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Treatment of Thin Capitalisation in Malawi

A thesis submitted to the Bucerius/WHU Master of Law and Business Program in partial fulfillment of the requirements for the award of the Master of Law and Business (“MLB”) Degree

REENA PURSHOTAM

July 16, 2010

13,107 words (excluding footnotes) Supervisor 1: Mr Florian Lechner Supervisor 2: Professor Deborah Schanz

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Table of contents

Table of Contents………………………………………………………………………….…(i)

Table of Cases……………………………………………………………………………….(iii)

Legislation considered……………………………………………………………………….(iv)

List of Abbreviations……………………………………………………………………..…..(v)

Chapter 1 – Introduction……………………………………………………………………….1

1.1 Taxation Generally……………………………………………………………………..1

1.2 What is Tax Evasion…………………………………………………………………...2

1.3 What is Tax Avoidance………………………………………………………………...4

1.4 Objectives of this Thesis……………………………………………………………….6

1.5 Structure………………………………………………………………………………..6

1.6 Methodology…………………………………………………………………………...7

Chapter 2 – The essence of Thin Capitalisation……………………………………………....8

2.1 What is thin capitalization? .......................................................................................8

2.2 Difference between Debt and Equity…………………………………………………..8

2.3 Advantages of Debt over Equity …………………………………………………..…..9

2.4 Why do countries have thin capitalisation rules? …………………………………….11

2.5 Different approaches to thin capitalisation …………………………………………..12

2.5.1 No rules approach……………………………………………………………..12

2.5.2 Fixed debt to Equity Ratio…………………………………………………….13

2.5.3 Arm’s Length Approach………………………………………………………13

2.5.4 Hidden Profits Distribution…………………………………………………...14

Chapter 3 – Overview of Corporate Taxation in Malawi…………………………………….16

3.1 Brief Facts about Malawi – Political and Economic……………………………….…16

3.2 Malawi Tax Authorities………………………………………………………………16

3.2.1 The Minister of Finance……………………………………………………....17

3.2.2 Malawi Revenue Authority…………………………………………………...18

3.3 Taxes Applicable to Corporate Entities………………………………………………18

3.4 Self-Assessment………………………………………………………………………18

3.5 Residence……………………………………………………………………………..18

3.6 Taxable Persons………………………………………………………………………18

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3.7 Tax Rates ……………………………………………………………………………..19

3.8 Dividends …………………………………………………………………………….20

3.9 Interest ……………………………………………………………………………….21

Chapter 4 – Thin Capitalisation Rules in Malawi, Germany and the United Kingdom……22

4.1 Thin Capitalisation in Malawi – A Brief Introduction ………………………………22

4.2 Anti-Avoidance under the Taxation Act ……………………………………………..22

4.3 Thin Capitalisation in Germany – Background ……………………………………..23

4.4 Current Treatment of Thin Capitalisation in Germany ……………………………..25

4.4.1 Exceptions to the Limitation on Interest Deduction …………………………27

4.5 Thin Capitalisation in the United Kingdom – Background …………………………29

4.6 Current Treatment of Thin Capitalisation in the United Kingdom …………………31

Chapter 5 – General Anti-Avoidance Rules – are they a necessary evil or are specific anti-

avoidance rules the answer? …………………………………………………………………34

5.1 Introduction …………………………………………………………………………..34

5.2 Significance of the Rule of Law ……………………………………………………...35

5.3 Are General Anti-Avoidance Rules bad? …………………………………………….37

5.4 Are specific anti-avoidance rules the answer? ……………………………………….38

Chapter 6 – Conclusion ………………………………………………………………………40

6.1 Critique of Malawi’s general anti-avoidance provision and suggested solutions ….42

6.2 Specific thin capitalisation rules: which way for Malawi? ………………………….45

Bibliography…………………………………………………………………………………..49

iii

Table of Cases

IRC v Duke of Westminster [1936] AC 1

Commissioners of Inland Revenue v McGuckian 1997 3 All ER 817 HL

McDowell and Co Limited v CTO ITR 148 (1985) (India)

Lankhorst-Hohorst GmbH v Finanzamt Steinfurt ECJ Case C-324/00, 12 December 2002

Ensign Takers (Leasing) Ltd v Stokes (1992) STC 226

VIR v Challenge Corporation Ltd (1887) 2 WLR 24 (NZ)

United States v Title Guarantee & Trust Co 133 F.2d 990 (6th Cir.1993)

Fin Hay Realty Co. v. United States 398 F.2d 694, 696-697 (3d Cir.1968)

R v Home Secretary ex p. Pierson [1998]AC 539 at 591

IRC v Brebner 43 TC 703

iv

Legislation Considered

Malawi

Taxation Act

Malawi Revenue Authority Act

Germany

German Corporate Tax Act

German Income Tax Act

German General Tax Code

United Kingdom

Finance Act

v

List of Abbreviations

MRA Malawi Revenue Authority

OECD Organisation for Economic Co-operation and Development

SOCAM Society of Accountants in Malawi

HMRC Her Majesty’s Customs and Revenues

GAAR General Anti Avoidance Rule


1

Chapter 1 - Introduction

1.1 Taxation generally

Taxation is central to the economic development of a country. The money that tax

authorities collect goes to Governments for implementation of various socio-economic

development projects. A challenge for most countries is finding the optimal balance

between a tax regime that is business and investment friendly, and one which can

leverage enough revenue for public service delivery to enhance the attractiveness of

the economy. Governments normally want to maximise the tax that they can collect.

Businesses on the other hand always seek to minimise their tax liabilities to the

greatest extent possible.

An oft repeated quote in one of tax law’s celebrated cases goes as follows:

“Every man is entitled if he can to order his affairs so as that the tax attaching

under the appropriate Acts is less than it otherwise would be. If he succeeds in

ordering them so as to secure this result, then, however unappreciative the

Commissioners of Inland Revenue or his fellow taxpayers may be of his

ingenuity, he cannot be compelled to pay an increased tax1”

However, not surprisingly, the learned judge’s statement in the above case has not

found much favour with tax authorities. The UK House of Lords itself has recognised

the limits of the Duke of Westminster case from which the above quote is taken. Lord

Steyn, in the case of Commissioners of Inland Revenue v McGuckian2 pointed out that,

“While Lord Tomlin‟s observations in the Duke of Westminster case still point to a

material consideration, namely the general liberty of the citizen to arrange his

financial affairs as he thinks fits, they have ceased to be canonical as to the

consequence of a tax avoidance scheme.

It is difficult to estimate exactly how much tax revenue countries (and particularly

developing countries like Malawi) lose to tax evasion and tax avoidance due to a lack

of data – companies that evade or avoid tax do not normally volunteer such

1 IRC v Duke of Westminster [1936] AC 1 per Lord Tomlin

2 1997 3 All ER 817 HL


2

information. Further, economic data in general is difficult to obtain in developing

countries. Fuest and Riedel state that “these data problems may explain why there is

very little reliable empirical evidence on tax avoidance and evasion in developing

countries. The existing studies mostly rely on highly restrictive assumptions and have

to make use of data of mixed quality”3. Fuest and Riedel add that “estimates of

revenue losses suffered by developing countries due to corporate profit shifting range

between approximately US$ 35 billion and US$ 160 billion per year”4. This wide

range of estimates shows how difficult it is to state with certainty the true extent of

revenues lost due to tax avoidance and tax evasion in developing countries.

Tax avoidance and Tax evasion are not the same thing and a distinction must be drawn

between them. Although this thesis discusses specific aspects of Tax Avoidance (thin

capitalisation) rather than Tax Evasion, one cannot discuss the former without

however briefly explaining the latter as it is sometimes difficult to draw a distinction

between them. What then is Tax evasion?

1.2 What is Tax Evasion

Tax evasion implies that there is an intention to avoid payment of tax even where there

is actual knowledge of liability. It normally involves deliberate concealment of the

facts from the revenue authorities, and is illegal. Evasion does not generally require an

intention to evade although a wilful intention or tax fraud is essential to establish a

criminal offence5.

The following remark has been attributed to Denis Healey, former UK Chancellor of

the Exchequer:

3 Fuest, C and Riedel, N. (June 2009). Tax evasion, tax avoidance and tax expenditures in developing countries:

A review of the literature. Oxford University Centre for Business Taxation at page 6 (Report prepared for

prepared for the UK Department for International Development (DFID)). Available at

http://www.sbs.ox.ac.uk/centres/tax/Documents/reports/TaxEvasionReportDFIDFINAL1906.pdf

4 Id at page III

5 Rohatgi, Roy. Basic International Taxation (Second Edition) Volume 2: Practice of International Taxation

(2007) at page 138

http://www.economicexpert.com/a/Denis:Healey.htm

http://www.economicexpert.com/a/Chancellor:of:the:Exchequer.htm

http://www.economicexpert.com/a/Chancellor:of:the:Exchequer.htm



3

“The difference between tax avoidance and tax evasion is the thickness of a prison

wall”6.

