Foreign Direct Investment, Thin Capitalization, and the Interest Expense Deduction: A Policy Analysis

Australia, Denmark, Germany, Italy, and New Zealand have all recently adopted comprehensive restrictions on the deductibility of interest expense applicable in the context of foreign direct investment. Recently-enacted section 18.2 of the Income Tax Act (the Act), which denies the deduction of interest expense that can be traced to the earning of certain forms of exempt income in the context of outbound direct investment, is consistent with these legislative developments only in the broad sense of its attempt to impose some form of deductibility restriction. The approach chosen by the Department of Finance differs in two important respects from that in these other countries. First, it appears to be based on an assumption that different types of deductibility restrictions are required in the context of outbound and inbound direct investment, with the thin capitalization rules in subsections 18(4) to (6) applying in the latter context to limit the deduction of interest expense on debt held by significant shareholders. Second, tracing is used to link interest expense and foreign-source income in the context of outbound direct investment. The comprehensive thin capitalization regimes in Australia and New Zealand apply equally in the context of outbound and inbound direct investment, as well as equally to intra-group debt and the external debt of a multinational group. Interest expense in excess of a specified leverage ratio is denied deductibility, unless a resident corporation's ratio is consistent with a multiple of the consolidated ratio of the multinational group to which it belongs. The deductibility restrictions adopted in Denmark, Germany, and Italy follow this same broad pattern, but an interest-coverage ratio, characteristic of earnings-stripping legislation, is used to specify the permissible level of interest expense. This article argues that the legislative models adopted in these particular countries are a preferable form of interest deductibility restriction in a second-best world in which tax policymakers pursue the maximization of national welfare. Although the legislative outcome is a largely symmetrical application of a comprehensive thin capitalization or earnings-stripping restriction in the context of outbound and inbound direct investment, the policy case for deductibility restrictions is somewhat different in these two contexts. The competing legislative alternatives to an unrestricted interest expense deduction are also different. As a modified form of asset apportionment, a comprehensive thin capitalization regime allows tax policymakers to realize a necessary balance between the need for revenue maintenance and the encouragement of desirable outbound and inbound direct investment. As a form of gross-revenue apportionment, a comprehensive earnings-stripping approach can realize the same balance, but there are some differences in design features that may suggest a slight preference for a comprehensive thin capitalization regime. The authors conclude with the presentation of some empirical evidence of leverage ratios of Canadian corporations which tentatively suggest a baseline in specifying a safe-harbour ratio. They believe that the Department of Finance should take the opportunity provided by the report of the Advisory Panel on Canada's System of International Taxation to reconsider section 18.2, as well as the thin capitalization rules in subsections 18(4) to (6).