In the current economic climate, the responsibility of governments to collect tax, and the pressure on taxpayers (particularly large corporates) to pay their fair share, has never been so great. Tax authorities around the globe are scrutinising ever more carefully the tax-take from their largest taxpayers. The ability for corporate groups to treat interest paid on debt as tax-deductible forms part of this landscape.
In direct conflict with this is the need for jurisdictions to attract inward investment. A number of countries have introduced lower headline rates of corporate taxes, and tax regimes specifically designed to attract investment in specific areas (e.g. the UK’s patent box).
These conflicting priorities have resulted in an array of rules on the tax deductibility of financing costs. Some jurisdictions have trodden carefully, only disallowing costs which are artificially generated to avoid tax, whilst others have clamped down, introducing more draconian measures which apply to all taxpayers, regardless of motive. The remainder of this article looks at the different ways in which tax authorities restrict tax deductions for interest.
The general rule
In most jurisdictions, interest is treated as a trading expense incurred in earning profits and is therefore normally deductible for tax purposes. In contrast, dividends are treated as a distribution of those profits, and are in general not deductible for tax purposes. This distinction creates an incentive for companies to fund their subsidiaries with debt rather than equity for tax-efficiency.
Ways of restricting the tax deductibility of interest
Thin capitalisation rules
The ability to deduct interest for tax purposes influences the decision as to whether a company should fund a subsidiary with equity or debt. The amount of debt loaned by a company to a subsidiary may be far greater than a third party, lending on arms length terms, would be willing to offer. Companies funded with high levels of debt are said to be “thinly capitalised”: most countries have rules which prevent the interest on excessive debt funding within a group being deductible for tax purposes.
Many countries now have rules which impose a cap on the amount of interest which can be deducted for tax purposes, usually calculated as a percentage of the company’s taxable profits. Such rules are not usually restricted to funding between group members. They are sometimes used instead of thin capitalisation rules, and in some jurisdictions, alongside them. The rules are intended to prevent a company claiming large tax deductions for interest payments, where there is no resident lender paying tax on the interest received.
Interest treated as distributions
In addition to the above, some countries also have rules which re-categorize interest as a distribution where the interest is considered to more akin to equity. These rules typically apply where the payment of interest is linked to profit levels or business results.