It must be noted that what can be defined as legal or illegal depends on national laws

and varies between states. What may be illegal in one country may be legal in another

and in cross-border transactions, one cannot identify what is illegal from an

international point of view7. The OECD in its 1987 report “International Tax

Avoidance and Evasion”, tried to give a definition of tax evasion. According to this

report, tax evasion covers an action by the taxpayer which entails breaking the law and

which moreover can be shown to have been taken with the intention of escaping

payment of tax. The report further states that “within tax evasion, a distinction is

sometimes made between the less serious offence of omission, such as the failure to

submit complete returns of income, and more serious offences such as false

declarations or fake invoices.”8

Unintended evasion, normally leads only to tax payments with interest and penalties

unless it is due to gross negligence9.

Some common examples of tax evasion include “the failure by a taxable person to

notify the tax authorities of his presence or activities in the country if he is carrying on

taxable activities, the failure to report the full amount of taxable income, the deduction

claims for expenses that have not been incurred, or which exceed the amounts that

have been incurred but not for the purposes stated, falsely claiming relief that is not

due and the failure to pay over to the tax authorities the tax properly due”. 10

6 Where and when the Chancellor actually uttered these words is not clear.

7 Finnerty, C; Merks, P; Petriccione, M; and Russo, R. Fundamentals of International Tax Planning (2007) at

page 52

8 Id at p 50


(2007) at page 138

10 Id


4

1.3 What is Tax Avoidance?

Although the dividing line between tax avoidance and tax evasion is sometimes

unclear, tax avoidance is generally considered to be legal11

. Tax avoidance has been

defined in various ways over the years by leading legal minds.

Justice Reddy in the case of McDowell and Co Limited v CTO defined tax avoidance

as “the art of dodging tax without breaking the law”12

.

The European Court of Justice in the case of Lankhorst-Hohorst GmbH v Finanzamt

Steinfurt13

defined tax avoidance as “artificial arrangements aimed at circumventing

the law”

It is important to note that the presumption that tax avoidance is a legal phenomenon

may not be completely right because most tax regimes have enacted anti avoidance

laws14

. There are countless methods of avoiding tax - the question is what is

acceptable tax avoidance and what is unacceptable tax avoidance? The difference is

sometimes difficult to delineate. Tax avoidance and evasion have an important effect

on the economic development of every economy and many countries have enacted

rules to deal with certain types of tax avoidance (mostly by laying down what is not

acceptable).

Lord Goff in Ensign Takers (Leasing) Ltd v Stokes15

stated that “Unacceptable tax

avoidance typically involves the creation of complex structures by which the taxpayer

conjures out of the air a loss, or a gain or expenditure, or whatever it may be, which

otherwise would never have existed...”

The 1987 OECD report “International Tax Avoidance and Evasion” states that “Tax

avoidance …is of concern to governments because such practices are contrary to

11

Id at page 139

12 ITR 148 (1985) (India)

13 ECJ Case C-324/00, 12 December 2002;

14 Commonwealth Association of Tax Administrators (CATA). Tax Evasion and Avoidance Australia. Available

online at CATA : http://www.catatax.org/upiloads/Tax%20evasion%20and%20avoidance.pdf

15 (1992) STC 226

http://www.catatax.org/upiloads/Tax%20evasion%20and%20avoidance.pdf


5

fiscal equity, have serious budgetary effects and distort international competition and

capital flows.”16

A country’s tax laws will largely determine the scope of tax avoidance. In most

countries, the concept of the sham transaction applies: where the taxpayer presents to

the tax authorities a purported transaction, but the legal reality of the transaction is

different under private law, tax will be applied according to the actual legal reality, not

the taxpayer’s pretended reality. This situation is borderline between tax avoidance

and tax evasion17.

Acceptable tax avoidance or tax planning on the other hand, reduces tax liability

through the movement (or non-movement) of persons, transactions or funds, or other

activities that are intended by legislation. It refers to tax mitigation by the use of tax

preferences given under the law or by means that the tax law did not intend to tax. For

example, the law may provide the taxpayer with tax incentives, allowances and

deductions to avoid tax liabilities or to gain a tax advantage18

.

With respect to tax planning, the 1987 OECD Report states that:

“It is possible to reduce or remove tax liability by perfectly acceptable tax

planning (e.g. choosing among tax reliefs and incentives the most

advantageous route consistent with normal business transactions), or even by

refraining from consuming a taxed product, and it is clearly not the intention

of Governments to combat activities of this kind. To describe tax planning or

abstention from consumption as “tax avoidance” is however, to strain the

meaning of language, ordinarily used, and governments tend to take an

operational approach towards tax avoidance to cover those forms of tax

minimisation which are unacceptable to governments”19

.

16

Para 10 of the OECD report

17 Thuronyi, V. (Senior Counsel (Taxation), International Monetary Fund). Rules in OECD Countries to Prevent

Avoidance of Corporate Income Tax at page. 2


(2007) at page 142

19 OECD Paris (1987). International Tax Avoidance and Evasion – Four Related Studies at p 11.


6

The court, in the case of VIR v Challenge Corporation Ltd20

, aptly described the

difference between acceptable and unacceptable tax avoidance as follows:

“Income tax is mitigated by a taxpayer who reduces his income or incurs

expenditure in circumstances which reduces his assessable income or entitles

him to a reduction in his tax liability....the taxpayer‟s tax advantage is not

derived from an “arrangement” but from the reduction of income which he

accepts or the expenditure which he incurs. The taxpayer engaged in

(unacceptable) avoidance does not reduce his income or suffer a loss or incur

expenditure but nevertheless obtains a reduction in his liability to tax as if he

had”.

Companies use many different ways to avoid or mitigate tax – most of which are too

numerous to mention and are beyond the scope of this thesis. One of the ways in

which a company can reduce its tax burden is through thin capitalisation which will be

discussed in detail in the following Chapter. Many countries have adopted thin

capitalisation rules to prevent non-resident shareholders of resident corporations from

using excessive debt capital to extract corporate profits in the form of deductible

interest rather than non-deductible dividends21

.

1.4 Objectives of this Thesis

The focus of this thesis is on the methods employed by Malawi to counteract the

effects of thin capitalisation. The thesis evaluates the adequacy of current legislation

on thin capitalisation in Malawi, looks at how various jurisdictions deal with thin

capitalisation (focusing in particular on two OECD countries, Germany and the UK),

concludes that the present legal framework is inadequately structured to deal with

revenue losses through thin capitalization and identifies key areas for reform.

1.5 Structure

This thesis is organised as follows: Chapter 2 discusses what is meant by thin

capitalisation generally. Chapter 3 gives an introduction to Malawi Corporate Taxation

and Chapter 4 discusses the ways in which Malawi, Germany and the UK deal with

20

(1887) 2 WLR 24 (NZ)

21 Arnold, B. J. and McIntyre, M.J. International Tax Primer. Second Edition (2002), at page 83


7

thin capitalization. This thesis chooses to discuss Germany because as the largest

economy in Europe, it has a complex and interesting tax system that is worth

discussing and chooses the UK because Malawi, a former British colony, has strong

ties to the UK. Malawi’s legal system is based on the British legal system and as a

common law jurisdiction Malawi continues to be greatly influenced by the United

Kingdom in terms of its laws which it mostly inherited from the UK. UK case

authorities have persuasive value in Malawi courts. Chapter 5 analyses the pros and

cons of general and specific anti-avoidance legislation, explores the strengths and

weaknesses of Malawi’s anti-avoidance legislation and suggests ways in which

Malawi can improve its laws on thin capitalisation taking into account its own

experience and the experiences of other jurisdictions (mainly the UK and Germany).

Chapter 6 concludes and takes the position that while there is a need to amend

Malawi’s General Anti-Avoidance provision and to introduce specific thin

capitalisation legislation, the way forward for the country is not to simply copy laws

from other jurisdictions but rather to draft laws that will be suitable for Malawi, taking

into account the country’s own unique characteristics.

1.5 Methodology

The main sources of information and data are primary and secondary materials.

Primary sources include domestic legislation, regulations and guidelines. Secondary

sources consulted include journal articles and books. Case law has also been

considered where necessary. Internet sources are only used where they provide

information that is otherwise not available in journals and in primary sources and

where they provide current information and data.


