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Electronic copy available at: http://ssrn.com/abstract=1987301
Domestic Antiavoidance Rules and Their Interplay
With Tax Treaties
by Oz Halabi
Tax avoidance and antiabuse rules are among the
primary issues concerning international tax.
Countries sign income tax treaties in order to, among
other things, reduce double taxation imposed by both
source and residence countries.
1
Countries also sign
treaties to minimize tax avoidance from multinational
transactions. In 2003 the OECD made the dual pur-
poses of treaties explicit by stating that the scope of a
treaty is not only to prevent double taxation but also to
prevent tax avoidance and evasion.
2
There are many ways countries reduce tax avoid-
ance, but there is no way to completely eliminate it.
Some countries enact general antiavoidance rules, such
as substance over form and step transaction, in their
domestic legislation. Other countries attempt to limit
tax evasion by enacting specific legislation targeting
areas that are more vulnerable or exposed to tax eva-
sion. Examples of specific antiavoidance rules include
controlled foreign corporation rules, beneficial owner-
ship, and thin capitalization (earnings stripping in the
United States). Another way to reduce tax avoidance is
by adding an antiabuse rule in a treaty.
The three treaty models (OECD, U.S., and U.N.)
each include some antiabuse and antiavoidance rules,
such as beneficial ownership (in articles 10 (dividend),
11 (interest), and 12 (royalties)), exchange of informa-
tion, limitation on benefits, and transfer pricing. All
those provisions are structured to reduce double taxa-
tion, distribute revenues between the treaty partners,
and help combat tax avoidance.
The interplay between a treaty and domestic law
should be examined at the time tax treaties are negoti-
ated and signed between countries. And after the treaty
is signed and entered into force, countries can still en-
act new domestic laws that might influence the interna-
tional transaction addressed in the treaty. One such
area is antiavoidance rules. The question of whether a
country’s GAAR conflicts with treaty provisions has
been addressed by the OECD and also in a few court
cases. Some courts upheld the OECD position that
GAARs do not violate treaties, but actually support
them by reducing treaty shopping and preventing trea-
ties from being manipulated.
3
However, other courts
took a different position, ruling that:
as long as the finance structure adopted by the
taxpayer is not specifically prohibited by the ap-
plicable DTT provisions and so long as there are
1
Any reference to a tax treaty article number is to the number
in the OECD model tax treaty (2010) (hereinafter, OECD
model) unless otherwise noted.
2
Commentaries on the Articles of the Model Tax Conven-
tion, 2010 OECD (hereinafter, OECD commentaries), commen-
tary on article 1, para. 7.
3
AdminC (TA) 5663/07, Yanko Weiss (Holdings) 1996 LTD. v.
Holon Tax Assessor, PM 5767 (2007) (Israel). See also OECD com-
mentaries, commentary on article 1, paras. 9 and 9.1.
Oz Halabi is an SJD candidate at the University of Michigan Law School and former head of the Israel
Tax Authority’s tax treaty department.
The author wishes to thank Prof. Reuven S. Avi-Yonah and fellow JD student Marisa Adelson for their
help in preparing this article and for their useful comments.
TAX NOTES INTERNATIONAL SEPTEMBER 26, 2011 • 955
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Electronic copy available at: http://ssrn.com/abstract=1987301
no specific anti-abuse provisions, the effect of the
finance structure can not be ignored.
4
In other words, these courts stated that unless the
treaty includes an antiavoidance rule, the countries are
prohibited from raising that assertion.
This article will focus on whether specific (as op-
posed to general) domestic antiavoidance rules contra-
dict with the application of a treaty and, more specifi-
cally, whether thin capitalization rules, as adopted by
domestic legislation, conflict with a treaty.
I. Treaties and Domestic Law
When a treaty party has the ability to enact laws
that will unilaterally change the application and provi-
sions of a treaty, the treaty network is seriously
threatened.
5
Most countries treat the treaty, once
signed, as an applicable law that has a superior status
to the domestic law. Some countries have a specific
section in their tax code to determine the primacy of
the treaty
6
; others give supremacy to a treaty in their
constitution
7
(which generally has a superior status
over the domestic general legislation). The first country
to prioritize a treaty over the domestic legislation was
Japan in 1947. In Europe, the Netherlands did so in
1953; since then, 15 more countries followed suit be-
tween 1975 (Greece) and 2003 (Italy).
8
Some countries have a specific provision in their tax
treaties stating that domestic legislation overrides treaty
provisions.
9
In the United States, the Constitution has
precedence over everything, including tax treaties.
However, the relationship between a U.S. treaty and
the U.S. tax code is too complex to discuss in detail in
this article. In order to understand the connection, one
would have to take into account U.S. domestic laws
and procedures, tax treaty model status, tax treaty
model technical explanation status, the IRS practice as
evidenced by revenue rulings and procedures, compe-
tent authority agreements, court cases, and other
sources.
10
Tax treaties between contracting states are instru-
ments of international law. Their main purpose is to
avoid double taxation by modifying the domestic law
of the contracting states.
11
In order to achieve and sup-
port the treaty goal, treaties must be implemented by
domestic legislation and therefore have the force of
domestic law in that state.
Since a treaty consists of provisions and rules in a
specific area (the transaction between the contracting
states) and deals with a specific person (resident of a
contracting state), it has the power of a piece of spe-
cific legislation.
12
According to long-standing rules of legislative his-
tory, specific legislation overrides general legislation.
13
Therefore, changes of a domestic law generally will not
affect the treaty. This rule, however, will not apply if
the treaty itself includes a provision granting superior
status to the domestic law. Moreover, under the Vienna
Convention on the Law of Treaties (VCLT),
14
a coun-
teracting state may not invoke the provisions of its in-
ternal law as justification for its failure to perform a
treaty
15
unless the country that is bound by a treaty
has violated a provision of its internal law regarding
competence to conclude treaties as invalidating its con-
sent unless that violation was manifest and concerned
a rule of its internal law of fundamental importance.
The VCLT suggests that a violation is manifest if it
would be objectively evident to any state conducting
itself in the matter in accordance with normal practice
and in good faith.
16
II. Thin Capitalization — In General
Thin capitalization is when a company is overtly
financed by debt but covertly appears to be financed by
capital.
