Interest deductibility: Evaluating the advantage of earnings stripping regimes in preventing thin capitalisation

Transcription

1 Interest deductibility: Evaluating the advantage of earnings stripping regimes in preventing thin capitalisation Craig Elliffe, University of Auckland

2 The problem When a payment of interest is made cross-border income can be transferred from one jurisdiction to another A fundamental and simple tax planning technique but hardly a recent phenomenon Canada adopted thin capitalisation rules in 1972 By 2004 more than 50% of 54 selected countries had adopted explicit thin capitalisation regimes In 2008 an IFA review identified the following trends: The thin capitalisation rules applied to all debt Fell into two main categories- limiting deductions to a percentage of a profit related figure (such as EBIT), or based on the financing of assets held by the borrower

3 The Solution? Recommendation for a best practice An optional de minimus monetary threshold to remove smaller, low risk entities; and A fixed ratio rule, which allows an entity to deduct net interest expense up to a benchmark net interest/ebitda ratio. It is suggested that the appropriate benchmark ratio falls within the corridor of 10 % to 30 %; and An optional group ratio rule, which allows an entity to deduct net interest expense up to its group s net interest/ebitda ratio, where this is higher than the previously referred to benchmark fixed ratio. A country can also provide an uplift of up to 10 % to this group s net third-party interest expense; and An optional rule which allows for the carry forward of disallowed interest expense (unused interest capacity) and/or the carryback of disallowed interest; and Targeted rules to support the general interest limitation rules and to address specific risks; and Specific rules to address issues raised by the banking and insurance sectors.

4 Is it Mandatory? Final Base Erosion and Profit Shifting package released by the OECD has four minimum standards which it expects to be adopted: (Action 5), preventing treaty abuse (Action 6), transfer pricing documentation (Action 13) and improving dispute resolution (Action 14). Mr Rob Heferen But it was quite clear in saying that countries, for their own specific reasons, may decide to continue with the debt-to-asset treatment, which Australia has, and indeed also an arm s-length. The majority of the OECD members are European. The secretariat is heavily European based. So they look at it through a German and French perspective, because the British come in and go out and ignore it anyway, and the Americans do not participate We still have to go through the process of making sure that our rules do not allow companies to have quite a departure from the base of 30 per cent EBITDA under reasonable assumptions. in limited cases, a country may apply a fixed ratio rule based on asset values rather than earnings Action Final Report, at [23].

5 Assessing the alternatives The single most important tax base issue in determining New Zealand's share of the taxes payable on income earned on FDI is the method of financing employed by the parent company of the New Zealand operations (New Zealand's taxation framework for inbound investment) Evaluate the thin capitalisation proposed changes in the light of the key principle of the TWG of Tax working group principle Net interest/ebitda ratio Assets-based regime Efficiency and growth (How various taxes affect key economic and social variables such as employment, investment, savings, productivity, growth and international competitiveness) Not the method itself which is important but the ratio- The balance is between increasing fiscal gain against driving up the cost of capital and decreasing FDI Would an EBITDA adversely affect operating lease arrangements but give a preference to the assets intensive purchase or finance lease arrangements? Equity and fairness (Examining the fairness of the system-are certain taxpayers and industries advantaged) EBITDA method can overcome problems with asset valuation (situations where the same asset has a significantly different value in different groups because of timing of acquisition or other activities) Heavily capitalised groups that have tangible fixed assets with long depreciation periods may be advantaged by an EBITDA measurement. An EBITDA method may adversely affect industries that are very volatile in their earnings.

6 Assessing the alternatives Tax working group principle Net interest/ebitda ratio Assets-based regime Revenue integrity (The tax system should be sustainable and minimise opportunities for tax avoidance and arbitrage) Positive The connection between earnings and interest expense is seen as much more direct. More robust against planning?* Deals positively with the problem of highpriced debt because the amount of net interest is measured in absolute terms against earnings. The OECD suggest that the level of debt may vary throughout the period and be manipulated? New Zealand has targeted anti-avoidance rules as well as a robust GAAR. Compliance and administration costs (The tax system should be as simple and low cost as is possible for taxpayers to comply and Inland Revenue to administer) Negative EBITDA method is likely to be complex and expensive to administer particularly when dealing with issues such as loss and unused capacity brought forward rules.# Positive In general asset values are more stable leading to a relatively steady and predictable limit on interest relief. Low cost. Measured by GAAP.

7 Is EBITDA an accurate measure of profit and cash flow?* If Generally Accepted Accounting Principles are the hallmark of transparency and consistency in financial reporting, then EBITDA is the funhouse Hall of Mirrors. Because EBITDA is essentially a tool that shows what a company would look like if it wasn t actually that company ( Let s see what this tax-paying, debt-ridden, asset-heavy company looks like without any debt, without tax burden, without assets and with no working capital needs!, it is easily manipulated. (Forbes Magazine) EBITDA can easily be manipulated through aggressive accounting policies relating to revenue and expense recognition, asset write downs and concomitant adjustments to depreciation schedules, excessive adjustments in deriving adjusted pro forma EBITDA, and by the timing of certain ordinary course asset sales. (Moody s Investor Service-Global Credit Research)

8 What are loss and unused capacity brought forward rules?# Year EBITDA ($M) Net interest expense 30% of EBITDA In this situation the rules would allow for a carry forward of unused capacity $0.3 million from 2007 but a disallowance of $1.2 million in 2009 and $0.9 million in This results in a disallowance of $0.9 million net interest in 2009 and 2010 respectively. The recording of these carry forward provisions would necessitate compliance obligations and presumably the monitoring of shareholder continuity or other loss carry forward requirements. The current position, at least in New Zealand, is that disallowed interest expenditure arising from the asset-based interest limitation rules, is not carried forward.

9 Assessing the alternatives Tax working group principle Net interest/ebitda ratio Assets-based regime Coherence (Does the reform make sense in the context of the overall tax system?) Positive Cross-border harmonisation will reduce the possibility of double taxation and tackle profit shifting Australia is New Zealand's largest inbound investor and their approach to this issue is very important In summary the EBITDA regime seems to offer a solution to the problem which transfer pricing is struggling to fix (high-priced or high yielding debt). The EBITDA proposals will result in significant complexity and cost Whose international tax system should we harmonise with?

10 Dealing with high-priced debt? Can we introduce a currency related interest rate ceiling? Published on a regular basis such as prescribed rates. For lending transactions the maximum deductible interest rates for New Zealand borrowers may be (illustratively) as follows: New Zealand dollars, 5 per cent; Australian dollars, 4 per cent; US dollars, 2.5 per cent. Probably essential to provide an arm'slength override if the taxpayer can prove that a higher than ceiling rate is appropriate.