, the thin capitalization/interest deduction limitations of the eight smallest EUmembers will be reviewed. These countries have beenselected because information is readily available and allare in Europe. As most of the G-7 countries are in Eu-rope, comparisons are relevant. While the G-7 coun-tries have populations ranging from 33 million to 301million, the eight least populous European countrieshave populations ranging from 400,000 to 4.2 million.With one exception, each also has a population smallerthan Denmark, the Netherlands, and New Zealand.Ireland’s population is 4.2 million, while NewZealand’s is 4.1 million.

A summary of the thin capitalization policies ofthese EU members is included in Table 3. Half ofthese countries have no thin capitalization policies; theothers rely on debt-to-equity ratios. The debt-to-equityratios in the smaller countries are more lenient thanrestrictions found in the countries previously cited. Inaddition, the regulations in these countries also appear

Table 2. Summary of Thin Capitalization/Interest Deduction Policies in Denmark,the Netherlands, and New Zealand

Country/Max. 2009Corp. Tax Ratea

2006Population

(in millions)

Rules to LimitFinancial Leverage?

Approach to LimitAbuse

Financial Tests Comments

Denmark/25% 5.4 Yes A series of three rulesthat progressively limitinterest deductions

1) Related partydebt-to-equity ratios notto exceed 4 to 1.2) Interest expenses notto exceed a percent(currently 7%) ofqualifying assets.3) Interest expenses notto exceed 80% of EBIT.

De minimis rules apply.Rules are consideredcomplex.

Netherlands/25.5% 16.3 Yes Balance sheet tests 1) Net debt-to-equityratio not to exceed 3 to1.2) Firm can opt to belimited by theworldwide enterprise’sdebt-to-equity ratio.

Current rulesimplemented January1, 2004. Firm candetermine each year bywhich limit will apply.Revisions are beingdiscussed.

New Zealand/30% 4.1 Yes Balance sheet tests Taxpayer’s limited bythe higher of: 1) 3-1debt-to-equity ratio; or2) 110% of theworldwide enterprise’sdebt-to-equity ratio.

The 3-1 debt-to-equityratio includes allinterest-bearing debt.The 110% worldwideenterprise debt capexcludes the worldwideenterprise’s deferred taxliabilities and otheraccruals.

aCorporate tax rates for all G-7 countries were obtained from the OECD Tax Database (http://www.oced.org/ctp/taxadatabase). See TableII.1.

SPECIAL REPORTS


(C) T

ax Analysts 2010. A




to be somewhat more stable than in the G-7 countries;only one of the eight countries plans to change itslimit.

Cyprus, Estonia, Ireland, and Malta do not cur-rently have any thin capitalization or interest deductionrules. Latvia and Lithuania limit debt-to-equity ratiosto 4 to 1. Interest expenses for debt above this level arenot tax deductible. Luxembourg and Slovenia cap debt-to-equity ratios at 6 to 1. Slovenia plans to reduce itslimitation from 6 to 1 to 4 to 1 in 2012. The fourcountries with thin capitalization policies have notchanged their policies since they were first imple-mented.

Haufler and Runkel (2008) observed similar results,commenting, ‘‘Large countries, such as Germany,France or the United States have rather elaborate ruleslimiting the interest-deductibility of internal debt,whereas small countries such as Ireland, Luxembourgand many countries in Eastern Europe have either nothin capitalization rules at all, or very permissive ones’’(p. 4). Given that debt-to-equity ratio of 1.5 to 1 in theUnited States have been ineffective at constraining in-verted corporations there, it is unlikely that 4-1 or 6-1ratios will limit earnings stripping. The study of Cana-dian firms found that only 7.1 percent had debt-to-equity ratios exceeding 2 to 1. It is likely these smallercountries have maintained stable rules because their

regulations have not discouraged FDI. As their currentrules impose few restrictions on thin capitalizationstrategies, they have little motivation to modify theirregulations. A summary is shown in Table 3.

Ireland’s population is slightly larger than NewZealand’s, and it imposes no thin capitalization rules.While Haufler and Runkel (2008) have noted thatsmaller countries tend to enact lower tax rates andmore lenient thin capitalization rules, the political pro-cess and tax policies are not an exact science. Theremay be other considerations. Ireland’s close proximityto countries imposing high income tax rates may haveled it to conclude it could succeed at tax competition,while New Zealand’s remoteness from many MNEsand large markets may have led that nation in anotherdirection.