17
The term describes the greater portion of
debt in relation to the corporation capital (debt-to-
equity ratio). In general, debt burdens the lender with
4
M. Padmakshan, ‘‘Cos Can Use Legal Financial Structure to
Save Tax: Tribunal,’’ Economic Times, Nov. 10, 2010 (an opinion
paper on the Mumbai Income Tax Appellate Tribunal).
5
Reuven S. Avi-Yonah, ‘‘Chapter 4. Tax Treaty Overrides: A
Qualified Defence of U.S. Practice,’’ in: Guglielmo Maisto (ed.),
Tax Treaties and Domestic Law: EC and International Tax Law Series,
Vol. 2, IBFD, 2006.
6
Section 196 of the Israeli code gives full priority to the tax
treaty over the domestic legislation. See also OECD Committee
on Fiscal Affairs, ‘‘Report on Tax Treaty Overrides,’’ 90 TNI
7-13.
7
Jacques Sasseville, ‘‘Chapter 3. A Tax Treaty Perspective:
Special Issues,’’ in: Guglielmo Maisto (ed.), Tax Treaties and Do-
mestic Law: EC and International Tax Law Series, Vol. 2, IBFD,
2006.
8
Klaus Vogel, ‘‘Chapter 1. The Domestic Law Perspective,’’
in: Guglielmo Maisto (ed.), Tax Treaties and Domestic Law: EC and
International Tax Law Series, Vol. 2, IBFD, 2006.
9
Article 1(5) of the U.S. model treaty (2006) preserving the
rights of the contracting states to tax its citizens in accordance to
the states domestic laws. Avi-Yonah, supra note 5.
10
For detailed analysis, see Reuven S. Avi-Yonah, Diane M.
Ring, and Yariv Brauner, U.S. International Taxation: Cases and
Materials (3rd ed.), Thomson Reuters (2011).
11
Vogel, supra note 8.
12
Id.
13
‘‘Lex specialis derogat legi generali’’ (a special law repeals a gen-
eral law); and ‘‘Lex posterior generalis non derogat legi priori speciali’’
(a later general law does not repeal a prior special law).
14
Signed in Vienna May 23, 1969, and entered into force Jan.
27, 1980.
15
VCLT, article 27.
16
Id. at article 46.
17
Dept. of International Economic and Social Affairs, United
Nations, Contribution to International Co-operation in Tax Matters,
(New York, 1984).
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interest payments, while capital entitles the shareholder
to participation in corporation growth, profit distribu-
tion, and so forth.
A basic tax problem in corporate finance (whether
using capital or debt) is that the tax treatment of inter-
est differs from the tax treatment of dividend or other
distributions of profit. Interest is usually a deductible
expense in calculating the payer’s taxable income while
a dividend is a contribution of after-tax profits that will
not lead to a deduction. Countries usually treat divi-
dend income differently than interest income by taxing
dividends at a lower rate (or even exempting it — for
example, in the U.K.) or granting a more favorable for-
eign tax credit mechanism.
18
There is no clear way to distinguish what portion of
the corporation’s financing is done using capital and
what portion is done using debt. Some corporations
find it more economical to use more debt, while others
use more capital. The choice of how to finance a cor-
poration usually is determined through case-by-case
analysis of the particular facts and circumstances.
19
The corporation’s board of directors or management
generally decides the proportion of the debt-to-equity
ratio of the company. The leadership has this right if
their decision is based on a bona fide economic deci-
sion, and taxes should not be one of the primary rea-
sons for determining the applicable ratio.
However, as interest is a deductible expense while
dividends usually are not, payment of interest will lead
to paying less tax in a transaction.
20
Also, the variety
of tax rates in different jurisdictions and the diversity
of tax rates in treaties have even greater significance on
structuring corporate finance.
Countries structure their domestic laws in order to
achieve objectives and goals for their tax law, such as
combating tax evasion. Countries generally consider
three ways to form their own thin capitalization rules:
21
•The Fixed Ratio Approach. The tax authority will
specify a fixed debt-to-equity ratio for a specific
industry or sector. The ratio is rigid and not open
to negotiation or alleviation, even if the taxpayer
or the tax authority later finds it inappropriate.
The advantage of this approach is that it assures
certainty to taxpayers of the interest expenses that
will be allowed under the thin capitalization limi-
tations.
•The Safe Harbor Approach. The tax authority speci-
fies a fixed debt-to-equity ratio, but if the tax-
payer’s ratio is in excess of that ratio, the taxpayer
has the option of making an arm’s-length analysis
to support its existing capital structure.
•The Arm’s-Length Approach. This approach relies on
a case-by-case analysis, and the OECD endorses
it. The arm’s-length approach is consistent with
the OECD transfer pricing methods. The disad-
vantage of this approach is the lack of certainty
for taxpayers about which financial structure and
interest rate will be accepted by the tax authority.
Generally, thin capitalization provisions specify a
safe harbor debt-to-equity ratio and limit the deduction
of the cost of debt once this critical threshold level is
surpassed.
22
The effectiveness of thin capitalization legislation in
preventing income shifting (earnings stripping) in the
U.S. has been examined, and the conclusion was am-
biguous.
23
An analysis of corporate tax return data for
the 2004 tax year did not find conclusive evidence that
the reason for the low profitability of foreign share-
holders of U.S. corporations compared with domestic
shareholders was a result of the earnings stripping.
Moreover, the report concluded that there is strong
evidence that inverted corporations (corporations that
operate in the United States but incorporate overseas)
are stripping a significant amount of earnings out of
their U.S. operations; therefore it appears IRC section
163(j) is ineffective in preventing corporations from
engaging in earnings stripping.
24
III. Is Thin Capitalization a Problem?
In light of reduced tax rates around the world and
the absence of capital movement limitations, world-
wide investments, and tax competition between coun-
tries, one understands how the structuring of business
18
Underline Tax Credit. For additional reference to Tax
Credit, see discussion in Section XIV, infra, of this article.
19
Supra note 17, at p. 25.
20
Dividends generate two-tier taxation — first at the corpo-
rate level and then at the shareholder level. Interest payments
will be taxable for the recipient and deductible to the payer. In
some cases, a withholding tax may be imposed by the source
state according to its domestic law or a relevant tax treaty that
usually will be given as a foreign tax credit by the state of resi-
dency.
