Thin Capitalization in the OECD, the EU and Sweden: policy responses, evaluation and alternatives.

Abstract: The issue of thin capitalization has risen in importance in recent years, to the point that it warranted international action. That action came in the form of Action 4 of the OECD BEPS Project, of Article 4 of the EU ATAD and of the new interest deduction limitation rules in the national Swedish legislation. The main part of the chosen rule in all these instances disallows interest deduction over 30% of the deducting entity’s EBITDA. The purpose of the rules was to stop interest deductions from being used by BEPS-driven transactions. This requires a qualitative evaluation, where interest deduction for commercially justified loans would be allowed, while deduction for transactions set up to take advantage of tax rules would be disregarded. The chosen rule, on the other hand, includes a quantitative evaluation, where interest deductions, regardless of the nature of the underlying transaction, are allowed up to a specific amount and disallowed over that amount. This reveals an inconsequence between the purpose sought and the rule adopted. The reason that BEPS through interest deductions is possible in the first place is that there is a difference in the tax treatment of debt and equity finance, which results in a bias towards debt financing. Models better suited to address that difference have been proposed. The reforms such models require may have been too extensive, however, and the global coordination necessary for the effects of these models to be acceptable may have been beyond the reach of multinational consensus. As such, the chosen rule might have been the best measure the international community could agree on at this point.