As Haufler and Runkel (2008) noted, countries thatimpose lax or no thin capitalization policies often havelow income tax rates as well. (See Table 4.)

Evaluation of RegulationsThe G-7 countries and other nations attempting to

regulate thin capitalization have a challenging task.They must balance their short-term tax revenue goalsagainst the need to create an attractive investment envi-ronment. Countries such as Germany, France, the

Table 3. Summary of Policies in the EU’s Eight Least Populous CountriesCountry/Max. 2009

Corp. Tax Ratea2006 Population Rules to Limit Thin

CapitalizationApproach to Limit

AbuseFinancial Testb Changes to Law

Cyprus/10% 780,000 No rules to restrictthin capitalization

N/A N/A N/A

Estonia/21% 1.3 million No rules to restrictthin capitalization

N/A N/A N/A

Ireland/12.5% 4.2 million No rules to restrictthin capitalization

N/A N/A N/A

Latvia/15% 2.3 million Yes Balance sheet test Debt-to-equity ratiolimit is 4 to 1

No changes madesince implemented

Lithuania/15% 3.4 million Yes Balance sheet test Debt-to-equity ratiolimit is 4 to 1

No changes made tolaw sinceimplemented January1, 2004

Luxembourg/29.63% 470,000 Yes Balance sheet test Debt-to-equity ratiolimit is 6 to 1

No changes made tolaw sinceimplementation

Malta/35% 400,000 No N/A N/A N/A

Slovenia/22% 2.0 million Yes Balance sheet test Debt-to-equity ratiolimit 6 to 1

No changes made tolaw yet, but debt-to-equity ratio cap willdrop to 4 to 1 in 2012

aCorporate tax rates for Ireland and Luxembourg were obtained from the OECD Tax Database (http://www.oced.org/ctp/taxadatabase). SeeTable II.1. All others were drawn from the International Transfer Pricing Journal (Nov./Dec. 2008), p. 352.

bAll of the information on thin capitalization policies in these countries comes from a series of articles introduced by H. Lund, C. Korsgaard,and M. Albertsen, ‘‘Financing: a global survey of thin capitalization and thin capitalization rules in 35 selected countries,’’ InternationalTransfer Pricing Journal (Nov./Dec. 2008), pp. 283-352.

SPECIAL REPORTS


(C) T

ax Analysts 2010. A




United Kingdom, and Italy have all modified theirregulations in recent years as they seek to achieve bothobjectives. Denmark, the Netherlands, and NewZealand have drafted sophisticated rules designed togenerate tax revenue and still attract FDI.

All G-7 countries began their regulatory efforts bylimiting the debt-to-equity ratio of CFCs operatingwithin their borders. This appears to be a logical ap-proach, since it is the high debt that generates the in-tercompany interest expenses, shifting earnings to low-tax jurisdictions. However, experience has shown thatcountries cannot rely exclusively on debt-to-equity ra-tios to prevent earnings stripping. There are severalproblems with employing debt-to-equity ratios in thiscontext. One is the foreign neutrality tax doctrine, atleast within the EU. As discussed, both the UnitedKingdom and Germany found that its laws violated theEC Treaty’s freedom of establishment clause. Bothfound it difficult to draft laws that were specificallydesigned to prevent MNEs from leveraging corpora-tions with excessive intercompany debt, while treatingdomestic and internationally owned firms equally. Eachlost cases in the ECJ and has adopted a different strat-egy.

In addition, thin capitalization rules may notachieve their objectives. A debt-to-equity ratio does notlimit absolute debt levels, and thus it may not preventearnings stripping. If the MNE’s objective is to reduceincome taxes, it can determine how much debt is nec-essary to shift earnings from a country, inject sufficientdebt and equity to comply with limitations, and trans-fer profits. As von Brocke and Perez (2009) write, ‘‘Ina first stage, the majority of these thin capitalizationrules established the existence of safe harbours (e.g.,debt-to-equity ratio) in order to force related companiesto apply normal market conditions in their intra-grouptransactions. However, as it was very simple for com-panies to circumvent the limit established by debt-to-equity ratio by increasing the equity of the financedsubsidiary in a manner sufficient to push down as

