Specific limits on deducting companies’ interest expenses works better
International companies are in a position to turn rules on deduction of interest expenses into a means to avoid paying taxes. Authorities use a range of instruments to fight this type of tax avoidance. Natalie Speet, who wrote a doctoral thesis on this topic, thinks specific measures work best.
In 2019, the Dutch government will introduce new legislation capping tax deduction of interest expenses by companies. The new measure is based on European regulation and treats all forms of deduction of interest expenses - whether practiced by small or large companies, or whether companies operate on a national scale or internationally – in more or less the same way. Natalie Speet, who obtained her PhD in 2017 for her research on the functioning of existing tax regulations to restrict deduction of interest expenses, is not impressed. ‘This is a generic measure that may affect companies for which it is not intended. My research shows that the specific measures that Dutch authorities have introduced and implemented in the past are more effective, and fairer to the tax payer.’
The economics of taxation
Speet (33) is an expert on the issue. She has worked at Tax and Customs Administration for over 12 years now, dealing with large companies. As of 1 April 2018, Speet will be seconded to the Dutch Treasury, where she will join the division that prepares tax legislation.
Speet received her master’s degree in accountancy at Nijenrode Business Universiteit, directly followed by a post-master RA (chartered accountant) programme.She subsequently obtained a master’s degree in the economics of taxation at the Vrije Universiteit in Amsterdam.
Since 2010, Speet has been a part-time lecturer in the economics of taxation department at the University of Amsterdam (UvA).. She began working on her PhD degree in 2013 and defended her thesis in September 2017. Since October of that year she has been programme director of the economics of taxation bachelor’s programme.
Prior to obtaining her doctorate, Speet carried out empirical research into the relationship between tax measures restricting tax deduction of interest and companies’ use of debt as a source of financing. Worldwide, the view is held that interest expenses are generally a cost item to be deducted from profits, which are the basis for the calculation of company tax.
‘Foreign research shows that companies that operate in countries with high company tax rates are relatively high users of debt as a source of financing. After all, this reduces profits and with that, the tax bill’, says Speet.
This is not an ideal situation. ‘Economically, one would like to see the tax authorities treating equity and debt equally. Deduction of interest encourages companies to use large amounts of loan capital so as to optimise the cost of capital.’ This clever financing by companies entails a larger risk of liquidation, which in turn results in all kinds of social costs’.
For now, equal treatment will be difficult to realise. ‘It could only be achieved by international cooperation. A country cannot isolate itself and do this on its own. If interest expenses may no longer be deducted, the logical step would be to stop taxing income from interest as well. Capital being mobile, companies will respond by organising themselves in such a way that interest will be paid in countries where it is deductible while they’ll shift their profits to countries where company tax is low or absent.’ Speet does not believe that this is what we want. ‘We want to impose taxes on companies in the places where they carry out their operations.
The optimal situation is still out of reach, but European authorities have taken a great number of actions to firmly restrict tax deduction of interest and to force companies to adopt a more balanced capital structure. In contrast with many other – large – European nations, the Netherlands used to opt for specific measures, targeting specific types of abuse, says Speet.
An example is the restriction on artificially converting equity into debt in order to take advantage of the tax deduction of interest. A ceiling has also been placed on the use of the tax deduction of interest expenses by private equity. Private equity firms have been notorious for financing the companies they acquire by large amounts of debt. However, this strategy is accompanied by a parallel increase in the risk of liquidation.
Speet also studied the effect of tax regulations in the Netherlands. ‘Generally speaking, I did not find a correlation between the company tax rate and the debt-equity ratio. While in the 1990s, companies’ use of debt to finance their assets was relatively low, it increased after the turn of the century, only to go down again after the credit crunch. Profit tax steadily fell during all these decades. The most important conclusion to be drawn from this is that macroeconomic factors and business considerations are the primary elements determining the debt-equity ratio. The introduction – or revoking – of specific measures did not cause a significant response by companies in terms of a change of financing. Companies did, however, react in the way they structured loans to subsidiaries.
Speet is a supporter of specific actions. ‘The current caps on deduction work well for the purpose they are intended to serve.’ At one point, the Dutch tax authorities put a generic limit on the deduction, referred to as ‘thin capitalisation’. ‘In itself, the measure was effective, but it affected small and medium-sized businesses disproportionally, and that ran entirely opposite to intentions.’ The measure was soon rescinded.
In 2019, on the orders of the European Commission, the Dutch Tax and Customs Administration will introduce the Earning Stripping Rules, a new generic form of limiting tax deductions. The Commission follows one of the earlier recommendations by the OECD, which pushes for fighting against tax avoidance by international companies. Under this generic measure, the maximum amount of tax deduction for interest expenses depends on the level of the company’s profit before tax (EBITDA).
‘Generic comparisons are relatively easy to understand and increase international comparability,’ says Speet. ‘But they have a disruptive effect and they risk hitting the weakest parties.’ Earning Stripping can have serious negative effects for companies that are financed by relatively large amounts of loan capital and experience an economic downturn. ‘When a company’s profit falls, the margin from which to make the interest payments gets smaller. So, this company is actually hit twice.’ Speet concludes that, overall, the Earning Stripping Rules are not an improvement from the existing Dutch limitations on tax deductions and hopes that the legislator will use all of the leeway offered by the European Commission to prevent disruptive and unintended effects.
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