21
Luis Coronado, Patrick Cheung, and Justin Kyte, ‘‘An
Overview of Arm’s Length Approaches to Thin Capitalization,’’
IBFD, July/Aug. 2010.
22
Out of 29 countries that have introduced thin capitalization
rules, 15 also apply them to debt from a non-related person; An-
dreas Haufler & Marco Runkel, ‘‘Firms’ Financial Choices and
Thin Capitalization Rules Under Corporate Tax Competition,’’
CESifo Working Paper Series 2429, CESifo Group Munich
(2008). Detailed descriptions of existing thin capitalization rules
are given for most OECD countries by B. Gouthière, ‘‘A com-
parative study of the thin capitalization rules in the member
states of the European Union and certain other countries,’’ Eur’n
Tax’n45, 367-451 (2005); and for the EU member states by A.
Dourado and R. de la Feria, ‘‘Thin Capitalization Rules in the
Context of the CCCTB,’’ Oxford University Centre for Business
Taxation, Working Paper 08/04 (2008).
23
‘‘Report to The Congress on Earnings Stripping, Transfer
Pricing and U.S. Income Tax Treaties,’’ U.S. Department of the
Treasury, Nov. 2007.
24
Supra note 17, at p. 26.
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finance becomes an issue that demands much thought
and discretion. Thin capitalization usually is related to
tax abuse, tax evasion, and tax planning involving tax
arbitrage.
25
Tax expert Martin M. Lore chose to open
his book Thin Capitalization by naming chapter 1 ‘‘The
Problem’’; this chapter summarizes the reasons for thin
capitalization rules.
26
Many others share the view that
thin capitalization rules exist only to deal with a prob-
lem.
Countries use a variety of mechanisms to address
the thin capitalization problem. Some countries deal
with thin capitalization issues by requiring a specific
debt-to-equity ratio limitation. Others use their
GAARs. Finally, some countries apply their domestic
transfer pricing rules to determine the debt-to-equity
ratio in addition to the interest rate. A recent court de-
cision provided a counter to the common view that
thin capitalization is invariably a problem. In 2007 the
High Court of Justice (England & Wales), Chancery
Division ruled that the mere fact that a company is
granted a loan by a related company cannot be the
basis of a general presumption of abusive practices.
27
Instead, the European Court of Justice specifically tar-
geted wholly artificial arrangements, which do not reflect
economic reality and are designed to circumvent the
legislation of the member state concerned and particu-
larly to escape the tax normally due on the profits gen-
erated by activities carried out on national territory.
28
In this ruling, the court provided a different way of
looking at thin capitalization rules. Instead of treating
thin capitalization as a problem per se, the court only
considered thin capitalization a problem if and when a
substantial evidence of tax avoidance is proven.
IV. Thin Capitalization in the World
In general, domestic legislation dealing with thin
capitalization aims to treat interest paid in some cir-
cumstances as not being interest for tax purposes.
Some countries will disallow the interest deduction and
will not change the character of income for the recipi-
ent (the source change).
29
Other countries will not only
disallow the deduction but also change the character of
the income, instead treating it as a dividend and impos-
ing withholding tax rates
30
on it (the total change).
31
As will be discussed further, some countries have
moved in the past 10 years from the total change to the
source change. Other jurisdictions have introduced
lower debt-to-equity ratio thresholds, or reduced those
that previously had been at the 3-1 debt-to-equity ratio
in order to widen the application of their thin capitali-
zation rules.
The U.S. earnings stripping rule, introduced in 1989,
adopts a safe harbor debt-to-equity ratio of 1.5 to 1,
but disqualified interest (nondeductible to the extent a
U.S. group has excess interest expense) may be carried
forward indefinitely. Australia recently expanded the
debt base to which its thin capitalization rules apply,
but it reintroduced the 3-1 standard after lowering it to
2 to 1 for a short period.
Luxembourg’s and Slovenia’s debt-to-equity ratios
currently stand at 6 to 1, but the latter plans to reduce
its limitation to 4 to 1 in 2012.
32
Belgium applies two
sets of thin capitalization rules.
33
A 1-1 debt-to-equity
ratio applies to loans granted by individual directors,
shareholders, and nonresident corporate directors to
their company.
34
Interest relating to debt in excess of
this ratio is re-characterized as a nondeductible divi-
dend. Further, the interest rate may not exceed the
market interest rate. A 7-1 debt-to-equity ratio applies
to debt if the creditor (resident or nonresident) is ex-
empt or taxed at a reduced rate regarding the interest
paid on the debt. Interest relating to debt in excess of
this ratio is considered a nondeductible business ex-
pense.
35
It is quite safe to infer that a debt-to-equity ratio
greater than 1 to 3 is effectively not a thin capitaliza-
tion rule: It is a very generous ratio of debt to equity
and leads to an interest deduction allowance even
when the corporation is, by definition, thinly capital-
ized.
V. Canada: The Fixed Ratio Approach
In 1966 the Canadian Royal Commission on Taxa-
tion recognized that differences in the tax treatment of
interest and dividends incentivized the capitalization of
Canadian-based corporations with debt rather than
25
Id. at p. 26, para. 96.
26
Martin M. Lore, Thin Capitalization, New York, Ronald
Press Co. (1958).
27
Test Claimants in the Thin Cap Group Litigation v. HMRC,
[2011] EWCA Civ 127.
28
Test Claimants in the Thin Cap Group Litigation v. Commissioners
of Inland Revenue (C-524/04).
29
For an overview of French thin capitalization legislation,
see discussion in Section VIII, infra, of this article.
30
See OECD commentaries, observations on the commentary
on article 11, paras. 37 and 42.
31
The OECD model suggests withholding tax rates of 10 per-
cent on interest and 5 percent/15 percent on dividends. The U.S
model applies 0 percent on interest and 5 percent/15 percent on
dividends.
32
Stuart Webber, ‘‘Thin Capitalization and Interest Deduction
Regulations: A Worldwide Survey,’’ Tax Notes Int’l, Nov. 29,
2010, p. 683, Doc 2010-23763, or 2010 WTD 228-16.
