Interest Deductibility: Evaluating the Advantage of Earnings Stripping Regimes in Preventing Thin Capitalisation

Abstract

The Organisation for Economic Co-operation and Development (OECD) released the Final Report on Limiting Base Erosion Involving Interest Deductions and other Financial Payments (better known as Action 4, it was subsequently updated in late 2016). This Report recommended that countries adopt thin capitalisation regimes to allow interest expense on debt funding based on a proportion (fixed ratio) of earnings. For example, the rule would only permit an entity to deduct net interest expense up to a benchmark of net interest as a proportion of earnings before interest, taxes, depreciation and amortisation (EBITDA). The benchmark ratio suggested only permits interest deductions of an amount of 10 to 30 per cent of EBITDA. Should New Zealand adopt the OECD’s suggestion? This article evaluates the OECD’s proposal against the existing New Zealand thin capitalisation regime which currently operates on the basis of the entity’s balance sheet. This assets-based regime looks at the level of debt and compares this to total assets. In assessing the respective merits of the proposal against the existing regime the article uses key principles set out by the Tax Working Group when it carefully examined the New Zealand tax system in 2010. The conclusion reached is that, contrary to the strong recommendation in the OECD’s Report, there is no compelling case for change to an earnings-based EBITDA method. The article goes on to suggest a mechanism to deal with particular problems identified with “high priced debt” suggesting an interest rate cap as an alternative.