8

Chapter 2 – The essence of thin capitalisation

2.1 What is thin capitalisation?

A company is considered thinly capitalized when its capital is made up of a much

greater proportion of debt than equity. This is usually done with the sole or primary

motive to benefit from its tax advantages. The 1987 OECD Report states that the term

“thin capitalization is commonly used to describe “hidden equity capitalization”

through excessive loans22

.

2.2 Difference between Debt and Equity

Equity capital generally shares in the rewards of the business but it also bears the

entrepreneurial risks. The company does not owe the shareholder the money and

cannot repay invested capital except on liquidation or share reduction. Shareholders

generally only receive income when the company distributes that income to them.

They are entitled to their share of distributable profits as dividends without any limit,

but only if the company makes a profit and they can lose the entire capital in business

losses.23

The Court in the case of United States v Title Guarantee & Trust Co24

defined a shareholder as one “embarking upon the corporate venture, taking the risks

of loss attendant upon it, so that he may enjoy the chances of profit”25

.

Loan capital is different from equity capital in that the loan provider does not share in

the risks and rewards in the borrower’s business. Further, the capital lent is the

liability of the company and is repayable with interest. This repayment is not

independent of whether or not the company has made a profit or a loss. The rights of

the lenders take priority over those of the shareholders in respect of the interest and the

repayment of their loans.26

Thus, an equity risk is regarded as subordinate or junior to

22

Committee on Fiscal Affairs, Issues in International Taxation No. 2 – Thin Capitalisation (OECD, 1987)

23 Rohatgi, Roy. Basic International Taxation. (2002) at page 399

24 133 F.2d 990 (6th Cir.1993)

25 Id at page 993



9

a debt interest in a company and an equity interest generally carries greater risk than a

debt interest in the same company.27

However, it is not always easy to distinguish debt from equity. As the court put it in

Fin Hay Realty Co. v. United States28

:

“Neither any single criterion nor any series of criteria can provide a

conclusive answer in the kaleidoscopic circumstances which individual cases

present…The various factors….are only aids in answering the ultimate

question whether the investment, analysed in terms of its economic reality,

constitutes risk capital entirely subject to the fortunes of the corporate venture

of represents a strict debtor-creditor relationship. Since there is often an

element of risk in a loan, just as there is an element of risk in an equity

interest, the conflicting elements do not end at a clear line in all cases”

2.3 Advantages of Debt over Equity

Corporate issues of equity and debt are alternative methods of raising capital. One

could argue that from a financial perspective, changes in a firm’s capital structure will

not change the firm’s value and indeed from a purely economic point of view as

opposed to a tax point of view, it should not make much of a difference whether a

company raises funds through debt or equity29

. Why then do companies choose to

thinly capitalise?

From a tax point of view companies choose thin capitalisation because existing

corporate tax systems allow companies to deduct interest expenses from the corporate

tax base whereas equity returns to investors are not tax deductible. Income earned by a

resident corporation and distributed to its shareholders (in the form of dividends) is

subject to two levels of tax – corporate tax when the income is earned by the

corporation and shareholder tax when the income is distributed to the shareholder as a

dividend. In the case of a non-resident shareholder, the shareholder tax is usually

imposed as a withholding tax.30

27

Block C.D. Corporate Taxation. Fourth Edition (2009) at page 43.

28 398 F.2d 694, 696-697 (3d Cir.1968)

29 Block C.D. Corporate Taxation. Fourth Edition (2009) at page 47.

30 See Arnold, B. J. and McIntyre, M.J. International Tax Primer. Second Edition (2002), at page 83


10

A multinational company can choose its capital structure according to differences in

international taxation, in order to minimise the tax burden of the whole group of

companies. For instance, a company located in a low tax country could lend to an

affiliate in a high tax country. This would allow the company located in the high tax

country to deduct interest payments from its profits resulting in a significant reduction

of the overall tax payment which would not be the case if the company were funded

with equity31

. A simple illustration of the relative advantage of debt over equity

financing is shown below:

“NCo, a non-resident corporation, owns all of the shares of RCo, a resident

corporation. RCo requires capital of one million to finance its business activities. To

provide that capital, NCo can either subscribe for one million in additional shares of

RCo or it can loan RCo one million. RCo earns income before the payment of interest

or dividends, of 100,000 and distributes its entire after tax income as a dividend. The

arm‟s length interest payable on loans is 10 per cent, and the applicable rates of

withholding tax are 5 per cent on dividends and 10 per cent on interest. A comparison

of the tax results of advancing funds by debt and by equity are set forth in the

following table32

”.

Debt Equity

Corporate Income before

payment of interest or dividends 100,000 100,000

Deduction of interest 100,000 not applicable

Taxable Income nil 100,000

Corporate Tax (40%) nil 40,000

Dividends not applicable 60,000

Withholding tax(10%, 5%) 10,000 3,000

Total tax 10,000 43,000

The example above shows that a tax saving of 33,000 Euros is made by financing with

debt rather than equity. Considering that Multinational companies deal in transactions

31

See Overesch, M. and Wamser, G. (2010) Corporate tax planning and thin capitalization rules: evidence from

a quasi-experiment. Applied Economics, 42:5, 563-573, First published on: 13 November 2007 (iFirst).

32 Example taken from Arnold, B. J. and McIntyre, M.J. International Tax Primer. Second Edition (2002), at

page 84


11

worth millions rather than thousands, the tax savings are all the more significant. In

fact international debt shifting is suspected to be a core factor behind empirical

findings that multinational firms seem to pay substantially lower taxes, as a share of

pre-tax profits, as compared to nationally operating firms33

.

Given this bias for debt over equity financing, many countries have introduced rules to

limit the deductibility of interest expenses in cases where the leverage is considered

excessive. These rules are commonly known as “thin capitalization rules”

It must be stressed that the way a company is financed may on good commercial

grounds be decided by other reasons than just tax. For example, the proportion of a

company’s capital which is financed by either equity contributions and/or loans could

also arise due to economic or commercial necessity or desirability34

.

2.4 Why do countries have thin capitalization rules?

Thin capitalization rules are aimed at preventing the abusive use of debt or quasi-debt

in cross-border transactions. Generally they apply only to loans made or guaranteed by

shareholders of the company with the effect of disallowing the deduction of interest

payments on debt financing deemed to be excessive for tax purposes35

.

Although it is not known to exactly what extent thin capitalization is a widespread

phenomenon, studies seem to suggest that thin capitalization is indeed a significant

phenomenon within the international sphere. In 2003, R. Altshuler and H. Grubert,

using available data from the United States of America (US), found that 1% higher tax

rate in foreign affiliates of US multinationals raises the debt/equity ratio in those

affiliates by 0.4%36

. A similar study for Europe was conducted in 2006 by H.

Huizinga, L. Laeven and G. Nicodeme. Looking at evidence collected from over

90,000 subsidiaries, across thirty-one European countries, they found that an increase

33

Haufler, A and Runkel, M. Firm’s financial choices and thin capitalization rules under corporate tax

competition. Paper presented at the European Tax Policy Forum in London and at the CEifo Workshop

“Taxation and Multinational Firms” in Venice

34 OECD, Thin Capitalisation (1987) p. 9.


page 221

36 See Taxes, repatriation strategies and multinational financial policy (2003) Journal of Public Economics 87,

73-107.


12

in the effective tax rate of 0.06% in the subsidiary’s country, will result in a 1.4%

increase in its debt over total assets ratio37

.

It is hardly surprising therefore that many countries enact thin capitalisation rules.

However, not all countries have them. Some believe that such rules are not necessary,

others rely on general anti-avoidance provisions and yet others depend on their

transfer pricing rules (the UK for instance has repealed its thin capitalization rules;

however, thin capitalization is covered in its extended transfer pricing rules) or on

exchange controls. Of the countries that do have thin capitalization rules, many

diverge in their application of the rules38

.

2.5 Different approaches to thin capitalisation

Countries will commonly use one of the following approaches or combinations thereof

to control thin capitalization:

2.5.1 No rules approach

Some countries like Austria, do not have specific thin capitalization rules.

However, Austria’s Supreme Administrative Court established certain broad

and liberal guidelines, which are used to determine whether the equity for

commercial purposes is adequate for tax purposes. If the equity is inadequate, a

portion of the indebtedness to shareholders may be regarded as the equivalent

of shareholders’ equity.39

Some countries, as already stated above rely on

general anti-avoidance provisions rather than specific thin capitalization rules.

