Multinationals that raise debt in high-tax countries in order to reduce their overall tax burden have been targeted over the last several decades or so by thin capitalization rules that limited tax deductibility if the debt ration exceeded a certain number.
Now, academics from Wharton, CEPR and Solvay Business School have published a study indicating that these rules are only effective at limiting interest deductions and therefore boosting tax if they are applied automatically, without government discretion.
The paper, “Thin capitalization rules and corporate leverage,” authored by Jennifer Blouin, Harry Huizinga, Luc Laeven and Gaëtan Nicodème, looked at 54 countries between 1982 and 2004. As of the end of that period, 27 countries had enacted a thin capitalization regime that restricted interest deductibility if a debt ratio exceeded a certain limit.
Sixteen countries restricted interest deductibility if the total debt-to-equity ratio exceeded a certain numerical value. For example, the UK maintained a maximum total debt-to-equity ratio of one. Another 11 countries restricted the ratio of internal debt-to-equity, where internal debt means debt to the parent firm or another related party. Germany, for instance, had a maximum ratio of internal debt-to-equity of 1.5.
The group found that many of the rules did have the desired effect. “Thin capitalization rules that instead limit the internal debt-to-equity ratio on average reduce this leverage ratio by 6.3 percent, while the decline is larger if the maximum allowed debt ratio is lower.” However, automatic rules are much more effective. “A thin capitalization rule reduces the total debt-to-assets ratio by an average of 2.8 percent if it is automatically applied, but only by 1.1 percent if it is applied with discretion.”
The authors speculate that this is because tax authorities find it too burdensome to enforce the rules if they are not automatic.