Thin Capitalization Rules Research Articles

At a cost: The real effects of thin capitalization rules

Thin capitalization rules (TCRs) aim to mitigate profit shifting by multinational corporations (MNCs) but, by raising the cost of capital for affected affiliates, can also negatively affect real investment. Exploiting unique panel data on multinational companies in 34 countries during 2006–2014, we estimate that the size of this adverse investment effect can be large, and dependent on the statutory corporate tax rate and the tightness of the safe-haven ratio. Negative investment effects are more pronounced for highly-levered firms for which TCRs are more likely to be binding.

At a Cost: The Real Effects of Thin Capitalization Rules

Thin capitalization rules (TCRs) aim to mitigate profit shifting by multinational corporations (MNCs) but, by raising the cost of capital for affected affiliates, can also negatively affect real investment. Exploiting unique panel data on multinational companies in 34 countries during 2006-2014, we estimate that the size of this adverse investment effect can be large, and dependent on the statutory corporate tax rate and the tightness of the safe-haven ratio. Negative investment effects are more pronounced for highly-levered firms for which TCRs are more likely to be binding.

Evaluation of the Earnings Stripping Rules

Member States had to have implemented the anti-earnings stripping rules by 1 January 2019. In this article these rules are evaluated from an economic and EU law perspective. The author concludes that the rules are probably not in breach of EU law because they are implemented without distinction between domestic and cross border situations. In addition there is little room to assess rules which are the result of (full) harmonization. Nevertheless some risks exist in particular with regard to the interaction between the group regimes and the earning stripping rules and the design of the standalone exception. An important drawback of the earnings stripping rules is the risk of double taxation. This could have been avoided by the EU legislator. Earnings stripping rules, EBITDA, interest, thin capitalization rules, manifest error, ATAD-Directive, Equity escape, BEPS, Minimum standard

A Tax Policy Legacy: Tim Edgar's Contributions to Tax Scholarship and Tax Legislation

Tim Edgar's passing in December 2016 dealt a severe blow to tax scholarship in Canada and globally, not to mention being a sad loss for this journal, to which he was a contributor for over three decades. Tim's books, journal articles, and book chapters spanned a wide spectrum of tax policy issues and have played a central role in helping policy makers, academics, and students understand some of the most conceptually and technically difficult areas of tax law. Tim's book on the taxation of financial arrangements, published by the Canadian Tax Foundation, is viewed by policy makers worldwide as the definitive authority on the subject, setting out a principled path to carving out the debt component of financial instruments and subjecting it to neutral accrual taxation. In a closely related area, his detailed analysis of the difficulties confronting policy makers who seek a neutral application of the goods and services tax (GST) to financial supplies is considered to be foundational work in the field, and his proposal to remove the tax from business-to-business supplies has been adopted directly in New Zealand and via an indirect mechanism in Singapore. Tim's work on the general anti-avoidance rule is cited time and again as a key treatment of the topic, while his proposal to extend thin capitalization rules to outbound investment has been adopted in Australia. Tim's comprehensive analysis of the Canadian pseudo-imputation system opens the door to a much-needed reconsideration of the system. The more challenging the subject matter, the deeper Tim investigated and methodically dissected the topic to arrive at reasoned recommendations for reform. Tim's work will continue to be read, cited, and applied in practice for many years.

The Meaning of ‘Associate’: An Analysis of the Outcomes of Commissioner of Taxation v BHP Billiton (2019)

This article will discuss the judgment of the recent Australian tax case of Commissioner of Taxation v BHP Billiton Limited (‘BHP’). Specifically, it will discuss how the case affects the meaning of the word ‘associate’ and the phrase ‘sufficiently influenced.’ It will do this by recapping the original Administrative Appeals Tribunal (‘AAT’) case of MWYS v Commissioner of Taxation which formed the basis of the appeal in BHP. It will then discuss the majority and dissenting judgements in the BHP case and how they both interpreted the meaning of ‘associate’ and ‘sufficiently influenced,’ before reconciling the ideas from both judgments, and the original AAT judgement. This paper will then aim to highlight the precedential value of BHP and how BHP may affect other areas of Australian Taxation Law, namely the Controlled Foreign Corporation rules, Thin Capitalisation Rules, and the R&D grant rules.