much debt as necessary’’ (p. 29). Seida and Wempe(2004) also determined that a 1.5-1 debt-to-equity ratiowas ineffective at preventing ICs from stripping earn-ings from the United States. They write, ‘‘We concludethat inverted firms’ (presumed) technical compliancewith current, rule-based impediments to earnings strip-ping is producing U.S. tax outcomes (liabilities) thatbear very little resemblance to underlying economicevents and circumstances’’ (p. 826, emphasis in origi-nal). In fact, the behavior they documented was soegregious they believed both the substance-over-formtax standard and the fairness principle were violated.They write, ‘‘It seems implausible that the earningsstripping behavior we document is consistent with thenotion that a fair tax system must favor substance overform, and that the tax treatments of income and ex-pense items should produce a result that clearly reflectsan entity’s income’’ (p. 826). In short, capping thedebt-to-equity ratio may conflict with both the effec-tiveness and fairness principles. As a result, somenations, including France and Denmark, have supple-mented debt-to-equity limitations with other regulationsto limit interest deductions.

Beyond this, it may also be difficult to determineone debt-to-equity ratio limit that is fair and appropri-ate for all businesses. Based on their risk appetite, capi-tal needs, and the vicissitudes of credit markets, busi-nesses establish and negotiate capital structuresdesigned to achieve their business objectives. As a re-sult, studies of debt-to-equity ratios show that theyvary widely in practice. Farrar and Mawani (2008)found Canadian debt-to-equity ratios ranged from 4.2to 1 to 0.15 to 1. The U.S. Treasury Department (2007)found many debt-to-equity ratios above the 1.5-1 safeharbor. It states, ‘‘Commentators have noted, however,that many U.S. corporations have debt-to-equity ratiosthat exceed 1.5 to 1. For example, the capital structureof multinational businesses may vary based on theirlines of business and what the market will bear with

Table 4. Corporate Income Tax Rate Comparisons2009 Corporate

Income Tax Rate10-20% 20-24.99% 25-30% 31-35% 36%+

G-7 Countries 0 0 3Italy

United KingdomGermany

2CanadaFrance

2Japan

United States

Other CountriesAddressing ThinCapitalization

0 0 3Denmark

NetherlandsNew Zealand

0 0

Small EU Countries 4CyprusIrelandLatvia

Lithuania

2EstoniaSlovenia

1Luxembourg

1Malta

0

SPECIAL REPORTS


(C) T

ax Analysts 2010. A




respect to such a business. Consequently, some com-mentators have argued that the debt-to-equity safe har-bor should not be eliminated but should be modified toreflect this reality’’ (p. 29). However, determining ap-propriate debt-to-equity ratios for various industries isnot an easy task. It may be very difficult to determine‘‘fair’’ debt-to-equity limits for a range of industries.

The Treasury Department (2007) determined that‘‘modifying the debt-to-equity safe harbor to take intoaccount different levels of leverage supportable by dif-ferent assets was too complex and that almost any gen-eralization regarding the ability of the assets of a cor-poration to support debt, even within limited classes ofassets, meant that at least some taxpayers would be-lieve the test was insufficiently precise’’ (p. 30). Whilethat may be correct, this argument does not supportexisting regulations, which specify one debt-to-equitysafe harbor for all firms. And there are other regulatoryapproaches that could be effective. In some situationsNew Zealand and the Netherlands reference the world-wide enterprise’s debt-to-equity ratio when regulating aCFC’s leverage. Denmark establishes an interest deduc-tion limit based on a percentage of qualifying assets.20

The Treasury study showed no evidence it consideredmore effective regulatory strategies in other nations.

In the last two years, both Germany and Italy haveimplemented regulations directly limiting interest de-ductions to 30 percent of EBITDA. This approach hasseveral advantages over debt-to-equity caps. First, inter-est deduction rules directly address the real issue thatconcerns tax authorities, which is lost tax revenue. Themost straightforward way to retain tax revenue isthrough limiting tax-deductible interest, not controllingthe capital structure of the firm. Interest deductionlimits also support compliance with the capital importneutrality standard. As discussed, Italian legislatorshave taken more precautions than Germans to ensuretheir new rules treat domestic and foreign corporationsequally.