37

See “Capital Structure and International Debt Shifting”, CEB Working Paper Series, WP 07-015, 2007 as

discussed in “Thin Capitalization Rules in The Context of The CCCTB”, Dourado, A; and de la Feria, R;

Oxford University Centre For Business Taxation.


(2007) at page 216


page 222


13

2.5.2 Fixed Debt to Equity Ratio

Under this method, tax consequences emerge where the debtor exceeds a

certain proportion of its equity. The rules also stipulate the minimum

controlling interest that indicates the ability of a shareholder to influence the

financing decisions within the company40

. Although this method appears to be

one of the more straight forward methods of controlling thin capitalization, the

fixed ratio method often operates in a much more complex fashion, as the

application of the ratio is usually dependent on various other conditions.

The debt – equity ratio may be computed differently under the tax rules. In

some countries, the debt –equity ratio is calculated for each single non-resident

shareholder. While others base it on the total debt-equity ratio for all non-

resident shareholders or all shareholders.41

2.5.3 Arm’s length approach

This approach is based on the general principles of transfer pricing42

. Under

the arm’s length method, a comparison is made between the actual financing

structure, and that which would have arisen had the parties involved not been

related. The onus is on the taxpayer to prove that the same loan could have

been obtained from a third party under the same circumstances and conditions.

What will constitute proof, may vary amongst countries, but usually will

include aspects such as interest rates, the extent to which the lender and

borrower are related, a comparison of debt/equity ratio and also whether the

loan is subordinate to the rights of other creditors43

.

40

Rohatgi, Roy. Basic International Taxation. (2002) at page 397

Basic International Taxation, at p. 397


42 Id at p. 399

43 See Brosens, L. Thin capitalization rules and EU law. (2004) EC Tax Review 4, 188-213, at p. 190.


14

2.5.4 Hidden Profits Distribution

Some countries have specific provisions under their tax law that allow loan

interest to be reclassified as a hidden profit or constructive dividend in certain

circumstances44

. This would have the same effect as if the shareholder had

provided finance in the form of equity. As a consequence, the reclassified

interest (representing a dividend) increases the corporation’s profit and hence

the corporate tax applicable. Further, as the interest is treated as a distribution

of profit, the dividend withholding tax rate is applicable. These rules will

usually apply where the parties to the transaction are related parties or if the

subsidiary company is undercapitalised and a loan from the parent or affiliated

companies is of a permanent nature or is granted on a non-arm’s length basis45

.

The following table46

gives a summary of some OECD member states different

approaches to thin capitalisation.

TABLE 1: SOME OECD MEMBER STATES’ APPROACHES TO THIN

CAPITALIZATION Method Used Scope Effect

Thin

capitalizatio

n Rule

Arms’

Length

Principl

e

Fixe

d

Rati

o

Debt/Equit

y Ratio

Participatio

n Rule

Excess

Debt Non-

Deductibl

e

Interest Re-

Characterize

d as Dividend

Austria

Yes

47 X x

Belgium

Yes X 1:1/7:1 X x

Czech

Republic

Yes X 4:1/6:1 X

Denmark Yes X 4:1 50% X

Finland

No

France

Yes X 1.5:1 50% X

44

Rohatgi, Roy. Basic International Taxation. (2002) at page 397

45 Piltz, D. General Report in Cahiers De Droit Fiscal International: International Aspects of Thin

Capitalisation (1996) XXXIb International Fiscal Association, Geneva Congress at page 121

46 Table adapted from Dourado, A. and De La Feria, R. Thin Capitalization Rules In The Context Of The

CCCTB. at page18

47 No specific thin capitalization rule, but guidelines set out by the Austrian Administrative Court.


15

Germany

No

48 X

Greece

No

Hungary

Yes X 3:1 X

Italy Yes X 4:1 25% X X

Luxembour

g Yes

49 X 85:15

Netherlands Yes X 3:1 33% X

Poland Yes X 3:1 25% X

Portugal Yes X 2:1

10% / 90% /

Other X

Spain Yes X 3:1 X x

Sweden No

United

Kingdom Yes X

48

Thin capitalization rules have been substituted by a new “earnings stripping rule”, with effect from 1 January

2008.

49 No specific thin capitalization rule, but rules emerge from administrative practice.


16

Chapter 3 – Overview of Corporate Taxation in Malawi

3.1 Brief Facts about Malawi – political and economic

Malawi is a small land locked country in Central Africa. Malawi (formerly known as

Nyasaland) was a British colony until it attained its independence from Britain in

1964. For three decades after independence, Malawi was under one party rule under

President Hastings “Kamuzu” Banda. In 1994 Malawi became a democracy under the

leadership of President Bakili Muluzi. The current President Bingu wa Mutharika was

elected into office in 2004 and is currently serving his second and final term in

office50

.

Malawi’s population as of 2008 was 13.1 million51

. The country has enjoyed a seven

year period of uninterrupted growth even in the midst of a global recession52

.

Malawi’s GDP (purchasing power parity) stands at 12.81 billion US Dollars and its

GDP per capita is 900 US Dollars53

. The Malawi Kwacha is the legal tender currency

of Malawi. It is divided into 100 tambala.

3.2 Malawi Tax Authorities

3.2.1 Minister of Finance

The Minister of Finance has the overall responsibility for tax administration in

Malawi. The Minister is under the duty to determine and ensure the effective

application of Malawi’s fiscal policies and also to ensure the effective

coordination of the policies for the collection and preservation of revenue

accounts54

.

50

CIA World Factbook 2010 – last updated June 24, 2010, also see World Bank 2010, Country Brief

51 Information obtained from National Statistics Office Malawi

52 Randall, R. Matlanyane, A. Amo Yartey, C and Thornton, J IMF Survey Magazine. Malawi's New IMF Loan

Boosts Prospects for Sustained Growth. IMF African Department April 1 2010: Available at

http://www.imf.org/external/pubs/ft/survey/so/2010/car033110a.htm

53 2009 estimates - CIA World Factbook – last updated June 24, 2010

54 Section 7 (a) and (b) of the Malawi Revenue Authority Act



17

3.2.2 The Malawi Revenue Authority

The Malawi Revenue Authority (MRA) is an agency of the Malawi

Government that is responsible for the assessment, collection and accounting

of tax revenues. MRA was established by an Act of Parliament (the Malawi

Revenue Authority Act) in 1998 but was only launched in 2000.

The Malawi Revenue Authority which is headed by the Commissioner General

and is supported by the Commissioner of Income Tax, the Commissioner of

Customs and Excise and the Commissioner of Value Added Tax is responsible

for the implementation and enforcement of tax legislation. The duties of the

Authority are (among others) to promote voluntary tax compliance and

counteract tax fraud and other forms of fiscal evasion55

. The Commissioner

General is charged with the general administration of the Taxation Act under

the direction of the Minister of Finance56

and is required to furnish the Minister

with an annual report on the working of the Act for presentation to the

National Assembly57

. In the annual report the Commissioner is required draw

attention to any breaches or evasions of the Taxation Act which have come

under his notice.

Tax revenue mobilisation has been strong over the past five years, averaging

17% of GDP. The establishment of the semi-autonomous Malawi Revenue

Authority (MRA) in 1998 has helped to expand the tax base and improve

compliance. In 2009, 2516 new tax payers were registered. At MWK 75.36

billion, the total tax revenue in the 2008/09 tax year represented a 32 per cent

increase over the 2007/08 level. As a proportion of total revenues, tax revenues

have increased from 53 per cent in 2005/06 to 60 per cent in 2007/0858

. In his

2010/ 11 Budget Statement delivered to the National Assembly59

, the Minister

of Finance, the Honourable Ken E. Kandodo Banda stated that tax revenues are

55

See Section 4 (2) of the Taxation Act

56 See Section 3 (1) and 3 (2) of the Taxation Act

57 See Section 5 (1) and 5 (2) of the Taxation Act

58 Information obtained from Malawi Revenue Authority

59 On 28

th May, 2010


18

projected to rise to K139.9 billion from K105 billion last year representing an

increase of 41 per cent.

3.3 Taxes applicable to corporate entities

Corporations operating in Malawi pay various taxes including income tax, Value

Added Tax (VAT), property tax, fringe benefits tax, resource rent tax, customs duties

and excise duties.

The rules applicable to the income of different types of legal persons or different types

of transactions are all contained in the Taxation Act.60

3.4 Self - Assessment

Malawi operates a system of self –assessment. The tax payer is fully responsible for

the calculation of taxable income, its declaration and the payment of related tax. The

burden of proof therefore falls entirely on the taxpayer and he is liable to penalties for

any act of non-compliance.