33
Country Survey — Belgium, Information as of Dec. 19,
2005 (IBFD), available at http://ec.europa.eu/taxation_customs/
resources/documents/common/publications/studies/
ir_dir_be_en.pdf.
34
Belgian Tax Law, article 198(10) IR/WIB.
35
Belgian Tax Law, article 198(11) IR/WIB.
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equity.
36
The Canadian government acknowledged the
problem
37
and shortly thereafter introduced statutory
thin capitalization rules.
Canada was the first OECD country to adopt legis-
lation (section 18(4)-(6)) to protect its tax base this way,
limiting interest deductions in 1972.
38
Since then,
Canada adopted several changes that basically kept the
main idea in place. Canada’s current rules are con-
tained in subsections 18(4) to 18(8) of the Canadian
Income Tax Act.
39
Essentially, those rules disallow the
deduction of interest (otherwise deductible) that is paid
by a corporation resident in Canada to a specified non-
resident, to the extent that the ratio of outstanding
debts to specified nonresidents to equity exceeds 3 to 1.
VI. U.S.: The Fixed Ratio Approach
IRC section 168(j) creates a limitation on interest
deductions paid from a U.S.-based entity to a foreign
shareholder. (The limitation also applies to specific do-
mestic entities that are tax exempt.) IRC section 163(j)
applies when a corporation’s debt-to-equity ratio ex-
ceeds 1.5 to 1 and its net interest expense exceeds 50
percent of its adjusted taxable income. If a corpora-
tion’s debt-to-equity ratio exceeds that threshold, no
deduction is allowed for interest in excess of the 50
percent limit that is paid to a related party and that is
not subject to U.S. income tax. (Disallowed interest
amounts may be carried forward indefinitely.)
40
For
interest that is sourced in the U.S. and paid to a foreign
resident, the applicable tax rate is determined by the
U.S. code or by a treaty provision. Interest is not sub-
ject to U.S. income tax to the extent an applicable
treaty reduces the U.S. income tax on that interest to 0
percent. Currently, the U.S. model applies source-based
taxation only on dividends; there is no tax on interest,
royalties, or capital gains.
41
VII. U.K.: The Arm’s-Length Approach
According to U.K. tax law, a company may be con-
sidered thinly capitalized when it has excessive debt in
comparison to its arm’s-length borrowing capacity,
leading to the possibility of excessive interest deduc-
tions.
42
A parallel consideration is whether the rate of
interest is one that could have been obtained at arm’s
length.
The arm’s-length borrowing capacity is the amount
of debt that could and would have been raised from an
independent lender as a stand-alone entity, rather than
as part of a group.
43
It follows that in establishing the
arm’s-length capacity of a particular borrower, it is
necessary to hypothesize that the borrower is a sepa-
rate entity from the lender and that the relations be-
tween the parties have not affected the transaction.
The U.K. tax authorities rely on the arm’s-length
principle to define excessive debt and excessive interest
rates, and it is an important concept in U.K. transfer
pricing legislation.
In the context of thin capitalization, the application
of the arm’s-length principle requires the tax authori-
ties, if auditing a transaction, to form a judgment as to
what amount of debt (rather than equity) the company
or companies could — and would — have borrowed
on a stand-alone basis from an unrelated third-party
lender. Having formed this judgment, the tax authori-
ties must then compare that level of debt with the level
of debt that the same borrower has obtained from a
related party. This is typically another group company
or a third party that has the backing of other group
members through a guarantee or other form of secu-
rity. The interest payments, which can be deducted in
arriving at profits subject to corporation tax, will then
be limited to those payments that are not excessive and
within the arm’s-length debt level.
VIII. France: The Safe Harbor Approach
As of 2006 the French thin capitalization rules were
changed to comply with two decisions issued by the
French Supreme Court — SA Andritz and SARL Coréal
36
Elinore J. Richardson, ‘‘Canada Amends Its Thin Cap
Rules,’’ available at http://www.stikeman.com/newslett/
Richardson-CanadaAmends.doc.
37
In its 1969 white paper ‘‘Proposals for Tax Reform,’’ the
Canadian government stated:
Under present law it is attractive for non-residents who
control corporations in Canada to place a disproportionate
amount of their investment in the form of debt rather
than shares. The interest payments on this debt have the
effect of reducing business income otherwise taxed at 50
percent and attracting only the lower rate of withholding
tax on interest paid abroad.
38
Tim Edgar, ‘‘Interest Deductibility Restrictions and Inbound
Direct Investment,’’ Report for the Advisory Panel for Canada’s
System of International Taxation, Oct. 2008, available at http://
www.apcsit-gcrcfi.ca/06/rr-re/RR3%20-%20Edgar%20-%
20en%20-%20final%20-%20090623.pdf.
39
RSC 1985, c. 1 (5th Supplement), as amended.
40
The excess of the 50 percent limit over a corporation’s net
interest expenses for the year (if any) may be carried forward
three years.
41
Reuven S. Avi-Yonah, Double Tax Treaties: An Introduction, p.
8 (Dec. 3, 2007), available at http://ssrn.com/abstract=1048441.
42
HMRC, ‘‘Introduction to Thin Capitalization (Legislation
and Principles),’’ available at http://www.hmrc.gov.uk/manuals/
intmanual/intm542005.htm.
43
The definition is consistent with the definition of the arm’s-
length treatment in articles 7 and 9 of the OECD model tax
treaty and as presented in the OECD transfer pricing report
(1979), as amended and in the OECD report on the attribution
of profits to permanent establishment (2008).
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Gestion.
44
The new rules apply to interest for loans
granted by a parent shareholder (an entity that owns
more than 50 percent of the voting rights or share capi-
tal of the company). The rules state that interest ex-
penses will be deductible only if the following condi-
tions are met:
•The interest rate will not exceed the annual effec-
tive interest rate for midterm debts, with an initial
duration of more than two years, offered by credit
institutions to companies.
•The borrower’s share capital must be fully paid
and the debt-to-equity ratio will not exceed 1.5 to
1. If the financing exceeds 150 percent of the bor-
rower’s share capital, any interest incurred on the
loan beyond such threshold can no longer be de-
ducted for tax purposes.