However, interest deduction limitations share a prob-lem with debt-to-equity ratios, as it is very difficult todetermine one limitation that is appropriate for allbusinesses and industries. If a country establishes ahigh interest expense limit, few taxpayers will contendthe restriction is unfair, but the rule will not limit ex-cessive financial leverage. Tighter regulations may limitabuse, but may also unfairly constrain other businessesthat depend on debt. Such rules may also be incompat-ible with the arm’s-length standard. A single figureregulating all businesses is arbitrary and may be toorestrictive for some firms, and too lax for others. Whendebt-to-equity ratios vary widely in practice, one-size-

fits-all limitations may fail to satisfy both the fairnessprinciple and the effectiveness principle.

The U.K. is the only country today that relies exclu-sively on the arm’s-length standard. This approach failsto satisfy the certainty principle. Unlike any other ma-jor country analyzed, the U.K. gives taxpayers noquantitative guidance to determine how much debt orinterest expense might be considered excessive. Also,the CFC has to determine its debt capacity as a stand-alone business, ignoring its function within the largerenterprise. This is inherently difficult. These ambigu-ities can also make administration of these rules ineffi-cient, as regulators and tax authorities litigate their dif-ferences.

Debt-to-equity limits arenot always effective atpreventing firms fromstripping earnings fromone country to another.

Beyond that, the U.K.’s approach may be too le-nient. As van Saparoea (2009) writes, ‘‘The arms-length debt capacity of a UK business is defined as thelevel of indebtedness the UK business could havehandled from an independent lender, without consider-ing any larger enterprise to which the firm may be-long’’ (p. 6). By focusing on what a subsidiary ‘‘couldhave borrowed,’’ the U.K.’s approach may permit ex-cessive leverage. In practice, many firms borrow sub-stantially less than they could. The U.K. approach en-courages CFCs to define their maximum borrowingcapacity, though the MNE may have no intention ofassuming such leverage.

Limiting Interest ExpensesCountries have attempted a variety of regulatory

strategies to control highly leveraged financing struc-tures. Based on this article’s analysis of such tax regu-lations, several conclusions can be reached concerningthe most effective ways to control this activity.

One conclusion is that debt-to-equity limits are notalways effective at preventing firms from stripping earn-ings from one country to another. If the MNE has suf-ficient capital, it can inject debt and equity into theCFC, comply with debt-to-equity limits, and still stripearnings from one country to another. MNEs havebeen able to work around these restrictions, as severalstudies have shown. The comparatively strict U.S. 1.5-1debt-to-equity ratio was completely ineffective at pre-venting inverted corporations from shifting earningsabroad. It is very easy to inject both debt and equityinto a subsidiary, comply with regulatory restrictions,and strip earnings. For this reason, several countries,

20As mentioned, Denmark has three limitations that succes-sively reduce interest deductions. The second limitation appliesan interest rate on qualifying assets to limit deductible interestexpenses. The interest rate for 2009 was 6.5 percent (Bundgaardand Tell 2010, p. 7).

SPECIAL REPORTS


(C) T

ax Analysts 2010. A




including Germany and Italy, have adopted interestdeduction limitations, and this is a more effective ap-proach.

Second, it is inherently difficult to identify one debt-to-equity ratio, or one interest deduction limitation,that is fair and appropriate for all businesses. As men-tioned, a Canadian study found debt-to-equity ratiosthere ranged from 4.2 to 1 to 0.15 to 1. Thus, somefirms were leveraged with 28 times the debt ratio asother businesses. In addition, the U.S. Treasury Depart-ment (2007) considered establishing different debt-to-equity limits for various industries but determined thiswas too difficult to accomplish with any precision. Soit continues to limit all firms with one debt-to-equityratio, which is an unfair and inefficient regulation, dis-connected from marketplace realities.

Several countries have implemented rules that link afirm’s capital structure to the worldwide enterprise’sdebt-to-equity ratio, or to that of similar firms in thesame industry. The third escape clause in Germany’scurrent interest deduction rule exempts firms that areno more leveraged than the consolidated firm. Japanesethin capitalization rules allow firms to use the debt-to-equity ratio of a similar Japanese firm to determinetheir maximum debt-to-equity ratio. The Dutch ruleslimit a subsidiary’s debt-to-equity ratio to that of theworldwide enterprise. New Zealand’s rules limit a sub-sidiary’s debt-to-equity ratio to 110 percent of the con-solidated business. Thus, several countries impose thincapitalization rules that reference the debt level of theworldwide enterprise, or similar firms in like industries.

