handbook-tb

Peter A. Barnesspecial focus on the challenges faced by tax administrators in developingcountries. As discussed more fully below, developing countriesface many of the same challenges with respect to interest paymentsas developed countries, albeit with fewer resources to audit taxpayersand enforce the laws, and a greater need to attract investment capital.Accordingly, developing countries may choose to adopt more brightlinerules with respect to the tax treatment of interest payments thandeveloped countries, where often complex and overlapping limitationsand exceptions apply.1. Background1.1 Debt and equityIntuitively, taxpayers and tax administrators know what is meant bythe terms “debt” and “equity”:‣ ¾ A debt instrument, classically a loan (from a bank, for instance)or a bond (issued by a government or corporate borrower), entitlesthe holder to receive a fixed, periodic return, typically calledinterest. The holder does not have an ownership interest in theborrower, so the holder does not share in profits of the borrower.But, for the same reason, the holder ranks ahead of the ownersof the borrower in the event of a default or bankruptcy;‣ ¾ Equity, in whatever form issued, represents an ownership interestin the underlying entity.For business taxpayers, interest payments generally are viewedas an ordinary business expense and may be deducted by the taxpayerin determining taxable income. The interest payment is normallytreated as income to the recipient in determining the recipient’s taxableincome.Payments with respect to equity, on the other hand, are typicallynot deductible by the payer, since the payments represent an after-taxreturn on a capital investment. The tax treatment of the equity paymentin the hands of the recipient depends on the tax system applicableto the recipient; in some cases, the payment will be fully taxable inthe recipient’s home country, but in other cases, the payment will be156