The arm length principle and thin capitalisation

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The arm length principle and thin capitalisation Powered By Docstoc
					Lee Corrick

   A company is said to be thinly capitalised
    when its capital is made up of a much
    greater proportion of debt than equity, i.e.
    its gearing, or leverage, is too high.

   Example 1
    ◦ Company A has debt of 100 equity of 100
    ◦ Interest rate of 5% = total interest cost of 5
    ◦ Operating profit of 20
    ◦ Post interest profit of 15
   Example 2
    ◦ Company A had debt of 200, equity nil
    ◦ Interest rate of 5% - total interest of 10
    ◦ Post interest profit = 10

   Foreign exchange controls
    ◦ But this may hinder inward investment
   Withholding taxes
    ◦ Can be avoided
    ◦ If not avoided costs passed on to borrower
    ◦ May hinder inward investment and economic
   Thin capitalisation rules

   Rules to restrict the interest paid by
    subsidiaries of MNEs
   Interest can be excessive
    ◦ Too much debt
    ◦ Too high a rate of interest
   Thin capitalisation rules are about restricting
    the amount of debt.

   Risk to tax base because generally tax laws treat
    the the returns on equity capital and debt capital

   The returns to shareholders on equity investments
    are generally not deductible for the paying
    company, being distributions of profit rather than
    expenses incurred in the production of income. On
    the other hand, the returns to lenders in respect of
    debt, in the form of interest, are usually deductible
    for the paying company in calculating its taxable

   Interest
    ◦ Taxable in full, with relief for withholding taxes
    ◦ Often on accruals basis
   Dividend
    ◦ Maybe exempt
    ◦ May allow underlying relief in addition to
      withholding taxes
   For investors equity often more tax efficient
   But MNEs can arrange for receipt of interest in tax
    favoured location/form

   This can result in MNEs attempting to present what
    is in substance an equity investment in a company
    in the form of debt, and thereby to obtain more
    favourable tax treatment.

   Thin capitalisation commonly arises where a
    taxpayer is funded by a non-resident connected
    person. It can also arise where funding is provided
    to a taxpayer by a third party, usually a bank, but
    with guarantees or other forms of comfort provided
    to the lender by a non-resident connected person
    or persons (typically the non-resident parent).

   The effect of funding a company or
    companies with excessive intra-group or
    parent-guaranteed debt may lead to
    excessive interest deductions.

   It is this possibility of securing excessive
    deductions for interest, which countries thin
    capitalisation rules seek to counteract.

   Balance between attracting Foreign Direct investment and
    protecting tax base
   Interaction of thin cap rules with
    ◦ domestic withholding tax on interest and dividends
    ◦ domestic rules on deductibility of interest – sourcing rules
      E.g. UK has zero withholding on interest in most of its
        treaties and very generous rules for allowing interest
        therefore has resource intensive approach to thin cap.

   Ease (or otherwise) of administration, and compliance burden

   Arms’ length/Independent banker
   Fixed Debt/Equity Ratio
   Earnings Stripping/ Income cover
   Consolidated Group Structure
   Quasi thin-capitalisation
   PE issues
    ◦ fungibility
    ◦ tracing

   Many countries regard thin capitalisation as a
    avoidance issue
   In some instances tax administrations do not
    test how much a company could and would
    borrow if it was borrowing from a lender that
    was an independent enterprise.
   Instead a limit is set for the amount of debt
    where the interest will be deductible

   Example
   Canada's thin capitalisation rules required
    firms to limit their debt-equity ratio at 2:1
   Interest on debt in excess of 2 to 1 is not tax

   Brazil has a 2 tier approach in its thin
    capitalisation rules
   The rules enforce stricter limits on Brazilian
    companies financed by lenders in low tax
    rate territories.
   For debt from countries not defined as a
    low tax territory the ratio is a 2:1 debt to
    equity ratio
   For debt from countries defined as a low
    tax territory the ratio is 0.3:1 debt to equity

   Very resource intensive for tax payers and
   Only UK adopts this approach as its sole defence
    against thin capitalisation
   Asks what a comparable company would and could
    borrow from an independent lender who was not
    also a shareholder
   Disallows interest that exceeds the amount that
    would have been paid to third party

   Applying the arm’s length principle in thin
    capitalisation can be complex and difficult
   But it does provide parity between taxpayers
    who are part of an MNE and independent
   Some tax administrations reduce the
    compliance burden of applying the arm’s
    length principle by having safe harbours

   A fixed ratio of debt to equity or assets
   Interest on debt in excess of the ratio is disallowed
    ◦ Eg if ratio is 3:1 and equity is 100 and debt 400,
      then interest on debt of 100 would be disallowed
    ◦ May or may not be characterised as a distribution
   Need to define equity:
    ◦ Issued share capital ?
    ◦ Retained profits ?
    ◦ Revaluation reserves ?

   A fixed ratio of interest to income, interest in
    excess of the ratio is disallowed (US approach and
    also included in UK arm’s length approach)
    ◦ Eg if ratio is 3:1, income is 300 and interest is
      125. Interest is 25 is disallowed
   Advantage is that this approach is less easy to
    manipulate with bed and breakfasting
   Disadvantage seen by business as aggressive, may
    hit start-ups

   Instead of fixed ratio of debt to equity or assets for
    all companies the ratio of a subsidiary is set by
    reference to the ratio of the group of which it is a
    ◦ Eg MNE group has debt of 1000 and equity of
      1000, subsidiary has debt of 150 and equity of
      100, group ratio of 1:1 is applied to subsidiary
      and interest on debt of 50 is disallowed
   Reliability of this method depends on extent to
    which subsidiary is a homogenous sub-set of
    group as a whole.

   US has both a debt to equity and an income
    cover ratio
    ◦ Interest disallowed only if company fails both ratios
   UK, following practice of third party lenders,
    also includes 2 or more ratios
    ◦ Interest disallowed if company fails any ratio

   If too generous erosion of tax base
   If too aggressive
    ◦ May discourage foreign direct investment
    ◦ May result in taxing more than arm’s length amount
       of profits and lead to double taxation, unless arm’s
       length let out
    ◦ But if frequent recourse to arm’s length let out then
       lose benefits of administrative convenience, becomes
       resource intensive
    ◦ Another possibility for mitigating effect of thin cap
       rules is to allow carry forward or backwards of interest
       disallowed (see US observation on Article 9)

   Same ratio for all sectors?
   Different ratios?
   Financial sector, property investment
   Balance between administrative convenience
    and accuracy on a case by case basis.

   Much research is needed
   Look at interest rates in your country
   Return on capital
   Eg in UK a debt equity ratio of 3:1 would
    result in most of profits being paid away as
   Average third party ratios in different sectors
   Will anyone seriously lose out?

                     Company A

State X                                 Interest
                                      bearing debt
State Y                                   300

Interest free loan

                     Company B
                     (property 500)


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