Rules in these countries demonstrate that limiting afirm’s financing structure by referencing the worldwideenterprise’s financial metrics, or that of a comparablefirm, is a legitimate regulatory approach. However, itshould be noted that in all these cases, countries wereusing market-based measures as a backup strategy, inthe event the primary rules were too stringent. If thecountry’s primary limits were too restrictive, they pro-vided firms an alternative to demonstrate their leveragewas similar to the worldwide enterprise’s, and thus nota tax-motivated strategy.

This article proposes that the best approach to con-trolling excessively leveraged funding strategies is tolimit a CFC’s tax-deductible interest expenses to theworldwide enterprise’s ratio of interest expense toearnings. This should be the primary strategy to com-bat excessively leveraged financing structures. While itmakes sense to establish market-based financial meas-ures to control financial leverage, debt-to-equity limita-tions are not always effective. As Germany, Italy, andthe United States currently reference EBITDA (or aclose approximation) to limit tax-deductible interestexpenses, it makes sense to continue to use that earn-ings measure. Table 5 demonstrates how the worldwideenterprise’s ratio of interest expense can be used todetermine the maximum tax deductible expense for asubsidiary.

In the above example, the worldwide enterprise re-ported $15 million in trade interest expenses, andEBITDA totaled $200 million. Thus, its ratio of inter-est expense to EBITDA is 7.5 percent. This establishesthe subsidiary’s tax-deductible limit. The subsidiaryearned $10 million. The CFC’s tax-deductible interestexpense limit is determined by multiplying the 7.5 per-cent figure by its EBITDA of $10 million, which is$750,000. Interest expenses up to that figure are taxdeductible. Interest expenses above that figure are disal-lowed, and perhaps carried forward into a future taxyear.

This proposal supports the certainty principle. Cal-culating the worldwide enterprise’s ratio of interestexpense to earnings is straightforward and providestaxpayers and regulators with an unambiguous rule. Itprovides more certainty than the U.K.’s approach,which relies on the vagaries of the arm’s-length stand-ard. It also provides more certainty than safe harbors.These upper limits offer certainty for taxpayers operat-ing below the safe harbor limit. But leveraged taxpayersmay exceed the safe harbor boundary as part of theirnormal business activities, not as a tax minimizationstrategy. They have no assurance that their financingstructure will not be challenged by tax authorities.

Many international tax issues are filled with uncer-tainty, so establishing clear rules for all parties benefits

Table 5. Proposal to Limit a CFC’s Tax-Deductible Interest Expense by the Worldwide Enterprise’sRatio of Interest Expense to EBITDA

Financial Measures Worldwide Enterprise FinancialResults

Financial Measures CFC Financial Results/Limit

Total Trade Interest Expense $15 million Limit of tax deductible interestexpense to EBITDA

7.5%

Worldwide EBITDA $200 million CFC EBITDA $10 million

Worldwide Ratio of TradeInterest Expense to EBITDA

7.5% Tax deductible limit fortrade/intercompany interestexpenses

$750,000

SPECIAL REPORTS


(C) T

ax Analysts 2010. A




both MNEs and governments. As Smith and Dunmore(2003) write, ‘‘In the case of thin capitalization, it islikely that arm’s length debt/equity ratios of compa-rable enterprise’s will be easier to obtain than appropri-ate CUPs for transfer pricing investigations, given thatdebt/equity ratios can be simply calculated from com-panies’ financial statements’’ (p. 504). However, thisproposal creates even more certainty, as the MNEwould use its own financial results to establish limits,rather than search for comparable firms.

Because this proposal provides taxpayers and taxauthorities with certainty, it also supports the efficiencyprinciple. Both the taxpayer and tax authorities canquickly determine their limits by reviewing the world-wide enterprise’s income statement. In contrast, com-plying with France’s or Denmark’s complicated rulescan be difficult, expensive, and time consuming. TheU.K. rules encourage taxpayers to determine theirarm’s-length borrowing capacity, viewed as a stand-alone enterprise, which can also be a costly andlengthy process.