As a result of the two court decisions noted above,
the scope of application of the French thin capitaliza-
tion rules was significantly reduced, and they do not
apply in the EU. They also do not apply to non-EU
member states that have signed a treaty with France
and contain nondiscrimination clauses.
France’s highest administrative court (Conseil
d’Etat) has ruled that a German parent company
should be treated as a French parent company regard-
ing thin capitalization rules.
45
The court also ruled that
an Austrian parent company should be entitled to rely
on a nondiscrimination clause contained in a treaty
and therefore should benefit from the same exemption
as a French parent company.
46
Therefore, in France, the thin capitalization provi-
sions only apply to subsidiaries of non-EU parent com-
panies that also did not enter into treaties with France.
In some cases, subsidiaries of parent companies from
countries that signed a treaty with France may still be
subject to thin capitalization provisions. These provi-
sions will apply if the treaty between the parent com-
pany’s home state and France:
•does not provide for a nondiscrimination clause;
or
•provides for a nondiscrimination clause that does
not comply with the OECD model tax treaty.
However, France reserves its right to apply its do-
mestic legislation (for treaty manners) in the context of
thin capitalization.
47
The French tax authorities con-
firmed this position in an administrative guideline is-
sued in 2005.
48
The guideline states that the French
transfer pricing rules
49
may not be used to challenge
thin capitalization situations (except in banking activi-
ties). In this respect, French legislators have amended
the system to make it compliant with both the tax trea-
ties and EU tax rules.
50
IX. Germany: The Safe Harbor Approach
In 2007 two German practitioners stated that ‘‘the
U.S. earning stripping rules could have easily become
the big brother of ’’ the German thin capitalization
rules (as amended in 2008).
51
German thin capitaliza-
tion rules changed twice in the last 10 years, once in
2004 and again in 2008.
52
In 2004 the definition of
qualified shareholders changed.
53
For tax purposes, a
qualified shareholder was able to provide a corporation
with only a limited amount of debt. The relevant debt
to capital ratio was fixed at 1 to 1.5. Interest on debt in
excess of the debt-to-capital ratio (with exceptions for
the amount of interest and interest rate) was not al-
lowed as a deductible interest expense. Instead, it was
considered a constructive dividend.
Those rules also were applicable to a third party
(that is, a bank) if a qualified shareholder provided se-
curities to that third party to recourse the loan.
In 2008 Germany adopted an amendment to its tax
code
54
that altered the tax treatment of shareholder
loans. The new regulations changed the tax treatment
for debt financing. Interest expenses for shareholder
and other loans are now limited to 30 percent of the
paying corporation’s earnings before interest, taxes,
depreciation, and amortization. Interest expenses in
excess of that ceiling are not deductible, but can be
carried forward to later years with the 30 percent limi-
tation.
Notwithstanding the deduction disallowance, the tax
treatment for the recipient of the interest did not
change, and it is considered interest income. Thin capi-
talization does not apply to interest payments under €1
44
SA Andritz, Conseil d’Etat (Dec. 30, 2003), no. 233894;
SARL Coréal Gestion, Conseil d’Etat (Dec. 30, 2003), no. 249047.
45
SA Andritz,supra note 44.
46
SARL Coréal Gestion,supra note 44.
47
See OECD commentaries, article 24, para. 91.
48
No. 13 O-2-05.
49
Set forth by section 57 of the French Tax Law.
50
Winston & Strawn LLP, ‘‘International French Thin-
Capitalization Rules Likely to Change,’’ Nov. 2005, available at
http://www.winston.com/siteFiles/publications/Frenchthin
capitalizationruleslikelytochange10-2005.pdf.
51
Wolfgang Kessler and Rolf Eicke, ‘‘New German Thin Cap
Rules — Too Thin the Cap,’’ Tax Notes Int’l, July 16, 2007, p.
263, Doc 2007-15373, or 2007 WTD 141-9.
52
Gotz T. Wiese and Tobias Klass, German Thin Capitalization
Rules, Latham & Watkins, 2003; Wolfgang Richter, Claus Lemai-
tre, and Frank Schoenherr, ‘‘Investment Round-up Germany —
Thin Capitalisation Rules’’ The New Economy, Jan.-Feb. 2008,
available at http://www.rp-richter.de/publikationen/documents/
WRI_FSC_CLE_New_Economy_01_2008_128-131.pdf
53
A qualified shareholder is a person who holds more than 25
percent in a German corporation.
54
The Company Tax Reform Act 2008 and the Tax Act 2008.
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million per year or if the payer debt-to-equity ratio is
not greater than the consolidated group debt-to-equity
ratio.
55
X. Changes in Europe’s Thin Cap Rules
In 2002 the ECJ published its decision in Lankhorst-
Hohorst GmbH.
56
The case concerned a German tax-
payer, Lankhorst-Hohorst GmbH, that incurred interest
expenses to its related person established and resident
in the Netherlands on debt in excess of the German
safe harbor debt-to-equity ratio. The case was referred
to the ECJ to determine whether the German thin
capitalization provision discriminates against foreign
companies in violation of the EC Treaty. The ECJ af-
firmed the taxpayer’s position, concluding that the Ger-
man thin capitalization provision indeed infringed on
the EU parent entities’ freedom of establishment, as
the provision mainly targeted foreign-owned com-
panies.
In Lankhorst-Hohorst GmbH, the German government
said its purpose in enacting thin capitalization rules
was to combat tax evasion:
All things being equal, it is more advantageous in
terms of taxation to finance a subsidiary com-
pany through a loan than through capital contri-
butions. In such a case, the profits of the subsidi-
ary are transferred to the parent company in the
form of interest, which is deductible in calculat-
ing the subsidiary’s taxable profits, and not in the
form of a non-deductible dividend. Where the
subsidiary and the parent company have their
seats in different countries, the tax debt is there-
fore likely to be transferred from one country to
the other.
57
The German government also states that according
to its then-in-force tax law,
58
the provision allows inter-
est deductions even when the ratio is in excess of 3 to
1 if the borrower could have borrowed in the same
terms from an unrelated party:
That provision is in accordance with the arm’s
length principle, which is internationally recog-
nized and pursuant to which the conditions upon
which loan capital is made available to a com-
pany must be compared with the conditions
which the company could have obtained for such
a loan from a third party.
