To expand and make new investments domestically and in foreign markets, multinational corporations often take external loans or lend money within their global corporate structures. However, in some cases, such structures can also be used to decrease worldwide taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. liability. Thin-capitalization rules (henceforth thin-cap rules) are made to prevent businesses from using debt financing or international debt shifting for tax planning reasons.
For the case of international debt shifting, imagine a business headquartered in Belgium, with a subsidiary in Ireland. The Belgium headquarters takes a loan from its Irish subsidiary, and thus pays interest payments to its Irish subsidiary. Payments on loans and bonds are tax-deductible against profits, lowering the taxable profits. As Belgium has a comparably high combined corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. rate of 29.6 percent, this results in a significantly lower tax bill.
At the same time, the Irish subsidiary will receive interest payments from the Belgium headquarters, inflating its profits. However, these profits are taxed at the lower Irish tax rate of 12.5 percent. Because the tax saving in Belgium exceeds the increased tax liability in Ireland, the business faces globally a lower tax bill.
To prevent such international debt shifting, countries have implemented thin-cap rules. The two most common types used in practice are “safe harbor rules” and “earnings stripping rules.” Safe harbor rules restrict the amount of debt for which interest is tax-deductible by defining a debt-to-equity ratio. Interest paid on debt exceeding this set ratio is not tax-deductible. Most countries only include internal debt in this ratio; some countries also include external debt. Earnings stripping rules limit the ratio of debt interest to pretax earnings and have emerged more recently.
Belgium, where our company’s headquarters is located, has both rules in place. A 5:1 debt-to-equity ratio applies to intragroup loans, and interest deductions are limited to the higher of €3 million or 30 percent of EBITDA (Earnings Before Interest, Taxes, DepreciationDepreciation is a measurement of the “useful life” of a business asset, such as machinery or a factory, to determine the multiyear period over which the cost of that asset can be deducted from taxable income. Instead of allowing businesses to deduct the cost of investments immediately (i.e., full expensing), depreciation requires deductions to be taken over time, reducing their value and discouraging investment. and Amortization). Let’s say our business has taken a €100 million loan from its Irish subsidiary. Its current equity amounts to €10 million and there are no outstanding loans, resulting in a debt-to-equity ratio of 10:1. The annual interest on the loan is 5 percent, or €5 million. As the company’s debt-to-equity ratio is above 5:1, the safe harbor rule applies. Because the ratio is twice the limit, only half of the interest is deductible; in our example, €2.5 million (which is below the earnings stripping limit of €3 million).
The debate around taxation of multinational companies and international tax ruleInternational tax rules apply to income companies earn from their overseas operations and sales. Tax treaties between countries determine which country collects tax revenue, and anti-avoidance rules are put in place to limit gaps companies use to minimize their global tax burden. s in general has drawn new attention to thin-cap rules. OECD’s Base Erosion and Profit Shifting (BEPS) Action Plan, specifically Action 4, addresses the issue of base erosion through interest deductions and other financial payments. In its 2015 Final Report on Action 4, the OECD recommends the earnings stripping rule as the best practice measure to limit interest deductions. Specifically, the OECD recommends setting the limit for interest deductions at a ratio between 10 percent and 30 percent of EBITDA. This range is provided “to ensure that countries apply a fixed ratio low enough to tackle BEPS, while recognizing that not all countries are in the same position.” As of April 2019, 17 out of the 36 OECD countries’ thin-cap rules have similar features as the OECD’s recommended earnings stripping measure.
Thin-cap rules, however, not only limit international debt shifting but can also impact real economic activity. Traditional corporate income tax systems allow tax deductionA tax deduction is a provision that reduces taxable income. A standard deduction is a single deduction at a fixed amount. Itemized deductions are popular among higher-income taxpayers who often have significant deductible expenses, such as state/local taxes paid, mortgage interest, and charitable contributions. s of interest payments but not of equity costs, effectively favoring debt over equity finance. This is the so-called debt bias. By capping deductible interest, thin-cap rules eliminate the preferential treatment of debt over equity above a certain threshold. For some businesses, this decreases the optimal debt-to-equity ratio and increases the share of equity finance. But because equity is not tax-deductible thin-cap rules effectively increase the cost of capital for some firms, which can impede investment.
A 2014 study by Thiess Buettner, Michael Overesch, and Georg Wamser published in International Tax and Public Finance empirically estimates the economic effects of thin-cap rules by analyzing all foreign subsidiaries of German multinational businesses. Their results show that thin-cap rules increase the cost of capital and thus have negative effects on employment and investment for affected businesses, especially in high-tax host countries. Specifically, foreign direct investment is about twice as sensitive to a country’s tax rate if a 3:1 debt-to-equity ratio is implemented (compared to a scenario without thin-cap rules).
Another 2014 study, by Jennifer Blouin, Harry Huizinga, Luc Laeven, and Gaetan Nicodeme, published as an IMF Working Paper, analyzes how foreign affiliates of U.S. multinationals are affected by thin-cap rules using BEA data. The authors show that thin-cap rules on related-party borrowing reduce an affiliate’s debt ratio. Additionally, their results show that thin-cap rules decrease a firm’s aggregate interest expense bill but also lower the market value of a firm.
A 2017 study by Ruud De Mooij and Shafik Hebous, also published as an IMF Working Paper, analyzes how thin-cap rules impact corporations’ consolidated debt ratios (intracompany transactions are excluded) and how they mitigate corporate default risk. Excessive consolidated debt levels reflect excessive risk-taking and are seen as a risk to macroeconomic stability. Their findings show that thin-cap rules limited to intracompany debt have no significant impact on a firm’s consolidated debt ratio because they don’t affect external borrowing of corporate groups. If applied to all debt, thin-cap rules reduce the consolidated debt-asset ratio by five percentage-points and the probability of a firm being in financial distress by 5 percent. Their findings imply that if countries want to address the debt bias with their thin-cap rules, they should not limit the rules to related-party debt but include all debt.
As these studies show, thin-cap rules can have various adverse economic effects, such as less investment, decreased employment, and lower market values of firms. When designing thin-cap rules, countries are therefore facing a trade-off between adverse economic effects and limiting base erosion.
At the same time, depending on the design of the rules, they might also decrease the debt bias. If thin-cap rules are introduced to reduce the debt bias, however, measures that incentivize equity financing, such as allowances for corporate equity, can also be effective (see De Mooij and Devereux).
When implementing thin-cap rules, whether it is to restrict base erosion or to limit the debt bias, governments should recognize these trade-offs. As the OECD has stated, “Limitations on interest therefore need to be implemented carefully, in a consultative way that balances domestic considerations with the benefits that investors bring.”
This post is part of a series about the economic impact of tax policies addressing base erosion and profit shifting (BEPS). The series includes a total of seven posts focusing on CFC rules, patent boxA patent box—also referred to as intellectual property (IP) regime—taxes business income earned from IP at a rate below the statutory corporate income tax rate, aiming to encourage local research and development. Many patent boxes around the world have undergone substantial reforms due to profit shifting concerns. nexus rules, thin-capitalization rules, transfer pricing rules, and country-by-country-reporting.
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