When implementing low-cap rules, whether to limit base erosion or limit debt bias, governments should recognize these trade-offs. As the OECD has noted, “interest rate restrictions must therefore be implemented carefully, in a consultative manner that balances national considerations with the benefits that investors bring.” Thin capitalization rules determine the amount of interest paid on corporate debt that is tax deductible. Such rules are of interest to private equity firms that use large amounts of debt to finance buybacks over debt and in the context of strategic acquisitions where the buyer wants to push the debt to more taxed countries with significant pre-tax income.  Our findings suggest that such rules would only be effective if they were applied automatically when the maximum leverage ratio was reached. If, on the contrary, discretion is built into a thin-funded common system, it may seem that tax policymakers have succeeded with seemingly coordinated policies – but in reality, multinational corporations would continue to benefit from interest deductions, thereby reducing tax revenues. The effectiveness of thin capitalization rules depends largely on their automatic or discretionary application. A thin capitalization rule reduces the total debt-to-wealth ratio by an average of 2.8% when applied automatically, but only by 1.1% when applied with discretion. The possibility of discretion reduces the effectiveness of thin-cap rules, perhaps because tax authorities consider it too cumbersome to apply thin-cap rules that are not automatic. In 2004, 27 countries – exactly half of the countries we cover in our analysis – introduced a thin funding regime that limited interest deductibility when a debt ratio exceeded a certain limit. Two main categories of thin capitalization rules can be distinguished. First, 16 countries restricted interest deductibility when the total debt ratio exceeded a certain numerical value. The United Kingdom, for example, maintained a maximum total debt ratio of one.
Alternatively, 11 countries have limited the ratio of internal debt to equity, where internal debt means debt to the parent company or other related party. Germany, for example, had a maximum internal debt ratio of 1.5. Ireland is the only country covered on this map without formal thin capitalization rules. Confused about international tax proposals and rules like GILTI? Check out our latest research and analysis with our helpful guide. This article is part of a series on the economic impact of tax policies to combat profit erosion and profit shifting (BEPS). The series includes a total of seven articles focusing on CFC rules, patent box link rules, thin capitalization rules, transfer pricing rules, and country-by-country reports. Thin capitalization rules that instead limit the internal debt ratio reduce this debt ratio by an average of 6.3%, while the decline is greater when the maximum allowable debt ratio is lower. The sensitivity of affiliates` internal debt ratio to thin capitalization rules may suggest that multinational corporations can easily replace internal debt with internal equity if the tax advantage of internal debt is reduced due to a thin capitalization rule.3 This also suggests that thin capitalization rules can be effective tools to facilitate tax planning activities through Bias of the To counter the use of internal debt. In the latter case, the debt above the maximum allowable ratio triggers an investigation by the tax administration to determine whether the debt is indeed considered excessive (leading to a reduction in the deductibility of interest), taking into account the leverage effect of other comparable companies.
Only 17 countries automatically applied their thin capitalization rule, while 10 countries were able to exercise some discretion in applying their thin capitalization rule. A 2014 study by Thiess Büttner, Michael Overesch and Georg Wamser, published in International Tax and Public Finance, empirically estimates the economic impact of thin-cap rules by analyzing all foreign subsidiaries of German multinationals. Their results show that low-capitalization rules increase the cost of capital and therefore have a negative impact on the employment and investment of affected companies, especially in high-tax host countries. In particular, foreign direct investment is about twice as sensitive to a country`s tax rate when a debt ratio of 3:1 is introduced (compared to a scenario without thin capitalization rules). In general, most common law countries tend not to apply thin capitalization rules when raising and maintaining capital. However, a number of civil courts do so. A company is considered low capitalized if the amount of its debt is much higher than its equity, that is, its leverage or leverage ratio is very high. The debt financing of a company is sometimes expressed as a ratio. For example, a debt-to-equity ratio of 1.5:1 means that for every $1 of equity, the company has a debt of $1.5. It should be noted that thin capitalization rules have a significant impact on affiliate leverage.
However, their effectiveness is severely limited if tax authorities can, at their own discretion, take into account information about leverage in other companies when applying it, instead of automatically applying the rules. International tax policymakers should take note of this finding when discussing the optimal design of thinly funded plans within the OECD framework. Another 2014 study by Jennifer Blouin, Harry Huizinga, Luc Laeven and Gaetan Nicodeme, published as an IMF working paper, analyzes how foreign affiliates of US multinationals are affected by thin-cap rules that use BEA data. The authors show that thin capitalization rules for borrowing with related parties reduce an affiliate`s debt ratio. In addition, their results show that thin capitalization rules reduce the aggregate accounting of a company`s interest costs, but also decrease a company`s market value. Blouin, J., H. Huizinga, L. Laeven and G. Nicodème, (2013), “Thin capitalization rules and multinational firm capital structure”, CEPR DP 9830. Buettner, T., M. Overesch, U.
Schreiber, U. und G. Wamser, (2012), “The impact of thin-capitalization rules on the capital structure of multinational firms,” Journal of Public Economics 96, 930-938. In Belgium, where our company is headquartered, both rules apply. For intra-group loans, a leverage ratio of 5:1 applies and interest deductions are limited to the higher value of €3 million or 30% of EBITDA (earnings before interest, taxes, depreciation and amortization). Let us say that our company has taken out a loan of 100 million euros from its Irish subsidiary. Current equity amounts to €10 million and there are no outstanding loans, resulting in a leverage ratio of 10:1. The annual interest on the loan is 5% or 5 million euros. Since the company`s debt ratio is greater than 5:1, the safe harbor rule applies. Since the ratio is twice as high as the limit, only half of the interest is deductible; in our example, €2.5 million (which is below the profit stripping limit of €3 million). Some tax authorities limit the applicability of thin capitalization rules to groups of companies with foreign companies in order to avoid “base erosion and profit shifting” [circular reference] to other jurisdictions. The U.S.
“profit stripping” rules are an example of this. Hong Kong protects tax revenues by prohibiting payers from claiming tax deductions on interest paid to foreign companies, ruling out the possibility of using small capitalization to transfer income to a country with lower taxes.  However, small-cap rules not only limit the transfer of international debt, but can also have an impact on real economic activity. Traditional corporate tax systems allow tax deductions on interest payments, but not on the cost of equity, thus favouring debt over equity financing. This is called debt bias. By capping deductible interest, thin cap rules eliminate the preference for debt over equity above a certain threshold. For some companies, this reduces the optimal leverage ratio and increases the proportion of equity financing. However, since equity is not tax deductible, thin-cap rules actually increase the cost of capital for some businesses, which can hinder investment. .