Thin Capitalisation - time for a rethink?

Financing a company through debt is a common practice. However, when a company leans heavily towards debt financing compared to equity, it is referred to as "highly leveraged" or "highly geared". This type of financing attracts significant attention from revenue authorities as interest expense is usually tax deductible, and so could lead to a reduction in the amount of tax paid by an entity.

To address potential tax avoidance and profit shifting that may arise from such financial structures, Tanzania, like many other countries, has implemented thin capitalisation rules so as to curb the misuse of excessive debt financing. These rules set limits on the proportion of funding that can be attributed to debt and by extension the interest expense that can be deducted for tax purposes. In this article, I explore the effectiveness and relevance of these rules in the Tanzanian context, particularly when considered alongside Transfer Pricing rules that share a similar objective.

In Tanzania, the debt-to-equity ratio is 7 to 3 (i.e.2.33 times the equity amount) and this thin capitalisation limit applies to any “exempt-controlled resident entity”. Essentially, to the extent that the entity’s debt is in excess of this limit then the interest expense attributable to this excess is not deductible. The term “debt” essentially refers to related party financing whilst “equity” is the paid-up share capital. These rules are strategically designed to safeguard against Multinational Enterprises (MNEs) eroding their taxable income base through intra-group financing arrangements. 

A lot of changes have happened internationally as part of the “Base Erosion and Profit Shifting” (BEPS) project. One such change was the issue last year of new guidelines on financial transactions (in particular, Chapter X of the Organization for Economic Cooperation and Development (OECD) Transfer Pricing Guidelines 2022 (financial transactions)) which has been adopted by the Tanzania Revenue Authority (TRA) as seen in audits but also as part of the Tanzanian Transfer Pricing Guidelines of 2020. These guidelines broadly require a holistic approach when looking at financial transactions with an assessment of the commercial nature of loans (whether the funding is actually a loan), size (effectively mirroring thin cap) and the interest rate (whether at arm’s length). This approach helps prevent cross-border profit shifting through excessive debt arrangements.

The analysis under Transfer Pricing rules is more comprehensive than that of thin capitalisation rules. While thin capitalisation rules rely on financial ratios, such as debt-to-equity ratios, Transfer Pricing rules delve deeper into questions like whether the funding is really a loan from a substance perspective and whether the borrower could have obtained such a loan from the open market. Additionally, tests like the "could and would test" are applied, assessing whether a non related lender “would” have provided a loan to a borrower after consideration of borrower’s financial performance and credit worthiness.

The approach provided by Transfer Pricing rules offers a more customised way to determine the deductibility of debt interest, compared to the inflexible standard embodied in thin capitalisation ratios. This allows for a more nuanced consideration of each entity's specific circumstances, resulting in fairer and more equitable outcomes.

While thin capitalisation rules have been in place for quite some time and have served as an initial line of defence against profit shifting, their efficacy and equity has been questioned in recent years particularly for those based on a debt/equity test (like the one used in Tanzania). These rules tend to allow entities with higher levels of equity capital to deduct more interest expense. Critics further argue that these rules oversimplify complex financial transactions, leading to unintended consequences for legitimate business activities - for example, these rules may put new entrants into a market at a disadvantage compared to established players. In contrast, Transfer Pricing rules, which consider broader commercial aspects, offer a superior framework for addressing profit shifting concerns while permitting genuine business operations to continue unhindered.

The question arises whether thin capitalisation rules are redundant when Transfer Pricing rules effectively serve the same purpose but with added advantages. While thin capitalisation rules might have been a necessary step in the past, the more sophisticated and comprehensive approach of Transfer Pricing rules appears to address the concerns of profit shifting and tax avoidance more effectively. Moreover, it's worth noting that even the countries involved in the BEPS initiative had collectively agreed not to utilise fixed ratio debt/equity tests but rather to adopt other interest limitation rules based on the level of economic activity of an entity such as Earnings Before Interest, Taxes, Depreciation, Amortisation (EBITDA). 

Interestingly, as originally drafted Tanzania’s Income Tax Act 2004 was ahead of its time in using an EBITDA limit instead of thin capitalisation. For reasons that remain unclear in 2010 it was decided to replace these rules with thin capitalisation rules. Given the current context, policymakers may need to revisit the relevance of thin capitalisation rules in light of the existing Transfer Pricing framework to ensure an efficient and fair tax system in the ever-evolving global economic landscape. A move back to an EBITDA limitation instead of a thin capitalisation limit might be a step to consider.

By Dilip Thawery a Senior Associate - Tax Services at PwC Tanzania.