59
Article 9 of the OECD model reflects the concern
that income shifting might result from thin capitaliza-
tion in providing for inclusion of profits for tax pur-
poses when transactions occur between related persons
on conditions that do not correspond to the market.
While the ECJ held that interest paid by a resident
subsidiary on a loan provided by a nonresident parent
company is taxed as a dividend, the case did not
change the treatment of a resident subsidiary whose
parent company is also a resident. For the same resi-
dent parent and subsidiary, the interest paid is treated
as an expenditure and not as a covert dividend. That
difference in treatment between resident subsidiary
companies according to the seat of their parent com-
pany constitutes an obstacle to the freedom of estab-
lishment that is prohibited by article 43 of the EC
Treaty. In another case,
60
the ECJ decided that the
Dutch thin capitalization provision was in conflict with
EU law because it was not covered by article 56(1) of
the EC Treaty (after amendment, article 46(1) EC) and
did not constitute a matter of overriding general inter-
est that may be relied upon to justify a restriction on
the freedom of establishment.
XI. Summary So Far
As has been shown, the U.K., France, and Germany
have amended their domestic thin capitalization legisla-
tion and followed a common trend in international tax
law. This shift departs from the requalification of inter-
est payments into dividends in favor of nondeductibil-
ity of excessive interest payments. It also was demon-
strated that the courts in Europe are concerned about
the application of domestic thin capitalization rules in
an international context. It can be inferred that thin
capitalization rules that are based on the arm’s-length
principle will not violate international law as presented
in the treaty, as it is supported by article 9 of the
model treaty.
Fixed ratio thin capitalization rules that have a strict
limitation and do not allow proper adjustments to
arm’s-length transactions will contradict the arm’s-
length doctrine and therefore also contradict a treaty.
61
Limiting interest deduction on one hand, and taxing
the income as taxable interest on the other, may result
in double taxation and violate the fundamental prin-
ciple of exclusively taxing net income. As two German
practitioners put it, the rule ‘‘disallows the deduction
of real economic losses and thereby taxes income that
is simply not there.’’
62
XII. Thin Cap: A Treaty Matter?
According to Prof. Pascal Hinny of the University
of Fribourg in Switzerland:
55
Richter, Lemaitre, and Schoenherr, supra note 52.
56
Lankhorst-Hohorst GmbH v. Finanzamt Steinfurt, C-324/00
(2002).
57
Id.
58
Para. 8a(1) of the Law on Corporation Tax (version in
force from 1996 to 1998).
59
Id. at para. 12.
60
Bosal (C-168/01).
61
As can be inferred from the Lankhorst-Hohorst,Andritz,
SARL Coréal Gestion, and Bosal cases.
62
Kessler and Eicke, supra note 51.
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major tendencies in the field of thin capitaliza-
tion . . . include (a) the increasing number of
countries that employ such rules and the continu-
ous tightening of interest deductibility under
these rules . . . (d) a general understanding is
evolving that thin capitalization rules applicable
to related party lending, together with the appli-
cable interest rate, are to be understood as a
transfer pricing issue.
63
The U.N. presented this position several decades ago
when it said thin capitalization is linked to transfer
pricing because the arm’s-length principle may be in-
voked to deal with it.
64
Thin capitalization rules are invented, expressed,
and defined by legislators as a tool to combat tax
avoidance. Countries with relatively higher tax rates
will be more concerned with tax avoidance issues and
therefore are more likely to enact tougher thin capitali-
zation rules to protect their tax bases.
As noted above, GAARs, whether included in a
treaty or in a country’s domestic legislation, do not
contradict a treaty but instead support one of the goals
treaties aim to achieve — the prevention of tax eva-
sion. The question of whether the treaty is violated by
rules enacted by domestic legislatures arises when a
domestic legislature tries to prevent tax evasion using
specific, targeted legislation that can violate the wording
and the provisions of a treaty.
Article 9 of the treaty covers thin capitalization
rules regarding international transactions between re-
lated persons. This article makes it clear that a con-
tracting state may interfere in a transaction between
associated enterprises when the transaction differs from
that which would have been made if the enterprises
were unrelated. This, of course, applies only when the
use of a treaty is not achieved by artificial transactions.
The OECD, first in its 1986 report and later in the
commentary on article 9, adopted the position that
thin capitalization rules are considered transfer pricing
issues.
It has concluded that thin capitalization legislation,
if based on the arm’s-length principles, will not contra-
dict a treaty. Given that conclusion, the question then
becomes whether a fixed ratio approach contradicts a
treaty. According to courts in Germany, France, and
the Netherlands, the answer is that a fixed ratio ap-
proach probably does contradict a treaty.
While thin capitalization rules are designed to pre-
vent tax avoidance, there are several other methods that
may be used to combat tax abuse (such as antiabuse
rules or treaty shopping).
65
By using these methods,
countries may avoid violating provisions in a treaty.
When a payment recipient is affected by application
of the source country’s thin capitalization rules, and
both the source and resident countries have a treaty in
force, the question becomes whether the revised treat-
ment of the payment is compatible with the provisions
of the treaty or whether the treatment must be modi-
fied again to comply with these provisions.
XIII. Thin Cap Rules vs. Treaties?
As noted above, there are three approaches to thin
capitalization rules: the fixed ratio approach, the arm’s-
length approach, and the safe harbor approach.
Thin capitalization rules as specific domestic anti-
abuse rules raise many questions in an international
context. For instance, what will happen if a treaty ap-
plies and one of the contracting states implements its
thin capitalization rules? Will the domestic thin capi-
talization rules override the provisions of the treaty (for
example, articles 9 and 24)? What if a bona fide arm’s-
length transfer pricing study leads to a different out-
come than the state’s thin capitalization rule?
Over time countries have amended their thin capi-
talization rules from the fixed ratio method to an
arm’s-length method (U.K.), or to the safe harbor
method (France).
Several decades have passed since the OECD exam-
ined the question of whether thin capitalization and a
treaty can coexist.