Not only does this approach support efficient taxcollection, it supports market efficiency. As Musgraveand Musgrave (1976) wrote, ‘‘Taxes should be chosenso as to minimize interference with economic decisionsin otherwise efficient markets’’ (p. 210). Tax rules thatestablish one-size-fits-all debt limitations do not supportmarket efficiency, as they may encourage tax-motivateddecisions. Interest limitations that are consistent withthe worldwide enterprise’s funding decisions supportmarket efficiency. The motivations of the MNE and itssubsidiaries become aligned. The CFC’s limit is estab-lished by the worldwide enterprise’s own financing de-cisions. Subsidiaries in countries imposing high incometaxes would lose their incentive to incur excessive inter-company debt.

While ‘‘fairness’’ is difficult to define, in some waysthis proposal appears to be fairer than the one-size-fits-all rules adopted by many countries. Tax authoritieswould not create limitations inconsistent with a firm’sown funding strategy. In fact, tax authorities would notbe regulating an appropriate capital structure for theCFC. The business would be establishing its own finan-cial limit, through its own funding decisions. In con-trast to uniform regulations, it sets a fair and appropri-ate interest expense limit for each firm, neither toostrict nor too lenient. In some cases, a subsidiary maybe engaged in a fundamentally different line of workthan the worldwide enterprise. In those cases, fairnesswould dictate establishing an interest expense limitconsistent with other firms in that industry, as Japaneserules permit today.

Finally, this proposal improves effectiveness. Asdemonstrated previously, current debt-to-equity limita-tions are often ineffective at halting abuse. Interest de-duction limits are more effective, but they only estab-lish an upper limit for tax deductible interest expenses.As long as the MNE is careful not to exceed the regu-latory maximum, it is free to pursue tax-driven financ-

ing decisions. For example, suppose an MNE con-sciously chose to keep debt and interest expenses low.Today it is permitted to increase deductible interestexpenses to 30 percent of EBITDA in Germany andItaly. These countries may be depriving themselves oftax revenue because they permit MNEs to structureintercompany loans for the sole purpose of strippingearnings to the law’s limit. This proposal would estab-lish a fair and reasonable limit for each company bybasing it on the worldwide enterprise’s own fundingdecisions.

To evaluate this proposal’s effectiveness, we shouldalso ask if there are ways MNEs could work aroundthese rules to achieve tax-advantaged results. It is truethat MNEs that incur higher trade interest expensescan allow their CFCs to deduct more intercompanyinterest under this proposal. So it is possible MNEscould increase trade interest expenses, and this wouldallow them to leverage some subsidiaries more inter-company debt, and thus more earnings could bestripped from high-tax to low-tax jurisdictions. How-ever, to do this, the MNE would be reducing its pretaxearnings by increasing additional trade debt expenses,which would moderate such actions. In addition, banksand other lenders will not want to extend more debtthan a firm can be expected to repay. Lenders are alsomore likely to demand loan collateral or covenants thatcan place limits on a firm’s freedom to conduct itsbusiness operations. So there are several forces thatconstrain such a tax strategy. In addition, these aremarketplace forces that may act to limit a firm’s debt.Market forces that constrain debt can frequently bemore effective than tax rules, which can sometimes beevaded or become dated.

ConclusionThe U.S. federal government is facing some of the

largest budget deficits in its history. The CongressionalBudget Office has said the projected budget deficits areunsustainable and that the federal government needs toclose the budget gap through reduced spending and/orincreased revenue. One way the U.S. government couldincrease tax revenue is through tightening its thincapitalization/interest deduction rules. Experience hasdemonstrated that existing U.S. thin capitalization rulescan be avoided. U.S. tax authorities should be con-cerned with thin capitalization/interest deduction rules,as the U.S. corporate income tax rate is one of thehighest in the world, and thus the country is an attrac-tive target for earnings stripping activities. In addition,the U.S. has left its thin capitalization/interest deduc-tion rules essentially unchanged since 1989, whilemany other countries have regularly reviewed andmodified these rules to ensure they strike the right bal-ance between raising tax revenue and attracting FDI.

This article has reviewed a number of regulatoryapproaches to control excessively leveraged financingstructures and proposes that the worldwide enterprise’sratio of interest expense to EBITDA should determine

SPECIAL REPORTS


(C) T

ax Analysts 2010. A




a subsidiary’s tax-deductible interest expense limit.This approach achieves many of the objectives thatdefine a high-quality tax law by supporting the cer-tainty principle, the efficiency principle, the fairnessprinciple, capital-import neutrality, and the effectivenessprinciple. As tax authorities in the United States lookfor ways to increase tax revenue, they should considerthis proposal. Other countries may want to considerthis regulatory approach as well, as they seek to con-trol excessively leveraged financing structures of firmsoperating within their borders.