Counteraction to replacement of equity with borrowed capital for tax purposes: global practice

The movement of capital within an international group of companies allows not only optimizing business processes, it may also serve to reduce tax liabilities. To effectively counter this phenomenon, international initiatives are being created to coordinate the actions of countries. The aim of this study is to characterize the experience of applying the thin capitalization rules and earnings stripping rules when implementing an intragroup loan. This paper describes the tools to counter the replacement of equity with borrowed capital for tax purposes in the OECD recommendations, as well as corporate taxation practices in 151 countries in 2019-2020. The rules for regulating intra-group financing for tax purposes have been introduced by a predominant number of countries, while thin capitalization rules are more common than the limit on interest. National rules for thin capitalization and earnings stripping vary by a number of parameters, including by scope and tax implications. The greatest differences are observed in the key fixed ratio of borrowed and own capital and the nature of restrictions on the interest. The authors’ hypothesis about a high degree of convergence of national rules for regulating thin capitalization and earnings stripping rules with the recommendations of the OECD has not been fully confirmed. However, the trends of the second half of the 2010s confirmed the second hypothesis that in developed countries there is a gradual transition from thin capitalization rules to earnings stripping rules in accordance with BEPS actions.

A few remarks on Czech interest limitation rules in the context of pandemic

This contribution focuses on an economic impact of the pandemic on Czech taxpayers in the context of the rule limiting deductibility of net financial expenses and thin capitalization rule. For this purpose, a hypothesis is proposed that these rules may in fact increase the negative economic impact of the pandemic.

Substitution Across Profit-Shifting Methods and the Impact on Thin Capitalization Rules

Thin capitalization rules limit firms’ ability to deduct internal interest payments from taxable income, thereby restricting debt shifting activities of multinational firms. Since multinational firms can limit their tax liability in several ways, regulation of debt shifting may have an impact on other profit shifting methods. We therefore provide a model under which a multinational firm can shift profits out of a host country by issuing internal debt from an entity located in a tax haven and by manipulating transfer prices on internal goods and services. The focus of this paper is the analysis of regulatory incentives, (𝑖) if a multinational firm treats debt shifting and transfer pricing as substitutes or (𝑖𝑖) if the methods are not directly connected. The results provide an explanation for why hybrid thin capitalization rules are used. These insights can add to the existing literature since the results explain why hybrid rules can result in improvements in welfare if multinational firms treat methods of profit shifting as substitutes.

The Relationship Between Restrictions on the Deduction of Interest Under Canadian Law and Canadian Tax Treaties

The author analyzes the provisions of Canadian tax treaties and those of the Organisation for Economic Co-operation and Development (OECD) and United Nations (UN) model conventions to determine whether they would prevent the application of the restrictions on the deduction of interest under the Canadian Income Tax Act—namely, the thin capitalization rules and rules that deem interest to be dividends. Although the provisions of the model conventions would prevent the application of the Canadian thin capitalization rules, the provisions of Canadian tax treaties have been carefully negotiated to allow the application of those rules. The author also questions whether the provisions of the OECD and UN model conventions should be interpreted to prevent the application of thin capitalization rules, and he concludes that restrictions on the deduction of interest under domestic law should be prevented by the provisions of the model conventions only if those restrictions are discriminatory.

The Impact of Thin Capitalization Rules on Subsidiary Financing: Evidence from Belgium

In order to prevent excessive profit shifting using internal debt by multinational firms, several countries have introduced thin capitalization rules limiting the deductibility of interests on internal loans. While prior research has consistently found that firms affected by thin capitalization rules reduce their internal debt-to-equity ratio, the means through which this reduction is achieved are understudied. This paper employs a Comparative Interrupted Time Series methodology to identify the short-term effects of newly introduced thin capitalization rules on subsidiaries’ financing preferences, using a new dataset of detailed firm-level accounting data. The results indicate a reduction in internal debt and an increase in equity for affected firms, both by an increase in paid-up capital and by an increase in retained earnings. These findings about the way firms react may help lawmakers to estimate impact of future tax regulations.

