handbook-tb

Protecting the tax base of developing countriesexternal financing. It can structure the investment in CountryDC so that all of the financing expense falls in Country DCand is deducted there while the interest receipts are taxed inCountry P or in a third country.3.2 Possible responses3.2.1 Recharacterization of debt as equityIf the financing instrument takes the legal form of a loan, it wouldbe nonetheless possible for tax purposes to treat the instrument as anequity investment and disallow the deduction of the purported interestexpense. This might be the approach if the debt is subordinatedto other debt or if the “interest” payments are dependent on profits,giving the financing the economic character of equity despite itsformal legal status as debt.3.2.2 Thin capitalization rulesA number of countries have so-called thin capitalization rules thatdeny the interest deduction where the amount of debt in relation toequity capital exceeds certain ratios. Thus, in Example A above, wherethe borrowing was four times the amount of the equity capital, allor part of the interest deduction in Country DC could be disallowedif it has thin capitalization rules that deny the deduction of intereston a corporation’s debt to the extent that it exceeds, say, two or threetimes its equity. In some cases, only related-party debt is included, butin other situations all loans are taken into account in determiningwhether the interest expense is deductible.3.2.3 Earnings stripping rulesInstead of focusing on the amount of debt relative to equity, it is alsopossible to restrict the amount of the interest deduction by focusing onthe amount of the interest expense relative to the company’s income.Thus, in Example A above, where the profits of 100 were completelyeliminated by the interest deduction of 100, it would be possible tolimit the interest deduction to, say, 30 per cent of the before-tax earnings;as a result, 70 of the interest deduction would be disallowed. It13