Limits to Tax Planning

S. 255 1. Introduction

Traditional thin capitalization rules were designed to prevent taxpayers from borrowing money in excess from a related party abroad. With this type of debt financing the taxpayer will deduct the interest while the recipient of the interest will not be taxed in the same jurisdiction. Insofar as debt financing within a group is tax motivated, profits of a subsidiary located in a high tax jurisdiction may be “stripped out” to lower taxed group companies and reduce a group’s total effective tax burden. In many jurisdictions the phenomenon of thin capitalization lies on the borderline between two important decisions: Firstly, interest for debt financing is usually tax deductible for the borrower while dividend distributions are not. Secondly, under double tax treaties the source state’s right to tax interest is usually more limited than its right to tax dividends.

The common feature of thin capitalization rules is to disallow deduction of interest expense occurring from debt with related parties not because of the interest rate as such, but on the basis of an analysis of the borrower’s capital structure. In contrast, interest barrier rules primarily determine the amount o...