66
At that time, the OECD took the
position that thin capitalization rules did not contradict
articles 7 (business profits), 9 (associated enterprises),
10 (dividend), 11 (interest), 24 (nondiscrimination), and
27 (mutual agreement).
As reflected in the OECD commentary, since adopt-
ing the report of 1986, there has been interplay be-
tween tax treaties and domestic rules on thin capitali-
zation.
67
Article 9 does not prevent the application of
domestic rules on thin capitalization if their effect is to
compare the profits of the borrower to an amount cor-
responding to the profits that would have accrued in an
arm’s-length situation,
68
but does article 24 prevent the
application of domestic rules? As shown by the ECJ
cases noted above, it might. It is reasonable to assume
that the ECJ’s position concerning transactions within
the EU also will expand to transactions taking place
outside the EU, as worldwide transactions and the glo-
balization of businesses are now more common.
Some countries have taken steps to eliminate the
possible conflict between their thin capitalization rules
63
P. Hinny, IFA General Report (2008).
64
Supra note 17.
65
Id. at p. 26.
66
OECD Committee on Fiscal Affairs, ‘‘Thin Capitalization
Report’’ (Paris 1986).
67
OECD commentaries, article 9, para. 3.
68
See also Australian Taxation Office, Draft Taxation Ruling,
‘‘The Interaction of Division 820 of the Income Tax Assessment
Act 1997 and the Transfer Pricing Provisions,’’ TR 209/D6, Dec.
22, 2009.
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and tax treaties. Thin capitalization rules that disallow
interest expense deduction but treat the payment as
interest and withhold tax accordingly will result in
double taxation of the same income. This double tax
imposed by the source state cannot be eliminated by
the state of residency. It is true that these taxes have
not been legally imposed on the same taxpayer, but
they have been imposed on the same economic tax-
payer.
69
Some countries, when faced with these issues,
took active steps to clarify their position; others have
not.
That some countries have not worked to clarify their
position creates an uncertain environment for taxpayers
and makes them more insecure about their corporate
financing.
Canada reserved the right to apply its domestic leg-
islation in article 24(8) of the Canada-U.S. treaty,
which provides:
notwithstanding the provisions of paragraph 7, a
Contracting State may enforce the provisions of
its taxation laws relating to the deductibility of
interest, in force on September 26, 1980, or as
modified subsequent to that date in a manner
that does not change the general nature of the
provisions in force on September 26, 1980; or
which are adopted after September 26, 1980, and
are designed to ensure that non-residents do not
enjoy a more favorable tax treatment under the
taxation laws of that State than that enjoyed by
residents. Thus Canada may continue to limit the
deductions for interest paid to certain non-
residents as provided in section 18(4) of Part 1 of
the Income Tax Act.
70
Russia’s income tax treaties with some countries (for
example, Germany and the Netherlands) expressly pro-
vide for unlimited deductibility of expenses such as
interest. Therefore, the countries’ thin capitalization
rules are not applicable (in Russia the thin capitaliza-
tion rules are based on a debt-to-equity ratio of 3 to 1).
Russia’s treaty with Cyprus has no such provision,
which might lead to applying the Russian thin capitali-
zation rules. Nevertheless, in 2009 the Federal Arbitra-
tion Court of Moscow issued a decision on the unlim-
ited deductibility of expenses in relation to the Cyprus-
Russia treaty based on article 24 (nondiscrimination)
71
and ended the uncertainty. The court ruled that the
thin capitalization rules would not apply on transac-
tions between persons covered by a treaty that includes
article 24 in it.
Israel and Brazil agreed in their tax treaty, signed in
2002, that article 24 does not prevent a contracting
state from applying the provision of its tax law regard-
ing thin capitalization.
72
As Israel lacks specific thin
capitalization rules in its domestic legislation, it can be
inferred that Brazil proposed adding this provision to
the treaty.
Israel and the U.K. have agreed in article 7(5) of
their tax treaty
73
that:
any provision of the law of one of the territories which
relates only to interest paid to a non-resident company
. . . shall not operate so as to require such interest paid to
a company which is a resident of the other territory to be
left out of account as a deduction in computing the tax-
able profits of the company paying the interest as being a
dividend or distribution. The preceding sentence
shall not however apply to interest paid to a com-
pany which is a resident of one of the territories
in which more than 50 per cent of the voting
power is controlled, directly or indirectly, by a
person or persons resident in the other territory.
[Emphasis added.]
Therefore, the countries agreed that the domestic
thin capitalization rules would not apply unless there
was a 50 percent holding threshold.
While the U.S. model treaty includes an earnings
stripping provision that prevents the deduction of inter-
est in excess of a determined threshold, the OECD and
U.N. models do not include this provision.
74
When the
U.S. earnings stripping rule was enacted in 1989, the
U.S. went to great lengths to avoid the appearance of a
treaty violation by extending the provision to domestic
tax-exempt entities and not just to foreigners. This pre-
vented an apparent violation of the nondiscrimination
article.
75
In 1991 then-Sen. Larry Pressler of the Com-
mittee on Foreign Relations wrote a letter to the Treas-
ury secretary for tax policy expressing his deep con-
cerns on the potential conflict between some provisions
of IRC section 163(j) and tax treaties to which the
United States is a party.
76
XIV. Can Thin Cap Rules Violate Article 23?
Article 23(A and B) deals with the methods for
eliminating double taxation. Paragraph A(1) of the
69
See Section XIV, infra, of this article.
70
See also David Kerzner, Vitaly Timokhov, and David Chod-
ikoff, The Tax Advisor’s Guide To The Canada-U.S. Tax Treaty,
Thomson-Reuters-Carswell (2008), amended in 2010.
71
Emily Yiolitis, ‘‘Russia’s Thin Capitalization Rules in Light
of the Russia-Cyprus DTT’’ (2010), available at http://www.
sapphirecapital.proboards.com/index.cgi?board=taxes&action=
display&thread=3786.
72
Protocol to the Brazil-Israel tax treaty.
73
In 2009 Israel and the U.K. signed a new treaty that has not
yet entered into force, which is based on the OECD model. As
the U.K.’s thin capitalization rules are based on the arm’s-length
principle, the parties have not included a specific provision re-
lated to thin capitalization rules.
74
Avi-Yonah, supra note 41, at p. 14.
