Corporate 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. avoidance has become a serious area of focus for the OECD. In 2013, the organization started the Base Erosion and Profit Shifting (BEPS) initiative, advising countries to adopt policies to prevent shifting of pre-tax corporate income to low-tax jurisdictions. Most countries have had regulations to prevent earnings stripping for decades, but it has only become a pressing policy issue in recent years.
There are many ways corporations are able to legally shift income to decrease their overall tax burden. One such method that the OECD believes is a significant source of avoidance is the ability to deduct interest from pre-tax income in a high-tax country and pay the interest to a subsidiary in a low-tax country. In order to prevent interest stripping, countries have adopted different interest deduction limitations – rules that deal with the way a firm is financed, putting restrictions on interest payments. There are three approaches to interest deductibility rules that the OECD countries have implemented:
1. Arm’s Length Principle
All countries in the OECD apply this principle to any related-party transactions. A transaction performed at an arm’s length is a transaction between two affiliated companies where the seller receives a market price for the service it provides, as if the buyer is not related to the seller. Firms have an incentive to overstate their deductible expenses in high-tax countries to transfer them over to low-tax countries. Interest rates are, in a way, prices as well. Therefore, some countries extend the arm’s length principle to interest and scrutinize debt payments between affiliated companies to make sure the interest charged is within the range of what a third party, like a bank, would charge.
2. Debt-Equity Ratio
The arm’s length principle requires a lot of auditing and scrutiny by a third party. A simpler approach is to use a debt-to-equity ratio threshold to limit interest deductibility instead. For example, a country may limit a company’s foreign debt-to-equity ratio at 4:1, and anything past that ratio will be taxed. Therefore, a company that takes on too much debt would not be able to deduct as much interest as it otherwise would have.
The problem with this regulation is clear: these ratios are quite arbitrary and may distort economic activity, as some industries tend to take on more debt than others due to the nature of their work. It comes with an advantage, however – companies know exactly what is expected of them to make sure their interest payments are deductible. Administrative costs of scrutiny are much lower as well.
3. Earnings Stripping Approach
In the last eight years, some European countries have abolished the debt-equity rules and have transitioned over to a new system – the earnings stripping approach. This policy targets interest expensing overall, limiting it as a certain percentage of pre-tax operating income (EBITDA). Suppose the expense is capped at 30% of EBITDA. A company with the pre-tax income of $1,000 would only be able to deduct $300 for interest from that income, as anything above $300 would be subject to tax.
It is clear why the rule is called the way it is, as it is putting a cap on the amount of money that can be deducted from pre-tax income, thus targeting the correct transaction. However, this regulation tends to take into account all debt payments, including bank loans or corporate bonds. As a result, this rule may be the most economically distortive of the three.
Each method has its own advantages and disadvantages. As we can see above, the OECD as a whole has not settled on a single rule, as the 35 countries in the organization are almost perfectly split among the three. Some countries combine two of the three – mostly as a transition period towards the earnings stripping approach, giving businesses flexibility and a smooth transition. The earnings stripping approach is a new concept and may be implemented by more countries in the future, but even this regulation is by no means perfect.
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