Interest Deductibility Rules in the EU with a Focus on Germany Alfons Weichenrieder Goethe University Frankfurt, WU Vienna, CESifo

2 1 Leverage Decisions of Multinationals 2 German Rules against Thin Capitalization 3 Conceptual Advantages and Disadvantages (IB/TCR) 4 Restrictions of Interest Deductibility - Empirical Studies 5 Thin-Capitalization Rules and the Fear of Investment Reductions 6 Summary and Outlook Plan of the Talk Weichenrieder

3 Significant, yet moderate elasticity of debt finance. A ten-percentage point difference in the corporate tax rate may lead to a three-percentage point difference in the debt-to-asset ratio (Heckemeyer, Overesch and Feld 2013). Potentially limiting factors –Ruf (2011) and Weichenrieder and Windischbauer (2008): Studies may overlook debt shifting that results from establishing new holding companies. –Loss carry forwards (Buettner et al. 2011). –Thin-capitalization rules (Büttner et al. 2012, Blouin et al. 2014). 1 Leverage Decisions of Multinationals Weichenrieder

4 First thin-cap rule (TCR) in 1994 with a safe haven of 3:1 (9:1 for holdings). In 2001, the safe haven was reduced to 1.5:1 (3:1 for holdings). In 2002, ECJ’s Lankhorst-Hohorst decision required extension to domestically-owned corporations revision: €250,000 exemption for interest payments. Preference for holding companies abolished. 2008, TCR was replaced by an interest barrier (IB). Earnings-stripping rule that does not condition on the amount of intra-company loans, but on the net-interest payments in relation to a subsidiary’s earnings. 2 German Rules against Thin Capitalization Weichenrieder

5 Unlike the old rule, there is no more need to trace financial flows and guarantees to differentiate between external and related party loans. Interest deduction may be restricted if net-interest payments exceed 30 percent of earnings before interest, tax and depreciation (EBITDA). No safe harbor debt-to-equity ratio. Several clauses may nevertheless allow interest deductions in excess of 30 percent of EBITDA. 2 German Rules against Thin Capitalization Weichenrieder

6 Exemption clauses 1.Net interest payments up to €3m 2.Businesses that are not part of a company group are exempt. In this case, however, a corporation has to show that affiliated recipients do not account for more than 10 percent of all net interest payments. 3.Third, net interest deduction in excess of 30 percent of EBITDA is possible, if equity ratio is not significantly lower than in the company group as a whole. Unused EBITDA can be carried forward for 5yrs. Unused interest can be carried forward unlimited, subject to ownership change restriction. 2 German Rules against Thin Capitalization Weichenrieder

7 Generally harsh critique of the IB among German academics. Some issues are similar for TCRs and IB. On the plus side: from the perspective of a host country IB is nearer to the actual policy objective than previous TCR. –Equal treatment of intra-company and third-party loans. –Yet, some 33% of international TCRs condition on total debt. –IB focuses on tax deductible interest. Limits riding the yield curve. –No circumvention by using ownership chains. 3 Conceptual Advantages and Disadvantages Weichenrieder

8 Ownership chains to circumvent TCR 3 Conceptual Advantages and Disadvantages Weichenrieder

9 Constitutional concerns, infringement of the net principle. Acknowledging exemption clause 3: IB works similarly to formula apportionment. This said, IB is a unilateral rule. IBs of other countries may lead to conflicts if rules are not identical. This compares to a situation in which different states use different allocation formulas. 3 Conceptual Advantages and Disadvantages Weichenrieder

10 IB may increase average tax rate for low profitability firms. Lack of safe haven debt-to-equity ratio. Exemption for interest payments below €3m p.a invites split- ups of firms. Split-up firms forgo profit and loss consolidation. May also happen under TCR with exemption. Should be easy to fix. As TCRs, an IB may be circumvented by leasing contracts. 3 Conceptual Advantages and Disadvantages Weichenrieder

11 Growing literature confirms that TCRs and IB reduce leverage. TCRs in Germany (Weichenrieder and Windischbauer 2008). 4 Restrictions of Interest Deductibility - Empirical Studies Weichenrieder

12 Econometrically confirmed: –Weichenrieder and Windischbauer (2008) for German inbound FDI –Overesch/Wamser (2010) for German inbound FDI –Buettner et al. (2012) for German outbound FDI –Blouin et al. (2014) for U.S. outbound FDI. Results suggests that the effect on total debt is much more pronounced if TCR targets total debt rather than intra- company loans only. Results on IB –Dreßler and Scheuering (2012). –Buslei and Simmler (2012). 4 Restrictions of Interest Deductibility - Empirical Studies Weichenrieder

13 Fear of increased cost of capital and a loss of investment. Often, tightening of interest deductibility is combined with a reduction of corporate rates (Merlo and Wamser 2014). Buslei and Simmler (2012) could not identify a negative (short- term) effect on investment. Similarly, Weichenrieder and Windischbauer (2008) could not establish significant negative investment effects of the tightening German TCR in Büttner et al. (2014) find that the existence of a TCR increases the tax sensitivity of investment. Tax increase vs. loophole tightening. 5 Thin-Capitalization Rules and the Fear of Investment Reductions Weichenrieder

14 Consider simple example. –Profit of a subsidiary  in country A is €100 before interest. –The parent  is located in country B, which is assumed to use an exemption system of taxing dividends. –Tax rate in B is 20%; in A it is 30%. –Parent has a tax incentive to finance its sub in A by using a high amount of debt. –Assume that in the unrestricted case this results in interest payments of €75 from  to . Simple example to show: –TCR/IB implies tax exporting. –Part of the burden falls on foreign government. 5 Thin-Capitalization Rules and the Fear of Investment Reductions Weichenrieder

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16Weichenrieder 5 Thin-Capitalization Rules and the Fear of Investment Reductions

17 Limits to tax exporting in the case of tax haven & weak CFC. Consider the use of a conduit country C. 5 Thin-Capitalization Rules and the Fear of Investment Reductions Weichenrieder

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19 TCRs and IB empirically restrict debt shifting activities. Pros and cons of IB (versus TCR). Although empirical results are mixed, investment losses are plausible. Yet, tax exporting may give a national preference to TCRs and IBs (over tax rate increases). Interaction of interest limitations and CFC rules. IB may be interpreted as unilateral apportionment of interest expenses. Should we think about EU wide apportionment factors? Alternative: change (abolish) the interest and royalties directive to give country alternative instrument against tax base shifting. 6 Summary and Outlook Weichenrieder