Thin Capitalisation

Generally, thin capitalisation refers to the heavy use of debt, rather than equity, as a source of finance. Companies that are thinly capitalised (that is, with a low proportion of equity finance) are also known as highly leveraged or highly geared. In the context of cross- border tax avoidance, thin capitalisation can be viewed as shifting debts to subsidiaries located in high-tax countries (such as Australia) so that a high level of tax deduction for interest expense can be claimed, resulting in subsidiaries in high-tax countries being highly geared. The following example illustrates how thin capitalisation facilitates cross- border tax avoidance.

Suppose an MNE based in Country C establishes a subsidiary operating in Country B to distribute the products manufactured by the MNE. Country C has a corporate tax rate of 20%, whereas Country B has a corporate tax rate of 40%. The subsidiary is financed by $1 million equity capital and $4 million debt capital at an interest rate of 10% per annum, both from the MNE based in Country C. Thus, the interest expense incurred is $0.4 million ($4 million × 10%), which can be translated into $0.16 million ($0.4 million × 40%) tax savings for the subsidiary, compared with that if the $4 million is equity capital. From the perspective of the parent company, the interest revenue of $0.4 million only attracts $0.08 million ($0.4 million × 20%) additional tax liability. At the aggregate level, the MNE group achieves a tax saving of $0.08 million ($0.16 million − $0.08 million).

Evidence on thin capitalisation for international tax avoidance

Prior studies have documented MNEs’ use of thin capitalisation for tax avoidance. For instance, Mills and Newberry (2004) examine the influence of tax rates on the tax reporting behaviour of U.S. subsidiaries of foreign MNEs. They find that, for foreign MNEs with relatively low average foreign tax rates (the U.S. tax rate is relatively high), their U.S. subsidiaries report lower taxable income, and have higher leverage ratios and higher interest expense to sales ratios. Mills and Newberry (2004) conclude that the income reporting strategies of the U.S. subsidiaries of foreign MNEs, as reflected in their U.S. debt policies, are tax-motivated.

Turning the angle to foreign subsidiaries of U.S. MNEs, Desai, Foley and Hines (2004) document a positive relation between leverage levels and local tax rates for foreign subsidiaries: 10% higher local tax rates are associated with 2.8% higher leverage ratios. Moreover, Huizinga, Laeven and Nicodeme (2008) develop a model of MNEs’ optimal debt policies that considers international taxation factors. Based on a sample of 32 European countries during the period 1994 to 2003, and using firm-level data on the financial structures of standalone domestic firms and MNEs, Huizinga, Laeven and Nicodeme (2008) show that the capital structure of a foreign subsidiary of an MNE is affected by both the local tax rate and the tax rate differential across the countries in which the parent company and other foreign subsidiaries operate. For example, for an MNE with two subsidiaries in two countries, a 10% overall tax rate increase in one country would result in 2.4% increase in the leverage ratio in that country, yet a 0.6% decrease in the leverage ratio in the other country (Huizinga, Laeven & Nicodeme 2008).85 In contrast, for standalone domestic firms, a 10% increase in the overall tax rate would lead to 1.8% increase in the leverage ratio.

Tackling thin capitalisation

To deter the tax base erosion at the national level caused by thin capitalisation, in 1987, the OECD released a report that provided policy recommendations on domestic thin capitalisation rules. Since then, an increasing number of countries have introduced thin capitalisation rules to limit the amount of interest expenses that can be claimed as tax deductions by companies. In the OECD’s (2012) draft titled ‘Thin Capitalisation Legislation: A Background Paper for Country Tax Administrations’, the organisation recognises two primary approaches by which thin capitalisation rules in various countries normally operate: (1) determining a maximum amount of debt on which interest payments can be claimed as tax deductions, and (2) determining a maximum amount of interest that is deductible by referring to interest ratios, such as interest to operating profit or cash flow.

Under the first approach (determining the maximum amount of debt), interest on the excessive debt (debt above the determined maximum amount of debt or debt limit) is not deductible for tax purposes. Generally, there are two ways to determine the debt limit: the arm’s length approach and ratio approach. The arm’s length approach determines the debt limit as the amount of debt that an independent lender would be willing to lend to the

85 _{In Huizinga, Laeven and Nicodeme (2008), the overall tax rate captures both corporate income taxes and}

specified company, considering the specific company’s circumstances. However, because it is based on an understanding of the independent lender’s decision-making process, substantial resources and skills are required. Under the ratio approach, the debt limit is determined by a pre-set ratio, such as a debt-to-equity ratio of 3:1. This approach is simple to implement and provides certainty and confidence to companies with regard to the level of debt that will not be challenged by tax authorities. However, since the predetermined ratio is one-size-fits-all, specific market conditions or industry-wide characteristics are overlooked. Buettner et al. (2012) notice that, during the 10-year period from 1996 to 2005, OECD countries with thin capitalisation rules or alike employed the ratio approach.