ReferencesAllen, D. (Dec. 2000). ‘‘Spare Debt Capacity: Com-

pany Practices in Australia, Britain and Japan.’’ Aus-tralian Journal of Management 25(3), 299-326.

Bagel, F., and C. Huning (Nov./Dec. 2008). ‘‘Financ-ing: Germany.’’ International Transfer Pricing Journal,309-311.

Becker, J., C. Fuest, and T. Hemmelgarn (May 2006).‘‘Corporate Tax Reform and Foreign Direct Invest-ment in Germany — Evidence From Firm-LevelData.’’ CESifo Working Paper No. 1722. Available athttp://www.ssrn.com.

Bundgaard, J., and M. Tell (2010). ‘‘Tax neutrality incorporate financing.’’ European Tax Studies. Availableat http://ste.seast.org/en.

Congressional Budget Office (Aug. 2009). ‘‘The Budgetand Economic Outlook: An Update.’’ Available athttp://www.cbo.gov.

Department of the Treasury (2007). Earnings Stripping,Transfer Pricing and U.S. Income Tax Treaties. Washing-ton: U.S. Government Printing Office.

Desai, M., C. Foley, and J. Hines (Dec. 2004). ‘‘AMultinational Perspective on Capital StructureChoice and Internal Capital Markets.’’ The Journal ofFinance, Vol. LIX (6), 2451-2487.

Dodwell, B., J. Bird, C. Buck, and P. Richards. ‘‘TaxAuthorities Review Draft Legislation on WorldwideDebt Cap.’’ Tax Notes Int’l, Feb. 16, 2009, p. 589,Doc 2009-2747, or 2009 WTD 26-1.

Doernberg, Richard L. (2008). International Taxation(8th ed.). Thomson-West.

Doupnik, T., and H. Perera (2009). International Ac-counting (2nd ed.). New York: McGraw-Hill Irwin.

European Commission (2004). ‘‘General Tax Prin-ciples.’’ Common Consolidated Corporate Tax BaseWorking Group. Available at http://ec.europa.eu/taxation_customs/resources/documents/taxation/company_tax/common_tax_base/cctbtorfinal_en.pdf.

Farrar, J., and A. Mawani (2008). ‘‘Debt-Equity Limi-tations in Thin Capitalization Rules: Canadian Evi-dence.’’ CAAA 2008 Annual Conference Paper.Available at http://ssrn.com/abstract=1080639.

Galinier-Warrain, G. (Nov./Dec. 2008). ‘‘Financing:Germany.’’ International Transfer Pricing Journal, 307-309.

Gresik, T. (2001). ‘‘The Taxing Task of Taxing Trans-nationals.’’ Journal of Economic Literature, Vol.XXXIX, 800-838.

Haufler, A., and M. Runkel (2008). ‘‘Firms’ FinancialChoice and Thin Capitalization Rules Under Corpo-rate Tax Competition.’’ CESifo Working Paper No.2429. Available at http://www.ssrn.com.

HM Revenue & Customs (Apr. 7, 2009). ‘‘WorldwideDebt Cap Current Thinking: Update Note on De-sign Changes.’’ Available at http://www.hmrc.gov.uk/drafts/090407-debt-cap-update.pdf.

HMRC (2009). ‘‘Draft Bill: Tax Treatment of Intra-Group Financing Costs and Income’’ [j0545sb (debtcap]. Available at http://www.hmrc.gov.uk/drafts/updated-reits.pdf.

Isenbergh, I. (2005). International Taxation (2nd ed.).New York: Thomson-West.

Joint Committee on Taxation (2009). ‘‘Description ofthe Revenue Provisions Contained in the President’sFiscal Year 2010 Budget Proposals. Part three: Pro-visions Related to Cross-Border Income and Invest-ments.’’ Available at http://www.jct.gov/publications.html?func=startdown&id=3578.

Jones, S. (2006). Principles of Taxation for Business andInvestment Planning: 2006. McGraw-Hill Irwin.