3.5 Residence

A company is considered resident if it is incorporated in Malawi61

.

3.6 Taxable persons

A person must be registered as a taxable person if he or she makes taxable supplies of

goods and services and his business turnover is or exceeds K6 million per annum. It

should be noted that the threshold is not taxable turnover of K6 million per annum but

total turnover, including non-taxable supplies, of K6 million per annum

Corporate entities are subject to corporate tax for each year of assessment upon

income of every company at a specified rate (see 3.7 (i) below).

60

Chapter 41:01 of the Laws of Malawi

61 Section 2 – Taxation Act


19

3.7 Tax Rates

(i) Tax rates on business income varies depending on the nature of trade and

incentives that a company may be entitled to. Under Schedule 11 of the

Taxation Act, the standard tax rate for all companies (with the exception of

those engaged in mining operations under a licence issued under the Mines and

Minerals Act), is 30 per cent of taxable income for companies registered in

Malawi and 35 per cent for branches of foreign companies. However, there are

further exceptions to this rule:

(ii) The applicable tax rate for companies in an export processing zone, is 0 per

cent. Export Processing Zones are as designated by the Minister of Finance by

order published in the Gazette62

.

(iii) The applicable tax rate in the case of companies operating in priority industries

(so designated by the Minister by Order published in the Gazette) is either 0

per cent for a period not exceeding 10 years (and 30 per cent thereafter) or 15

per cent63

. An additional 5 per cent of taxable income is charged in respect of

all companies not incorporated in Malawi.

(iv) The applicable tax rate for companies engaged in mining operations under a

licence issued under the Mines and Mineral Act is 30 per cent of taxable

income. An additional tax of 5 per cent of taxable income is charged in respect

of all companies not incorporated in Malawi and an additional resource rent

tax of 10 per cent is levied on profits after tax, if the company’s rate of return

exceeds 20 per cent64

.

A company carrying out mining operations is entitled to a mining allowance in

respect of its mining expenditure. This allowance is equal to 100 per cent of

such expenditure in the first year of assessment65

.

62

Schedule 11 paragraph c (i)

63 Schedule 11 paragraph c (ii)

64 Schedule 11 paragraph ca (i) and (ii) of the Taxation Act

65 Section 12 of Part II – Taxation Act


20

(v) in the case of life assurance business, the applicable rate is 21 per cent of the

taxable income66

;

(vi) in the case of fringe benefits, the applicable rate is 30 per cent of the taxable

value of fringe benefits67

.

3.8 Dividends

Under Section 70A. (1) of the Taxation Act, a distribution of dividends is subject to 10

per cent Dividend Withholding Tax. However, dividends are exempt from withholding

tax where the dividend is distributed by a subsidiary or a holding company to a

holding or related company and the income being distributed is derived from a

dividend which was subject to withholding tax in first instance.

Further, Dividends Withholding Tax should not be deducted in respect of dividends

payable to residents of countries which have a Double Taxation Agreement with

Malawi and the dividend is exempted from Malawi Tax in terms of the agreement.

It should be noted that while some Double Tax Agreements exempt non-resident

recipients of Malawi dividends from Dividend Withholding Tax provided that the

dividend is taxable in the recipient’s tax jurisdiction, the Malawi Revenue Authority

(MRA) has previously given instructions to listed companies to deduct the

Withholding tax even in such cases. The Society of Accountants in Malawi (SOCAM)

has noted that this could be due to administrative difficulties experienced by dividend

paying companies in applying the exemption as MRA is entitled to request proof that

the dividend is subject to tax elsewhere. This problem does not arise in respect of

unlisted companies68

.

Dividend Withholding Tax must be remitted by the company paying the dividend

within 14 days of the date of distribution69

. Although date of distribution has not been

defined, it is generally understood to be the date of declaration70

.

66

Schedule 11 paragraph d – Taxation Act

67 Schedule 11 paragraph e – Taxation Act

68 Information obtained from Society of Accountants in Malawi. Tax Guide to Malawi.

69 See Section 70A (1) – Taxation Act

70 See Society of Accountants in Malawi. Tax Guide to Malawi.


21

3.9 Interest

A withholding tax of 15 per cent is applies to interest payments made to non-residents

unless this is reduced under an applicable tax treaty. A 20 per cent rate71

applies to

residents as an advance tax.

71

See Schedule 14 of the Taxation Act


22

Chapter 4 - Thin capitalisation rules in Malawi, Germany and the United

Kingdom

4.1 Thin capitalisation in Malawi - Brief Introduction

Malawi does not have specific thin capitalisation legislation. However, the Malawi

Taxation Act contains a general anti – avoidance principle that has been used to

address the problem of thin capitalisation.

4.2 Anti- avoidance under the Taxation Act

Section 127 (2) of the Taxation Act provides as follows:

Where the Commissioner is of the opinion that the main purpose or one of the

main purpose for which any transaction or transactions was or were effected

(whether before or after the passing of this Act) was the avoidance or

reduction of liability to tax for any year, or that the main benefit which might

have been expected to accrue from the transaction or transactions was the

avoidance or reduction of liability to tax, he may, if he determines it to be just

and reasonable, direct that such adjustments shall be made as respects liability

to tax as he considers appropriate to counteract the avoidance or reduction of

liability to tax which would otherwise be effected by the transaction or

transactions:

Provided that no such direction shall require that adjustments shall be made

as respects liability to tax for any year of assessment prior to the year of

assessment commencing on the 1st April, 1968.

As can be seen from the above provision, Malawi’s anti- avoidance rules covers every

aspect of tax - avoidance from thin capitalisation to transfer pricing and to anything

else that the Commissioner in his opinion deems was effected for the avoidance or

reduction of liability to tax for any year.

Despite the lack of specific thin capitalisation provision in the Taxation Act, where a

foreign shareholder funds its Malawian subsidiary with debt rather than equity, it is


23

the practice of the Commissioner of Taxes to construe a deemed dividend where the

debt to equity ratio exceeds 3:172

.

The Act also provides for an appeals procedure against a decision of the

Commissioner. Section 127 (5) provides:

“Any person aggrieved by any direction of the Commissioner made under

subsection (2) may appeal therefrom either on the grounds that no direction

ought to have been given or that the adjustments directed to be made are

inappropriate; and all the provisions of this Act relating to appeals against

assessments, shall, so far as they are applicable, have effect with respect to

any such appeal as if such appeal were an appeal against an assessment:

Provided that any direction made under subsection (2) shall not be the subject

of any appeal except under this subsection”.

4.3 Thin Capitalisation in Germany - Background

The German legislature massively limited the tax-effective deduction of interest

expenses (intra group debt financing, shareholder debt financing, bank loans) for

German Corporate Income Tax and Trade Tax purposes by introducing the unique

concept of the interest barrier (Zinsschranke) within the German Business Tax Reform

200873

. Under the old rules, interest payments on long-term loans by companies to

their shareholders holding a substantial interest were classified as non-deductible

constructive dividends for corporate income tax purposes if the interest was paid on

excessive debt financing and exceeded the amount of EUR 250,000 per tax year.

Details of the application of these rules were laid down in a letter issued by the

Federal Ministry of Finance74

. According to notes 19 and 20 of this circular, the thin

72

See Deloitte International Tax 2010 – Malawi Highlights

73 See Homburg (2007, pp. 717-728), Kessler and Köhler and Knörzer (2007, pp. 418-422), Eilers (2007, pp.

733-735) as cited by Kollruss, T. in Tax optimal cross-border debt financing under the new German Thin-

Capitalization-Rule (German interest barrier) : Intra fiscal group cross-border debt financing via a foreign fiscal

group finance branch. Investment Management and Financial Innovations, Volume 7, Issue 2, 2010.

74 letter of 15 July 2004, IV A 2 – S 2742a – 20/04, BStBl I 2004 at 593.

http://ip-online.ibfd.org/linkresolver/static/cta_de_abb_bstbl


24

capitalization rules applied to loans granted by a third party to a corporation only if the

third party had a right of recourse against the substantial shareholder or a related party

based on a contractual claim (e.g. guarantee, comfort letter) or on security (e.g. pledge,

mortgage) and the interest payable by the corporation under the loan was linked to

interest-bearing deposits (not short-term) which are for the direct or indirect benefit of

the shareholder or a related party (“back-to-back financing”).

Under the old rules, a loan for longer than 1 year was generally treated as a long-term

loan for thin capitalization purposes. A substantial interest existed if a person (or

several persons in common interest) owned more than 25% of the nominal capital of a

resident company either directly or indirectly.

Debts were regarded as excessive if they exceeded the prescribed debt-equity ratios.

