Debt Ceilings30th August 2022
It’s been said that people can never be too thin or too rich—but does the same hold true for corporations? Many companies are facing new challenges as countries are putting them on a financial diet (caps on interest deductions, debt limits) to prevent what they consider to be an excessive cash drain. OK, so the authorities aren’t really worried about your cash position, but they do care about how your bottom line will impact your taxable income. And so, they set up structures and laws, so you can’t overload local subsidiaries with debt that will lessen a jurisdiction’s tax revenue.
Often, countries try to establish bright line rules to define what is acceptable. They may impose limits on the amount of debt that local entities can carry through debt-to-equity ratios—say, 50% of the paid in capital–or a limitation on deductibility, like capping a deductible interest up to a specified percentage of taxable income.
What does that mean to a corporation? Trouble. From a transfer pricing perspective, for example, capping interest deductibility on an intercompany loan can throw off the arm’s length price —but only on one side of the transaction. A borrower facing a limitation on the deductibility of interest expense may not be compatible with a jurisdiction’s interquartile requirement, for example. And on the other side of the same transaction, the lender’s rate, in economic terms, could still be seen as a viable arm’s-length rate but the resulting limitation on borrower’s part creates a different issue as the interest received by the lender will be the full amount less applicable withholding taxes. And from a provision point of view, the issue is what character the disallowed interest will take. If the interest expense disallowed in the current period is allowed as a deduction in a future period, then it would be a deferred tax asset, but if the disallowed interest expense will never be deductible, then it becomes a permanent item that will never benefit the company.
For corporations, the balance between debt and equity is not readily determined by an arbitrary formula, but a calibrated action determined, at least in part, by the working capital that is realistically needed to operate in a given country. But for multinational groups, that’s only part of the picture. Headquarters also have to balance the capital requirements for all the companies in the group. The problem is that each country is looking at a very narrow view of what is within its borders, while companies require a global view, which presents conflicts between countries and companies right off the bat.
So, tax planning strategies that take into account the restrictions countries impose on debt are more important than ever. You have to know how viable your financial structure is in any given environment, because in certain places, for corporations anyway, you can be too rich and too thin.