Can Financial Development Explain the Differences in Thin Capitalisation Rules Across Countries?
- Fiscal Policy
- KOF Bulletin
Debt shifting is a strategy applied by multinational firms to shift profits from high-tax to low-tax countries. Because interest payments on debt are generally tax deductible, while opportunity costs of equity are not, multinational firms can reduce their overall corporate tax payments by financing a related affiliate in a high-tax country with loans provided by another affiliate located in a low-tax country. Mohammed Mardan explains in a new paper why thin capitalisation rules vary across countries.
The OECD's BEPS initiative
In the aftermath of the global financial crisis, many governments had to cope with reduced tax revenues and rising debt levels. During this time, the debate about the taxation of multinational companies resurged among government commissions and the public. The public debate was kicked-off mainly by the fact that large global players such as Apple, Google, and Starbucks pay hardly any corporate income taxes. In its report “Base Erosion and Profit Shifting” (BEPS), the OECD confirms that profit shifting is a substantial issue that corrupts the integrity of the corporate income tax system. The OECD identifies debt shifting as one of the reasons why many high-tax countries have to deal with lower corporate tax revenues. One of the actions (Action 4) proposed in the OECD’s final report calls for the best practices in the design of rules to prevent base erosion through the use of interest expense.
Cross-country differences in thin capitalisation rules
The purpose of these so-called thin capitalisation rules is to limit the possibilities for multinational firms to engage in debt shifting. In practice, thin capitalisation rules vary in two ways across countries – generosity and type. The common way of introducing a thin capitalisation rule is to implement a safe haven rule, which disallows the tax deduction of interest payments to related parties if internal debt exceeds a specified debt-to-equity ratio. Table X shows that there is a clear pattern between financial development and the strictness of the thin capitalisation rule. While the least financially developed countries allow, on average, the highest deductions, this generosity declines the higher the financial development.
Moreover, recently, some countries decided to switch from a safe haven rule to an earnings-stripping rule, which restricts tax deductibility if internal interest payments exceed a certain fraction of an affiliate's earnings before interest, taxes, depreciation and amortisation (EBITDA), as an attempt to reduce multinational firms' ability to engage in tax base eroding practices. Interestingly, these switches have only been made in financially advanced countries.
Financial development and the design of thin capitalisation rules
Immediately, the question arises, which role financial development plays in explaining these patterns. Specifically, why are financially less developed countries more generous in their deduction allowances and why are financially advanced countries more eager to adopt an earnings-stripping rule?
The answer to the first question is based on the fact that financially less developed countries are characterised by a more difficult access for firms to external finance. This creates a need to use internal sources of funds to finance investment. Because the reduction of such distortions by adjusting institutions is not possible in the short run, governments of financially less developed countries may allow for more generous deduction rules for internal interest payments, in order to foster the use of internal funds and to boost investment also in the short run.
The answer to the second question is related to the main difference between an earnings-stripping rule and a safe haven rule. While the latter only restricts the amount of internal debt, the former restricts the value of internal interest payments. An earnings-stripping rule therefore curtails debt shifting more effectively but with the result that firms’ financing costs for internal debt increase with the consequence of reduced investment levels. However, because firms located in financially advanced countries have good access to external finance, the negative investment effect of a stricter thin capitalisation rule is small. Eventually, only the prevention of the erosion of the tax base matters for these countries, which can be achieved more effectively by using an earnings-stripping rule.
Mohammed Mardan (2017): external pageWhy countries differ in thin capitalization rules: The role of financial developmentcall_made, European Economic Review
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