The debt-equity ratios depended on the nature of the debt financing. Prior to 2001, the

allowed debt-to-equity ratio, also called “safe haven”, was accepted at 3:1 for ordinary

corporations. However, the safe haven debt-to-equity ratio was 9:1 in the case of a

holding corporation. This meant, in effect, that holding corporations could be used as

loopholes. In 2001 and 2004, there were two significant amendments to the German

thin-capitalization rule. In 2001 the allowed debt-to-equity ratios were significantly

reduced to 1.5:1 in the case of an ordinary corporation and to 3:1 in the case of a

holding corporation, respectively although a possible loophole in the shape of holding

corporations still remained. In 2004, this special rule for holding corporations was also

abolished, i.e. the safe haven was generally constituted at 1.5:1 for every

corporation75

.

A distinction was made between two kinds of debt.

(i) For debt on which a fixed interest was paid, a debt-equity ratio (safe haven) of

1.5:1 was accepted. Interest on excessive debt was not deductible and was

treated as a hidden profit distribution or a constructive dividend, unless the

third-party test was met. In the third-party test, the taxpayer had to demonstrate

that an unrelated person would also have granted the loan (third-party test with

regard to the solvency of the company). Fixed interest was interest calculated

75

Overesch, Michael & Wamser, Georg, 2006. "German inbound investment, corporate tax planning, and thin-

capitalization rules : a difference-in-differences approach," ZEW Discussion Papers 06-75, ZEW - Zentrum für

Europäische Wirtschaftsforschung / Center for European Economic Research.

http://ideas.repec.org/p/zbw/zewdip/5468.html

http://ideas.repec.org/p/zbw/zewdip/5468.html

http://ideas.repec.org/s/zbw/zewdip.html


25

as a percentage of the principal, which was not dependent in any way on the

debtor’s profit or turnover76

.

(ii) Variable interest was not deductible. This type of interest included payments

on profit-participating loans, participations or contributions by silent partners

and other liabilities with respect to which the interest was not calculated

exclusively as a percentage of the principal. The tax authorities included fixed

interest-bearing liabilities in the variable interest category if the loan contract

stipulated that interest needed not be paid in a loss situation77

.

The thin capitalization rules included any debts from shareholders with a substantial

interest, a related person of this shareholder, or a third party with a right of recourse

against the substantial shareholder or its related persons.

4.4 Current Treatment of Thin Capitalisation in Germany

General Rule – limitation of deduction of interest expenses to 30%

EBITDA

In general terms, the interest ceiling rules (Section 4h of the German Income Tax Act

and read in conjunction with the amended Section 8a of the German Corporate Income

Tax Act) restrict the deduction of all types of excessive (net) interest expenses

incurred by a “Business” (A business is defined as any corporation or partnership

generating business income78

. This is typically a company but could also be two or

more companies that form an income tax group, i.e. an Organschaft ) to 30% of the

Business Taxable earnings before interest, taxes, depreciation and amortization

(EBITDA i.e. taxable income reduced by interest income and increased by interest

expenses as well as depreciation and amortization)79

.

76

Information taken from Finnerty, C; Merks, P; Petriccione, M; and Russo, R. Fundamentals of International

Tax Planning (2007) at pages. 223 - 224

77 Id. At p. 224

78 See Köhler and Hahne (2008, pp. 1505-1516) as cited by Kollruss, T. in Tax optimal cross-border debt

financing under the new German Thin-Capitalization-Rule (German interest barrier) : Intra fiscal group cross-

border debt financing via a foreign fiscal group finance branch. Investment Management and Financial

Innovations, Volume 7, Issue 2, 2010

79 See IFBD Database European Tax Surveys


26

The principal aim of the interest barrier is to avoid the transfer of taxable profits from

German Corporations to foreign intra group debt finance companies. As a result, tax

planning opportunities for German Corporations reducing their high tax burden by

using cross-border intra group debt financing structures have been limited to a great

extent. So far German tax literature has only developed instruments optimizing the

interest deduction within the 30% EBITDA-threshold, yet there is still no financing

structure allowing German companies and foreign investors in Germany to avoid the

interest barrier completely80

.

Interest expenses of a business are fully deductible up to the amount of its interest

income of the same year whereas as discussed above expenses in excess of exceeding

interest income (net interest expenses) are deductible only up to 30%. Non-deductible

net interest payments may be carried forward indefinitely, thereby increasing interest

expenses but not taxable income in the calculation of the limited deductibility of

interest payments in future tax years. Interest expenses carried forward may be fully

set off81

. Under Section 8a (1) of the German Corporate Income Tax Act, the rules

also apply to non-resident companies subject to tax in Germany on German-source

income calculated using the net income method.

For financial years ending after 31 December 2009, an EBITDA carry-forward

applies. Unused EBITDA, i.e. interest expenses lower than 30% of the EBITDA in a

tax year, must be carried forward for a maximum period of 5 years. Consequently, if

net interest expenses in a subsequent financial year cannot be deducted because of the

30% limitation, such excess net interest expenses can be deducted from taxable

income up to the amount of the EBITDA carry-forward. Existing EBITDA carry-

forward cannot be increased in financial years in which any of the exceptions to the

limited deductibility of interest expenses apply (see below). Upon application to the

tax authorities, EBITDA carry-forward resulting from previous financial years

beginning after 2007 may be calculated and taken into account for assessment in 2010

only.82

80

Kollruss, T. in Tax optimal cross-border debt financing under the new German Thin-Capitalization-Rule

(German interest barrier) : Intra fiscal group cross-border debt financing via a foreign fiscal group finance

branch. Investment Management and Financial Innovations, Volume 7, Issue 2, 2010

81 Section. 4h(1) German Income Tax Act and Section. 8a(1) German Corporate Tax Act

82 See IFBD Database European Tax Surveys 2010


27

Interest expenses are defined as all interest on capital that has reduced taxable income.

Correspondingly, interest income constitutes interest that has increased taxable

income. Payments on low-interest-bearing or non-interest-bearing assets or liabilities

(e.g. zero bonds) also constitute interest income or expenses83

.

4.4.1 Exceptions to the limitation on interest deduction

There are three exceptions from the interest ceiling rule:

(1) The Exemption Limit

As a relief for small and medium sized businesses, the total amount of

excess interest expenses is less than the exempt threshold of EUR 3

million i.e. in this case the interest barrier is not applicable. If one

assumes an interest rate of 5%, only debt financing structures with a

volume of less than Euro 60 million borrowed capital are unaffected by

the interest barrier84

. However, if the net interest payments exceed the

threshold, the limitation applies to the full net interest payments. The

minimum threshold applies per business. While partnerships and

companies are deemed to be only a single coherent business, sole

entrepreneurs may be engaged in multiple independent businesses,

applying the minimum threshold for each separately85

. Under Section

4h (2)a of the German Income Tax Act Consolidated corporate groups

under German group taxation rules are deemed to be one business,

therefore the minimum threshold may be applied only once for the

whole group;

(2) Stand- alone clause

The interest barrier does not apply if the company does not belong to a

group of related companies, or belongs to such a group only partially

83

See Section. 4h(3) German Income Tax Act.

84 See Scheunemann and Duttine-Muller (2007,pp 518-525) as cited by Kollruss, T. in Tax optimal cross-border

debt financing under the new German Thin-Capitalization-Rule (German interest barrier) : Intra fiscal group

cross-border debt financing via a foreign fiscal group finance branch. Investment Management and Financial

Innovations, Volume 7, Issue 2, 2010

85 See IFBD Database European Tax Surveys 2010


28

(stand-alone clause). A company is deemed to belong to a group, if the

company is or could be part of the consolidated group’s accounts under

the applicable accounting regime (primarily IFRS, then German GAAP

or other EU accounting rules)86

or if the financial and business policy

of the company can be determined in uniformity with that of one or

several other companies. Affiliated companies may be sole

entrepreneurs, partnerships or companies. Consolidation occurs in

particular if a company holds more than 50% of the voting rights of

another company (see Section 4h(2)b of the German Income Tax Act)

Under Section 8a (2) of the German Corporate Income Tax Act, no

hidden profit distributions is assumed if the company can prove that not

more than 10% of the net interest payments are paid to a substantial

shareholder (i.e. a person holding an interest of more than 25% in the

lending entity), a person closely related to such shareholder or a third

person with recourse against such shareholder or related person

(3) Escape Clause

If the business belongs to a group of companies, the interest barrier

does not apply as long as its ratio of equity over total balance sheet

assets is not lower than 2% (1% for financial years ending before 31

December 2009) compared to the overall ratio for the whole group.

