Analysis of Interest Deduction Rules Under Ethiopian Corporate Tax System

Abstract

The use of third party and related party interest is one of the profit-shifting techniques available in international tax planning. The fluidity and fungibility of money make it a relatively simple exercise to adjust the mix of debt and equity in a controlled company. When the level of debt capital is much greater than the equity capital of the company thin capitalization occurs. Nowadays, thin capitalization is one of the major challenges to the corporate tax system of Ethiopia. Thin capitalization reduces government income from tax by increasing deductible interest paid or payable on the debt. To address this problem, Ethiopia has implemented tax rules restricting the deductibility of interest payments. This article aims to qualitatively examine the interest deduction rules under the Ethiopian income tax regimes through a qualitative analysis of existing literatures and laws. To this end, the analysis start unfolding the conceptual framework of interest deduction and its rules followed by an examination of interest deduction rules of Ethiopia. As the finding has revealed, the newly enacted federal income law has taken a big step in tightening the interest deduction rules through the adoption of debt-to-equity ratio and arm’s length approach to determine the maximum debt on which interest deductible. In doing so, the income tax rules of Ethiopia incorporated the indirect interest deduction rule which indirectly limits the amount interest on which is deduction is allowable. In addition to this, the withholding tax imposed on interest paid to non-resident and limit on maximum deductible interest rates are adopted as an interest deduction approach to supplement arm’s length and debt-to-equity ratio to protect tax base erosion. Despite these positive developments, the Ethiopian tax law has failed to recognize direct interest deduction rules which directly limit the maximum interest on which deduction is allowed. Nowadays, interest stripping rule is widely appreciated as the modern and most effective approach that directly restricts interest deduction. So, the failure to introduce a direct interest deduction rule is one of the major defect interest deduction rules in Ethiopia. Besides, the income tax law has failed to limit the special debt-equity ratio that applies to financial institutions. Furthermore, the tax law has failed to set a maximum deductible rate that applies to financial institutions licensed to lend in Ethiopia. To fill these gaps and ensure efficient protection of the tax base against erosion by deduction of interest payment, the researcher called for a direct interest deduction rule. Besides, the researcher called for the introduction of the debt-equity ratio that applies to a financial institution and the maximum deductible interest rate concerning the interest payment to legitimate financial institutions.