75
‘‘Pressler Says Interest, Thin Capitalization Rules Conflict
With Treaties,’’ Doc 91-4110,91 TNI 22-18.
76
‘‘Altman Defends Earnings Stripping Amendment,’’ Doc
93-9720,93 TNI 180-13.
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commentary on article 23 starts by explaining the rea-
son for having article 23. The OECD states that the
article deals with juridical double taxation, in which
the same income is taxable in the hands of the same per-
son by more than one state. In paragraph A(2), the
OECD says that juridical double taxation should be
distinguished from economic double taxation. The
OECD suggests that if states wish to solve problems of
economic double taxation, they must do so in bilateral
negotiations. In other words, states should address the
solution in their treaty or via mutual agreement proce-
dures. Paragraph 1(59) on article 23B states that the
residence country has an obligation to allow credit for
the tax levied by the source state if those taxes were
levied in accordance with the treaty.
In its commentary to article 23A, the OECD ad-
dresses dividends from substantial holding companies.
77
The OECD states that the effect of paragraphs 1 and 2
of article 10 and article 23 is that the state of residence
of the shareholder is allowed to tax dividends arising
in the other state, but that it must credit against its own
tax those dividends on which the tax has been col-
lected by the state where the dividends arise at a rate
fixed under paragraph 2 of article 10. These provisions
effectively avoid the juridical double taxation of divi-
dends, but they do not prevent recurrent corporate
taxation on the profits distributed to the parent com-
pany: first at the level of the subsidiary and again at
the level of the parent company. Such duplicative taxa-
tion creates a significant obstacle to the development of
international investment.
One of the suggestions given by the OECD to solve
the problem of duplicative taxation is to add a provi-
sion to the treaty that grants credit for underlying
taxes. The OECD suggested the following wording:
as regards dividends received from the subsidiary,
the State of which the parent company is a resi-
dent gives credit as provided for in paragraph 2 of
Article 23 A or in paragraph 1 of Article 23 B, as
appropriate, not only for the tax on dividends as such,
but also for the tax paid by the subsidiary on the profits
distributed (such a provision will frequently be
favoured by States applying as a general rule the
credit method specified in Article 23 B). [Empha-
sis added.]
In most of Israel’s tax treaties, in the U.S model
treaty (article 23(2)(b)), and in other OECD member
countries tax treaties, an underlying tax credit provi-
sion is included. The provision basically changes the
tax treatment on dividends from a subsidiary and treats
it, for credit purposes, as income derived directly by
the parent company.
78
If a country applies thin capi-
talization rules that prohibit a deduction to some inter-
est payments and treats the payment as interest to a
shareholder, that country will tax the corporate income
and then again tax the interest to the recipient, and it
would tax a third time on the same amount if it were
to be distributed as a dividend in the future. The tax
levied on the corporation’s disallowed deductions will
not be used in the residence country as the underlying
tax credit only applies to dividend income. As the
countries agreed bilaterally on how to grant credit, it is
an obligation of both counties to make sure they com-
ply. It is my opinion, therefore, that thin capitalization
rules that disallow a deduction while taxing the recipi-
ent as received interest income violate the idea behind
article 23 of the treaty.
XV. Conclusion
Thin capitalization rules are a tool to combat and
reduce tax avoidance, especially in the international
context. Thin capitalization is covered by transfer pric-
ing and nondiscrimination rules included in treaties,
whether the U.S., OECD, or U.N model. It is clear that
in some cases, thin capitalization rules (for example,
those that are different than the arm’s-length principle)
can contradict treaties.
However, by understanding the importance of anti-
avoidance legislation and the necessity of fighting tax
avoidance, one should remember that the antiavoidance
rules will be applied only when the transaction is an
artificial one and its main reason, considering all the
facts and circumstances, is to avoid tax.
79
If this is the
case, using GAARs that do not contradict or violate
tax treaties could be more appropriate.
Therefore, it is preferable to deal with international
tax abuse by specific antiabuse rules that will be added
in the treaty.
80
Consideration must be given to interna-
tional law and good faith compliance by the contract-
ing states.
There are some countries that already reserve their
right (as can be found in the OECD commentary) in a
bilateral negotiation and while signing treaty to use
their domestic thin capitalization rules. As the use of
thin capitalization rules is constantly increasing, it is
recommended that a specific provision should be added
to the OECD model that grants contracting states the
77
OECD commentaries, article 23, paras. 49-53.
78
When the parent corporation’s country of residency allows
the parent corporation to receive tax credit for income taxes paid
by its foreign subsidiary to the subsidiary’s residence country,
this has the same economic effect as treating the income as if it
were derived directly by the parent company in the subsidiary’s
residence country through a PE. (The source state, however, is
allowed to withhold tax on the dividend distribution.)
79
Gregory v. Helvering, 293 U.S. 465 (1935).
80
U.N. Committee of Experts on International Cooperation
in Tax Matters, Report on the first session Dec. 5-9, 2005, para.
22.
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right to include a specific provision allowing the use of
domestic thin capitalization rules.
81
Thin capitalization rules can be added to the model
by a specific provision that excludes the excess interest
payment from the application of the treaty (as is usu-
ally the case in articles 10, 11, and 12, but the excess is
determined by the arm’s-length principle) by determin-
ing the excess interest payments according to thin capi-
talization in the domestic law. An alternate approach is
to determine in the treaty that the excess interest over
the domestic thin capitalization rules will be subject to
a higher withholding tax rate, as long as the applicable
rate in the domestic laws allows a higher rate. Yet an-
other approach would be to have the countries (and the
treaty models) abandon the specific antiabuse rules and
instead promote the general antiabuse rules that will
not be limited to specific transactions but would in-
clude any transaction that has as its main purpose, or
one of its main purposes, tax avoidance. The courts,
the OECD, and the countries discussed are heading
toward the position that the parties should be allowed
to enter into transactions as they choose, unless the
reason for the transaction is tax avoidance. Therefore,
it is reasonable to conclude that specific antiavoidance
legislation will be replaced in the future by GAARs. ◆
81
The statement in the commentary on article 9 accepts thin
capitalization rules that are based on the arm’s-length approach
rather than the fixed debt-to-equity ratio approach.
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