handbook-tb

Hugh J. Ault and Brian J. Arnoldbe excessive, but there is also an incentive to have an excessively highinterest rate on the loan. From the point of view of developing countries,where inward investment is financed through debt, this can result inserious problems of base erosion and profit shifting.Example A: Company P has no external debt. It has providedcapital to Company F, organized in a tax haven, which functionsas a financing vehicle to all of Company P’s operating subsidiaries,including Company DC, which is resident in CountryDC, a developing country. Company DC has paid in capital of250 and is able to borrow 1,000 from Company F, deducting 100of interest expense at 10 per cent in Country DC, which entirelyeliminates the profits of 100 of Company DC.As this example shows, there are a number of connected issuesinvolved in determining the appropriate treatment of cross-borderinterest. First, because there is no external debt anywhere in theCompany P group, the only effect of allowing the interest deductionis to shift profits from Company DC to Company F — that is to say,the combination of the deduction in Country DC and the exemptionfrom tax of the interest in the country of the recipient has resultedin part of the profits of Company DC and the Company P group notbeing taxed anywhere. If Company P had instead financed the investmentin Country DC through a direct equity investment, CompanyDC would have been taxed on the profits, which would be transferredto Company P as a dividend and which might be subject to withholdingtax by Country DC. It is worth noting here that, from an economicperspective, money is fungible — apart from tax consequences,Company P is generally indifferent to whether the internally derivedfunds are represented by a loan or an equity investment.Issues with respect to the interest deduction can also arise evenwhere the borrowing does not involve a related party. Although theborrowing is from an unrelated party, there will still be an incentiveto locate the borrowing where it will be most advantageous from a taxpoint of view, which can have a base-eroding aspect.Example B: Company P, resident in Country P, pays tax at arate of 20 per cent in Country P and wishes to make an investmentin Country DC, which has a tax rate of 40 per cent. Ithas determined that it will need to finance this investment by12