The second approach of formulating thin capitalisation rules (determining maximum amount of interest, rather than debt) is sometimes referred to as the ‘earnings stripping’ approach. Germany and Italy generally limit the interest deduction at 30% of earnings before interest, tax, depreciation and amortisation (EBITDA).86

Thin capitalisation rules have been suggested to be effective in shaping MNEs’ capital structures. Take two examples from the U.S. and Germany for illustration. Blouin et al. (2014) investigate the effect of thin capitalisation rules on the capital structures of U.S. MNE’s foreign affiliates over the period 1982 to 2004. They report that the debt-to-asset ratio limitation reduce the ratio by 1.9% on average, and the restrictions on an affiliate’s borrowing from the parent-to-equity ratio reduce the ratio by 6.3% (Blouin et al. 2014). Buettner et al. (2012) examine the capital structures of subsidiaries of all German MNEs in 36 countries during the period 1996 to 2004. They find that thin capitalisation rules effectively reduce the use of internal debt for tax avoidance, yet encourage greater use of external debt. Stated in a quantitative way, if a host country with a tax rate of 34% (the sample average) disallowed interest deduction for debt above the debt-to-equity ratio of 2:1, the internal debt ratio would be reduced by 12% or 24%, depending on the specific definition of thin capitalisation rule (Buettner et al. 2012).

Thin capitalisation in Australia

As with transfer pricing, Australia has legislated thin capitalisation rules to deal with the highly geared structures adopted by companies for tax avoidance. The current rules, contained in Division 820 ITAA 97, apply from the income year commencing on 1 July

86 _{Germany amended its thin capitalisation rules to impose a special interest limitation rule that took effect}

2001 for Australian inward-investing entities, as well as outward-investing entities, on their total debt.87 An inward-investing entity is an Australian entity that is controlled by a foreign entity. An outward-investing entity is an Australian entity controlling a foreign entity, with business performed through a foreign branch. Note that the thin capitalisation rules are different among general entities, financial entities and authorised deposit-taking institutions. The rules pertaining to general entities are described below.

The Australian thin capitalisation rules impose a debt limit (maximum allowable debt) above which tax deductions for interest incurred on exceeded level of debt are disallowed. The debt limit is determined by the type of the entity and by referring to one of the three measures:

1. the safe harbour debt amount: debt-to-asset ratio of 3:4, or debt-to-equity ratio of 3:1

2. the arm’s length debt amount: the debt amount that an independent entity with the same operations in Australia would bear

3. the worldwide gearing debt amount: no more than 120% of the gearing of an outward-investing entity’s worldwide controlled investments.

Specifically, for outward-investing entities, the debt limit is the greatest of the safe harbour debt amount, the arm’s length debt amount, and the worldwide gearing debt amount; for inward-investing entities, the limit is the greater of the safe harbour debt amount and the arm’s length debt amount.

In 2014, Australia tightened its thin capitalisation rules by reducing the debt limit from a debt-to-equity ratio of 3:1 to 1.5:1, and making available the worldwide gearing ratio to inbound investors, while reducing the ratio from 120% to 100%. The rules have not been amended further, despite the release of the BEPS Project (Action 4 Interest Deductions, 2015 Final Report) by the OECD in 2015 which suggests a fixed ratio approach to replace the previous thin capitalisation rules. Under the recommended approach, interest payments would not be deductible for tax purposes if the ratio of net interest expense to EBITDA exceeded a certain threshold in the range of 10% to 30% (OECD 2015).

As with intra-group transfer pricing, using thin capitalisation to claim more tax deductions for interest expenses incurred in Australia, and thereby shifting profits out of

87 _{Amendments to the rules have taken effect from 1 July 2014. However, since the sample year is 2012}

Australia, may be perceived differently by FOACs and DOLACs. Given the relatively high corporate tax rate in Australia and the restriction to claim the franking credit tax offset by foreign shareholders, FOACs have strong incentives to claim substantial interest expenses to reduce their tax liabilities in Australia. In contrast, DOLACs have fewer incentives to adopt highly geared structures to claim substantial interest expenses to shift profits from Australia to foreign low-tax countries, because reducing Australian tax may not provide any real cost savings, yet impedes the company’s ability to distribute franked dividends. As discussed in Chapter 3, a number of Australian studies observe declines in the leverage ratios of listed companies after the introduction of the dividend imputation system in Australia (e.g. Twite 2001).

DOLACs’ consolidated financial reports only reflect the results of transactions with external parties, yet not the results of any internal debt shifting (except for the resultant tax expenses). Thus, DOLACs serve as a benchmark for the levels of debt and interest expense that Australian companies normally have. Therefore, comparing FOACs with DOLACs in terms of their interest expenses and leverage ratios can infer the use of thin capitalisation by FOACs to shift profits out of Australia.

Following the discussion above, this study hypothesises that FOACs employ thin capitalisation to increase their tax deductions for interest expenses, which is most likely manifested in higher interest expense to sales revenue ratios and higher leverage ratios in comparison with those of DOLACs. The level of interest expense and level of debt, as relative measures, are suggested and used by countries to formulate thin capitalisation rules. Thus, the following two hypotheses are developed:

Hypothesis 6.2A: FOACs have higher interest expense to sales revenue ratios than do comparable DOLACs.

Hypothesis 6.2B: FOACs have higher leverage ratios (long-term borrowings to total assets) than do comparable DOLACs.88

88 _{Short-term borrowings are not included in the leverage calculation. Thin capitalisation is mostly achieved}

by intra-group debts. However, intra-group debts are not separately disclosed in financial reports. Short- term borrowings may include genuine third-party accounts payable, loans payable and tax payable, which means they contain more noise than long-term borrowings with respect to capturing intra-group debts.