handbook-tb

Limiting interest deductionsthe potential for these payments to become excessive and erode a country’stax base. Excessive payments can arise either because the amountof the debt is excessive, or because the rate of interest is inappropriate.Today, tax audits tend to focus more on the second concern — excessiveinterest rates — than on the first issue. Transfer pricing audits frequentlyfocus on the rate of interest charged. Determining whether the totalamount of debt is excessive is generally a more difficult issue to analyse.1.3 Related-party debt in capitalizing an enterpriseAs noted above, debt may be used in connection with the capitalizationof an enterprise. One situation deserves special focus: the simultaneoususe of debt and equity by a single investor (or an investor andits related affiliates) to capitalize a new investment, as can be demonstratedby the following example:Acme Corporation, a resident of Country X, seeks to create asubsidiary corporation, Beta Corporation, in Country Y. Beta requiresinitial funding of $1,000 in order to begin business. Acme could providethat funding by:‣ ¾ Investing $1,000 of equity; or‣ ¾ Investing $500 of equity and $500 of debt (or any other combinationof debt and equity).The choice of whether to use equity only, or a combination ofdebt and equity, generally will depend on a complex blend of both taxand non-tax considerations.1.3.1 Tax considerationsReturning to the example above, if Acme Corporation invests whollywith equity, Beta will not be required to make any interest payment(because there is no debt) and Beta will have no tax deduction relatedto its initial funding. Acme’s return on the investment will be entirelyin the form of dividends.If the initial funding is partly in the form of equity (say, $500)and partly in the form of debt ($500), the interest payments of BetaCorporation on the $500 worth of debt generally will be deductible159