This is also known as the “Escape clause”.

Companies cannot utilise either the stand-alone or escape clauses if a

part of the interest payments of a company constitutes hidden profit

distributions to substantial shareholders, who directly or indirectly hold

more than 25% in the capital of the company. In the case of the escape

clause, the same applies concerning qualifying interest payments for

debt of the company or another member of the group to a substantial

shareholder of a group member, a person related to such shareholder or

86

See Weber-Grellet (2009, pp. 557-560), Heinrichs 2007, pp. 2101-2107) as cited by as cited by Kollruss, T. in

Tax optimal cross-border debt financing under the new German Thin-Capitalization-Rule (German interest

barrier) : Intra fiscal group cross-border debt financing via a foreign fiscal group finance branch. Investment

Management and Financial Innovations, Volume 7, Issue 2, 2010


29

third person with recourse to such shareholder or related person,

however, only for interest payments reported in the consolidated

group’s financial statements and in cases of back-to-back financing

with recourse of the third person against a shareholder or related person

who is not a member of the group87

.

The equity ratios are determined according to the separated financial

statements of the business and the consolidated group’s financial

statements. The financial statements used for the comparison have to be

prepared under the international financial reporting standards (IFRS). If

these financial statements are not available financial statements

prepared under the commercial code of an EU Member State may be

used. In case such financial statements are also not available for the

same reasons, financial statements prepared under the generally

accepted accounting principles of the United States may be used88

If the statements turn out to be inaccurate and a correction of the

inaccuracies leads to an increase of non-deductible interest expenses, in

addition to the increased tax, a penalty of at least 5% up to a maximum

of 10% of the increased income is assessed.89

4.5 Thin Capitalisation in the United Kingdom - Background

Previously, excess interest payments from thinly capitalized resident companies could

be treated as dividend payments. Only the excess of what would have been paid

between unconnected parties dealing at arm's length, having regard to the debt/equity

ratio, rate of interest and other terms that would have been agreed, was treated as a

dividend. There was no fixed debt/equity ratio, but tax authorities would generally

accept a maximum 1:1 debt equity ratio. The rule applied only to 75% or more owned

nonresident companies90

.

87

See Section 8a(3) of the German Corporate Tax Act

88 See Section. 4h(2)c – German Income Tax Act

89 Id



30

Prior to April, 2004, the UK’s thin capitalisation rules used an arm’s length test which

restricted the tax relief allowed for interest relief where a company borrowed more

from another company within its group than it did from an unrelated third party.

However, these restrictions only applied to borrowings from overseas group

companies and not from group companies based within the UK.

For example91

:

Assuming that the maximum a UK company could borrow on the open market

is £100 at a 5 per cent rate of interest. That interest expense calculated at 5 per

cent (£5) would be tax deductible.

If a UK company borrowed £200 from another company within in the group

(as opposed to the maximum of £100 it could obtain on the open market), the

level of interest that could be deducted for interest purposes would depend on

the location of the company within the group that provided the finance. If the

borrowing was from an overseas group company, the level of interest that

could be deducted could not exceed the maximum it could achieve by

borrowing on the open market – since it could only borrow £100 on which it

would pay interest calculated at 5 per cent (£5), this meant that although it

borrowed £200 from its group company, it could deduct interest expense

calculated at 5 per cent on £100 (£5) for tax purposes, not the £10 interest

arising on the whole amount of the borrowing.

If, however, the money was borrowed from a UK group company, the thin cap

rules would not apply and it would be able to deduct the full interest payment

for tax purposes –£10 (assuming the same interest rate prevailed).

These rules meant that sales of goods or services (including financing) between related

parties should take place on an “arm’s length” basis i.e. on the same terms that could

be obtained on the open market. If a related party sale was not conducted on an arm’s

length basis, a tax adjustment was required. The adjustment was only required

however if the sale was between related parties where one of the parties was overseas

91

Example adapted from KPMG Article “European Court of Justice strengthens taxpayers’ case in multi-million

pound cross-border funding disputes” – available on the KPMG website:

http://www.kpmg.co.uk/news/detail.cfm?pr=2561



31

(and not subject to UK tax) and the effect of the sale was to reduce the taxable profits

of the UK party. In other words, the adjustment would apply to prevent any net

outflow of tax from the UK92

.

In 2004 the UK abolished its thin capitalisation rules largely as a result of the

Lankhorst Hohorst case93

. In that case, Lankhorst Hohorst, a loss – making German

company with very little equity had borrowed money from its Dutch grandparent. The

loan was intended as a substitute for capital and it was used to repay a bank loan as

third party finance would not have been available on arm’s-length terms.

However, the German thin capitalisation rules kicked in when the level of debt

exceeded a fixed ratio of debt to equity of 3:1, and equivalent finance was not

available on arm’s length terms. If the loan had been from a German parent company,

rather than a Dutch company, there would have been no disallowance.

The ECJ ruled that if there was to be an exception for a loan between German

nationals, then the benefit of the exception must be extended to loans to EU nationals

as the difference of treatment between a German and an EU loan was a restriction on

the freedom of establishment because the lender controlled the borrower.

Although this was a German case, the UK was concerned that its own thin

capitalization rules would also be considered to be in contravention of EU law,

abolished its thin cap rules94

.

4.6 Current Treatment of Thin Capitalisation in the UK

Although the UK has abolished its specific thin capitalisation legislation, it has

replaced this with new legislation that forms part of the extended transfer pricing

regime. In March 2010, Her Majesty’s Revenue and Customs (“HMRC”) issued an

updated “Thin Capitalisation Guidance” The Guidance sets out the principles to be

used and the range of possible structures and factors that companies should take into

92

Id

93 Lankhorst-Hohorst GmbH v Finanzamt Steinfurt - ECJ Case C-324/00

94 See HMRC “Reform Of Corporation Tax Reform Of Rules On Transfer Pricing And Thin Capitalisation

Regulatory Impact Assessment” – available at Her Majesty’s Customs and Revenue (HMRC) website archives:

http://webarchive.nationalarchives.gov.uk/20091222074811/hmrc.gov.uk/budget2004/transfer-pricing.pdf .

http://webarchive.nationalarchives.gov.uk/20091222074811/hmrc.gov.uk/budget2004/transfer-pricing.pdf


32

account with regard to thin capitalisation. It also specifically puts to an end the

perception that safe harbours continue to operate in the UK.95

The UK tax authorities use the arm’s length principle to enable them to define

excessive debt. In the context of thin capitalisation the application of the arm’s length

principle requires an Inspector to form a judgement as to what amount of interest-

bearing debt the company or companies could - and would - have borrowed on a

standalone basis from a third party lender who was entirely unconnected with that

company or group of companies. Once he has determined this, the Inspector is then

required to compare that level of debt with the level of debt which the same borrower

has obtained from a related party which would typically be another group company, or

from a third party but with the backing of other group members by way of a guarantee

or other form of comfort. The interest payments which can be deducted in arriving at

profits assessable to corporation tax will then be limited to those on the non-excessive

or arm’s length debt96

.

The HMRC’s Thin Capitalisation Guidance states that in assessing whether borrowing

is on an arm’s length basis, it is essential to consider all the terms and conditions of

the lending, not just the narrow concerns of amount and rate. The arm’s length

approach assumes that borrowing will be on a sustainable basis so that the business

must be able to trade, invest and meet its other obligations as well as servicing the

debt. The consideration is not just what it “could” have borrowed but what it “would”

have borrowed.

The Guidance further states that it is essential to understand the activity of the

company, its long term plans and prospects and how it structures its money in order to

assess whether and to what extent a company is thinly capitalised.

In looking at potentially thinly capitalised companies, the Guidance states that each

aspect of the financing needs to be considered, so although thin capitalisation strictly

95

See HMRC Thin Capitalisation Guidance - Introduction to thin capitalisation (legislation and principles) note

INTM541020. Available at HMRC: http://www.hmrc.gov.uk/manuals/intmanual/INTM541020.htm

96 See HMRC Thin Capitalisation Guidance Issued on 30

th March, 2010. Available at:

http://www.hmrc.gov.uk/manuals/intmanual/intm570000.htm

http://www.hmrc.gov.uk/manuals/intmanual/INTM541020.htm



33

refers to the gearing or leverage of the company (the balance of debt to equity or

earnings), in practice the consideration for a thorough international financial health

check would include97

:

(1) Working out the arm‟s length of debt

(2) Considering whether the interest rate is greater that would be charged at

arm‟s length rate

(3) Ensuring there are no other non-arm‟s length terms to loan agreements

(4) Checking that the company is getting an arm‟s length return on any money

which it is lending out (perhaps to a connected company) and that it has good

commercial reasons for retaining cash while carrying a burden of dent

(5) Checking for financial avoidance such as loans with non business purpose, or

use of arbitrage opportunities

(6) Watching for issues such as treaty shopping, where benefits such as nil

withholding tax on interest paid are obtained when there is no entitlement98

.