Kaserer, C. (Mar. 2008). ‘‘Restricting Interest Deduc-tions in Corporate Tax Systems: Its Impact on In-vestment Decisions and Capital Markets.’’ Availableat http://www.ssrn.com/abstract=1130718.

Kyte, J. (Nov./Dec. 2008). ‘‘Financing: Germany.’’ In-ternational Transfer Pricing Journal, 347-349.

Lessambo, F. (2009). Taxation of International BusinessTransactions. iUniverse: Bloomington, Indiana.

Lund, H., C. Korsgaard, and M. Albertsen (Nov./Dec.2008). ‘‘Financing: A Global Survey of ThinCapitalization and Thin Capitalization Rules in 35Selected Countries.’’ International Transfer PricingJournal, 283-284.

Mintz, J., and A. Weichenrieder (Dec. 2005). ‘‘Taxa-tion and the Financial Structure of German Out-bound FDI.’’ CESifo Working Paper No. 1612.Available at http//www.ssrn.com/abstract=875306.

Musgrave, R. (1986). Public Finance in a Democratic Soci-ety, Volume II. U.K.: Wheatsheaf Books Ltd.

Musgrave, R., and P. Musgrave (1976). Public Theory inTheory and Practice (2nd ed.). New York: McGraw-Hill Book Co.

Nadal, L. ‘‘U.S. Earnings Stripping Rules — A Loop-hole to Close?’’ Tax Notes Int’l, Sept. 1, 2008, p. 713,Doc 2008-18304, or 2008 WTD 171-1.

Nakamura, T. (Nov./Dec. 2008). ‘‘Financing: Japan.’’International Transfer Pricing Journal, 320-323.

SPECIAL REPORTS


(C) T

ax Analysts 2010. A




Nethercott, L., and A. Smith (Mar. 2006). ‘‘Thin Capi-talization Rules and the Introduction of Interna-tional Financial Reporting Standards: A NewZealand Perspective.’’ New Zealand Journal of TaxationLaw and Policy 12(1), 61-77.

Nitikman, J. (Winter 2000). ‘‘The Interaction of Cana-da’s Thin Capitalization Rule and the Canada-United States Tax Treaty.’’ The International Tax Jour-nal 26(1), 20-64.

OECD (2010).Transfer Pricing Guidelines for MultinationalEnterprises and Tax Administrations. Centre for TaxPolicy and Administration, Organization for Eco-nomic Co-Operation and Development.

Packard, D. (1995). The HP Way: How Bill Hewlett and IBuilt Our Company (1st ed.). New York: HarperCol-lins Publishers Inc.

Polombo, M. (Nov./Dec. 2008). ‘‘Financing: Italy.’’International Transfer Pricing Journal, 318-320.

Schön, W. (Sept. 2009). ‘‘International Tax Coordina-tion for a Second-Best World (Part I).’’ World TaxJournal: IFA Congress Issue.

Seida, M., and W. Wempe (2004). ‘‘Effective Tax RateChanges and Earnings Stripping Following Corpo-rate Inversion.’’ National Tax Journal 57(4), 805-828.

Smith, A. (1776). The Wealth of Nations. New York:Barnes & Noble.

Smith, A., and P. Dunmore (Oct. 2003). ‘‘NewZealand’s Thin Capitalization Rules and the Arm’sLength Principle.’’ Bulletin for International Bureau ofFiscal Documentation 57(10), 503-510.

Sporken, E. (Nov./Dec. 2008). ‘‘Financing: Nether-lands.’’ International Transfer Pricing Journal, 327-330.

Strunin, I. (2003). ‘‘Current Developments in Interna-tional Tax.’’ Corporate Business Taxation Monthly, 52-55.

Van Saparoea, A. (Jan. 2009). ‘‘Optimizing the interestDeduction Rules — A Never-Ending Story.’’ Euro-pean Taxation, 3-10.

Von Brocke, K., and E. Perez (Jan./Feb. 2009).‘‘Group Financing: From Thin Capitalization toInterest Deduction Limitation Rules.’’ InternationalTransfer Pricing Journal, 29-35. ◆

SPECIAL REPORTS


(C) T

ax Analysts 2010. A




Thin Capitalization and Interest Deduction Rules: A ...corit-academic.org/wp-content/uploads/2011/12/60TI0683-Webber.pdf · Thin Capitalization and Interest Deduction Rules: A Worldwide

Documents