The Economic Effects of EU Tax Jurisprudence

The aim of this paper is to propose a new framework to assess the impact of Court of Justice of the European Union (CJEU) jurisprudence on the construction of a European Internal Market, by considering whether the jurisprudence of the Court on corporate taxation fulfils the mandate set-out in the European Treaties for establishing such a market. It is shown that the Court’s focus upon removing discriminatory obstacles to the fundamental freedoms does not necessarily lead to a more level playing field and increased tax neutrality, an instrumental objective towards attaining a European Internal Market. In order to assess the impact of the jurisprudence of the Court upon neutrality and level playing field, the decision in Lankhorst-Hohorst, regarding the compatibility of thin capitalisation rules with free movement provisions, will be used as case study. An economic analysis demonstrates that, depending on the reaction of Member States to the ruling, tax induced differences in capital costs faced by firms operating within the European Internal Market may increase, whilst GDP and welfare may decrease. Consideration of actual legislative amendments introduced to thin capitalisation rules by Member States following Lankhorst-Hohorst, appear to indicate that it is this negative scenario which has prevailed. Results demonstrate that it is not always or necessarily the case that decisions of the CJEU will led to an increased level playing field and tax neutrality, thus contributing to the establishing of a genuine EU Internal Market. The paper considers the constitutional implications of this conclusion, and the consequent breaking of the constitutional instrumental chain.

The impact of thin‐capitalization rules on the location of multinational firms’ foreign affiliates

AbstractThis paper examines how restrictions on the tax deductibility of interest cost affect location choices of multinational corporations (MNCs). Many countries have introduced so‐called thin‐capitalization rules (TCRs) to prevent MNCs from shifting their tax base to countries with lower tax rates. As of 2012, in our sample of 172 countries, 61 countries have implemented a TCR. Using information on nearly all new foreign investments of German MNCs, we provide a number of new and interesting insights in how TCRs affect the decision of where to locate foreign entities. In particular, stricter TCRs are found to negatively affect location choices of MNCs. Our results include estimates of own‐ and cross‐elasticities of location choice and also novel results on the relative importance of tax base vs. tax rate effects. We finally provide estimates for different uncoordinated as well as coordinated policy scenarios.

Brazillian Thin Capitalization Rule and the Capital Structure of Multinationals

We investigate the existence of a causal relationship between Brazilian thin capitalization rule and multinationals' capital structure by running a difference-in-differences model and matching by propensity score algorithms. Results indicate that regulation had no significant effects on firms' capital structure. A negative coefficient might indicate that the onerous debt by Total Assets ratio is decreasing in firms (partially) owned by foreign related parties anyway, while Brazilian thin capitalization rule seems to have had no improvements on the income tax revenue on that country. This investigation contributes to the current literature in the sense that it uses micro-level data to assess a group-related policy's effect on multinational firms' capital structure in a developing country. Further studies should employ micro-level intercompany debt to assess Brazilian companies' preference for debt of this nature instead of replacing it with external funds, as theory suggests.

Assessment of the Interest Barrier Rule of Article 4 of the EU Anti-Tax Avoidance Directive for a Sample of European Firms

This study investigates the economic consequences and the effectiveness of the interest barrier rule of article 4 of the EU Anti-Tax Avoidance Directive on an EU-wide basis. The analyses performed are based on a sample of 492,977 firms from 21 EU Member States. The economic consequences of the interest barrier rule are fairly small. Without an allowance and an exemption for stand-alone firms, the findings indicate that between 13.97% and 17.29% of all EU firms will be affected by the interest barrier. This percentage decreases substantially, to between 0.51% and 0.81%, if an allowance of EUR 3 million is granted. When evaluating the effectiveness of the interest barrier, the results show that the interest barrier is effective in aligning interest deductibility with real economic activity in the vast majority of EU Member States. Moreover, it is more effective than a thin capitalization rule with a safe harbour debt-to-equity ratio. The results obtained provide valuable insights for lawmakers as to how to choose effectively among the legislative options provided by article 4 of the EU Anti-Tax Avoidance Directive.

