Thin Capitalisation What is Thin Capitalisation. Main forms of profit reduction. OECD model convention. China DTA network. An example Domestic law design issues.

Thin Capitalisation Main forms of profit manipulation Transfer pricing: Serious risk to source country, Thin Capitalisation: Serious risk to source country, Leasing: Serious risk to source country Capital allowances: serious risk to source country.

Thin Capitalisation OECD Model Convention No specific article No specific prohibitions in domestic law Article 9 Model Convention Associated Enterprises Article 24 Model Convention Non Discrimination

Thin Capitalisation China DTA network Russia Hong Kong No article 9 Article 25: Nothing in this Arrangement shall prejudice the right of One Side to apply its domestic laws and measures concerning tax aviodance….[which ] includes any laws and measures for preventing prohibiting avoiding or resisting the effect of any transaction, arrangement or practice which has the purpose or effect of conferring a tax benefit on any person.

Thin Capitalisation China DTA network Singapore Article 26: Nothing in this Arrangement shall prejudice the right of each contracting state to apply its domestic laws and measures concerning the prevention of tax avoidance whether or not described as such in so far as they do not give rise to taxation contrary to this agreement. Netherlands, Switzerland, Luxembourg Article 9 and nothing else.

Thin Capitalisation mine Source country Operating Co. Source Country Parent Co. Australian Holding Co. AUSTRALIAN PUBLIC COMPANY dividends Australian Shareholders Foreign Shareholders

Thin Capitalisation mine Labour Technical Assistance Finance Essential inputs exploration Capital activities Research and equipment development mine Source country Operating Co. Source country Parent Co. PROFIT TRAP TAX HAVEN: Hong Kong. Australian group

Thin Capitalisation Conventional Result Transfer Pricing, Thin capitalisation, Leasing, capital allowances. Difference Revenue 100 75 (25) Expenses (50) (75) 25 Net Profit Before Tax 50 NIL Tax at 50% Net Cash

Thin Capitalisation Financing interest withholding tax DTA 5%-10% - Debt: lower tax: deduction/NRWT - Equity: higher tax; company tax/NRWT - Debt/Equity ratios: thin capitalisation Intellectual Property DTA 0% - 5% - royalties: lower tax; deduction/NRWT - management fees: deduction/NRWT - Expert employees: deduction no NRWT

Thin Capitalisation Cross boarder leasing domestic law- finance leases DTA PE substantial equipment interest article royalty article RESULT possible to avoid source country tax on lease payments to parent co.

16. THIN CAPITALISATION DEBT EQUITY Profit before interest 100,000 Deduction for interest (100,000) nil Taxable income Nil Tax payable at 50% (50,000) Dividend paid 50,000 Withholding tax @ 10% (10,000) (5,000) TOTAL TAX (55,000)

Thin Capitalisation Source Resources Source Sub MNC Third Party Source 100% debt Source Sub MNC 50% interest 100% debt 10% interest Third Party Source Source Sub Third Party Parent Difference Revenue 100 - Interest Expense (10) (50) 40 NPBT 90 50 Tax 50% 45 25 (20)

Thin Capitalisation Source Resources Source Sub MNC Third Party Source 100% debt 100% debt 50% interest 50% interest Third Party Source Third Party Parent 50% Source Sub Third Party Parent Difference Revenue 100 - Interest Expense (10) (50) 40 NPBT 90 50 Tax 50% 45 25 (20)

Thin Capitalisation The problem interest is an expense but dividends are not, source country taxation of interest paid to MNC LOWER THAN deduction to MNC SOURCE country subsidary Design features to reduce this practice non resident lenders, domestic entities; debt : equity ratio debt : asset ratio excessive interest 110% back to back loans