Vliv zdanění příjmů na zadlužení nefinančních podniků

Theory supposes that corporate income taxation encourages companies to issue debt as opposed to equity finance because interests are deductible while dividends are not. In addition, international differences in tax regimes incentivize multinational firms to shift debt to optimize their taxes. Since a high debt level can have adverse consequences, we decided to find out whether taxation is one of the causes of indebtedness of the non-financial corporate sector. We used a macroeconomic approach, i.e., all the variables were constructed at the country level, and employed data for 17 EU member states for the period 2006–2014. The model for short-term indebtedness suggests that there is a relationship between corporate debt and taxation, especially between the debt-shifting incentive and the thin capitalization rule. However, the model for total indebtedness does not provide any evidence that corporate taxation influences the non-financial corporate sector debt. The firms’ debt was affected rather by macroeconomic factors.

Safe haven or earnings stripping rules: a prisoner’s dilemma?

Multinational firms use internal debt financing to shift profits from high-tax to low-tax countries. Therefore, governments restrict the deductibility of interest expenses by applying thin-capitalization rules (TCRs). TCRs fall into two main categories: safe haven rules (SHR) and earnings stripping rules (ESR). We analyze the optimal TCR choice in a two-country tax competition model. We show that unilateral replacement of SHR by ESR imposes a negative profit shifting externality on the other country. This effect can explain the recently observed switch from SHR to ESR in many countries. However, ESR may be a dominant strategy even when SHR is socially optimal, i.e., the observed policies of ESR implementation may indicate a prisoner’s dilemma.

Excessive private sector leverage and its drivers: evidence from advanced economies

ABSTRACTThe paper provides novel quantitative assessments of the gaps between actual and sustainable levels of debt for households and corporates in selected advanced economies, revealing considerable heterogeneity across sectors and countries. The accumulation of gaps is found to precede financial distress. The paper also identifies key factors that drive excessive debt, separately for households and corporates. For households, excessive leverage is found to be higher in countries with lower interest rates and higher share of working population, but importantly also in countries with rising house prices and greater uncertainty as captured by unemployment. For corporates, debt overhang is estimated to be higher in countries with lower profitability, stronger insolvency frameworks and in absence of thin capitalization rules. There is therefore scope for the use of policy to limit the build-up of household and corporate debt overhang.

Corporate Tax Changes Implementing the EU Anti-Tax Avoidance Directive (2016/1164) and Other Developments

This note discusses changes to the Corporate Income Tax Act in respect of the introduction of new tax rules for certain operating lease agreements, a new interest deduction limitation rule, amendments to the thin capitalization rule and the controlled foreign company (CFC) rule, and other amendments relating to implementation of the EU Anti-Tax Avoidance Directive (2016/1164).

Simulating Tax Minimization Strategies of Multinationals: Evaluating the Effectiveness of Changes in the United Kingdom’s Corporate Interest Deductibility Rules

One of the most significant international taxation trends has been the rise of thin capitalization rules. However, these rules are one of many legislative approaches to restricting interest deductibility, and since 2015, a new trend has emerged. Increasingly, jurisdictions across Europe and Asia are replacing their thin capitalization rules with fixed-ratio rules in accordance with the OECD BEPS Action 4 recommendation for a net interest-to-EBITDA ratio. Yet, governments are not always able to observe how multinational enterprises structure their internal affairs in response to regulatory changes. Therefore, this article presents a case study of the United Kingdom’s corporate interest deductibility rules over the past 3 decades and analyses these reforms by simulating the behavioural responses of a tax-minimizing multinational enterprise. This review and analysis both facilitate a comparison of the effectiveness of these rules in the UK context, which can inform the framing and evaluation of such regimes in other jurisdictions.

Issues of Income Classification and Sourcefor Application of International Taxation Rules- Focusing on the case of income classification of interest that was received in excess of the thin capitalization rules and royalty of patents unregistered -

Issues of Income Classification and Sourcefor Application of International Taxation Rules- Focusing on the case of income classification of interest that was received in excess of the thin capitalization rules and royalty of patents unregistered -