Each case, the Guidance states, must be approached according to its own facts, with a

degree of commercial awareness99

.

97

Id 98

Taken from HMRC Note: INTM571020 - Thin capitalisation: practical guidance - introduction: The aims of

thin cap work. Available at: http://www.hmrc.gov.uk/manuals/intmanual/intm571020.htm

99 Id



34

Chapter 5 - General Anti – Avoidance rules – are they a necessary evil or

are specific anti-avoidance rules the answer?

5.1 Introduction

This Chapter discusses the advantages and disadvantages of general and specific anti-

avoidance rules. As observed in the preceding chapter Malawi has a general anti-

avoidance rule but has no specific thin capitalisation legislation. The Commissioner’s

current practice of declaring a constructive divided where the debt and equity ratio

exceeds 3:1 suggests that there is need for uniform application of the law

notwithstanding the lack of such specific legislation.

We have also seen in the preceding Chapter that Germany has specific thin

capitalisation rules and that while the UK has repealed its own, it has replaced them

with new legislation that forms part of the extended transfer pricing regime. Germany

also has a statutory general anti-avoidance rule which is contained in Section 42 of the

General Tax Code. The section provides as follows:

“The tax laws cannot be avoided by the misuse of legal construction

opportunities. If a specific anti-abuse tax law provision is fulfilled the tax

consequences shall be applied in accordance with such provision. Otherwise,

tax consequences in case of a misuse as defined in para. 2 shall be such as

would follow from a legal construction that is appropriate to the economic

circumstances.”

Paragraph 2 goes on to define what constitutes a misuse:

“A misuse exists if an inappropriate legal arrangement is chosen which leads

to a tax advantage at the taxpayer‟s or a third party‟s level which is not

intended by law. This does not apply if the taxpayer demonstrates that there

are valid non-tax related reasons for the chosen arrangement.”

The UK has judicial anti- avoidance rules but is currently considering the introduction

of statutory anti-avoidance rules100

.

100

Information obtained from Her Majesty’s Customs and Revenue Website (HMRC). Available at HMRC:

http://www.hmrc.gov.uk/consult/consult_1.htm#4



35

Statutory general anti-avoidance rules are found in many countries in Europe and in

the British Commonwealth with the exception of the UK itself. Malawi is certainly no

exception. Much of the force of these general anti avoidance rules comes from their

imprecision. This imprecision, one can argue, breaches the rule of law101

.

5.2 Significance of the Rule of Law.

The rule of law is a multi-faceted ideal and is a term for a number of related values

that people generally think good laws should adhere to. The rule of law according to

Dicey (an English jurist of note) requires “the absolute supremacy or predominance of

regular law as opposed to the influence of arbitrary power.”102

Lord Steyn, in the case

of R v Home Secretary ex p. Pierson103

stated that “…the rule of law enforces

minimum standards of fairness, both substantive and procedural”.

Many legal theorists since Dicey have come up with their own definitions of the Rule

of Law. A common thread running through these different conceptions of the Rule of

Law is the great emphasis on legal certainty, predictability, and settlement, on the

determinacy of the norms that are upheld in society, and on the reliable character of

their administration by the state104

. It is said that people need predictability in the

conduct of their lives and businesses. It may be difficult or indeed impossible to get

away from legal constraint in the circumstances of modern life, but freedom is

possible nevertheless if people know in advance how the law will operate and how

they have to act if they are to avoid the law from having a detrimental impact on their

101

Prebble, R and Prebble, J, Does the Use of General Anti-Avoidance Rules to Combat Tax Avoidance Breach

Principles of the Rule of Law? (2010). Saint Louis University Law Journal, Forthcoming. Available at SSRN:

http://ssrn.com/abstract=1523043

102 Prebble, R and Prebble, J, Does the Use of General Anti-Avoidance Rules to Combat Tax Avoidance Breach



103 [1998]AC 539 at 591

104 Waldron, J, The Concept and the Rule of Law (September 24, 2008). Georgia Law Review, Forthcoming;

NYU School of Law, Public Law Research Paper No. 08-50. Available at SSRN:





36

affairs105

. It is said that a legal system that provides legal certainty guides those subject

to the law106

and protects them from arbitrary use of state power107

.

Legal certainty is an essential component of the rule of law. It is important for both the

law-follower and the law-maker as most laws are effective when people can be certain

what they are meant to do or not to do108

. If people cannot be certain what to do, one

could argue that it could render the law ineffective. Lon Fuller, in his book “The

Morality of Law”109

, sets out eight criteria that must be met in order to give effect to

the rule of law. To illustrate these eight principles, Fuller gives an amusing example

of King Rex, an imaginary ruler who tried but failed to make law on eight separate

occasions. On one occasion for instance, he published a legal code that was so

complicated that no one could understand it and on another occasion he failed to

establish congruence between the law as announced and their actual administration. In

essence, King Rex was unable to rule effectively because his rules were incapable of

being followed. In fact there was no point in King Rex having any laws at all because

his laws failed in governing the behaviour of his subjects110

. They could not obey his

laws even if they wanted to because the laws were not clear and consistent.

Fuller’s examples illustrate the fact that laws that do not conform to the rule of law

can be frustrating to both the law maker and to the subjects111

.

105

Id

106 See Maxeiner, J.R. Legal Indeterminacy Made in America: U.S. Legal Methods and the Rule of Law, 41

VAL. U. L. REV. 517, 522 (2006)

107 Id

108 Prebble, R and P, John, Does the Use of General Anti-Avoidance Rules to Combat Tax Avoidance Breach



109 2ed, New haven (CT) Yale University Press, 1964)168

110 Fuller, L The Morality of Law (2ed, new Haven (CT) Yale University Press, 1964) 168.

111 Prebble, R and P, John, Does the Use of General Anti-Avoidance Rules to Combat Tax Avoidance Breach






37

5.3 Are general anti-avoidance rules bad?

Laws that are as vague as general anti-avoidance rules normally are, are often heavily

criticised. The argument is that general anti-avoidance rules are objectionable because

no one really knows how far their reach extends. People are prevented from taking

action that might be allowed because they do not want to take the risk of their action

being disallowed112

.

An example of a vague law that attracted considerable criticism was Article 386 of the

Criminal Code of the Qing Dynasty, which ruled China from 1644 to 1912. Among

the long list of specific offences was Article 386 which provided that “[Doing] that

which ought not to be done” was an offence113

. It is difficult to think of a vaguer law

than this that could authorise more arbitrary action on the part of authorities!

From a tax point of view, a vague law would have a negative effect on legitimate tax

planning and could result in preventing investors and businesses from utilising

effective business structures that may be economically sensible114

.

Another problem with a general anti avoidance rule is that it requires officials (such

Malawi’s Commissioner for Taxes), to exercise a lot of discretion. Philosophers such

as Ronald Dworkin have referred to discretion as "the hole in the doughnut" (doughnut

theory of discretion) and "where the law runs out" (natural law theory)115

. In this

perspective, discretion is the empty area in the middle of a ring consisting of policies

and procedures. It involves making personal contributions, judgment calls, exercising

autonomy, and individual solutions. It means reaching beyond the law for some other

sort of standard to guide him in manufacturing a fresh legal rule or supplementing an

old one. Where there are no specific guidelines on how to exercise that discretion as is

112

Id at p 11

113 Id at p 10

114 Prebble, R and Prebble, J, Does the Use of General Anti-Avoidance Rule to Combat Tax Avoidance Breach



115 Dworkin, R.M. The Model of Rules The University of Chicago Law Review, Vol. 35, No. 1. (Autumn, 1967),

pp. 14-46.



38

the case in Malawi, this could result in a lot of arbitrary decisions against the tax

payer.

This of course doesn’t necessarily mean that general anti-avoidance rules are bad.

Such rules may be useful to revenue authorities in situations where the rules necessary

to deal with tax avoidance cannot be defined in advance. The British Government in

its consultative document116

puts forward the following reason for considering the

introduction of a General anti-avoidance rule:

“In the last 20 years or so, much legislation has been enacted to counter tax

avoidance. At the same time, the courts have developed a doctrine, following

the Ramsay case1, which has put some limits on the scope for avoidance.

However, new devices for avoiding tax continue to be developed117

……………..

Legislation targeted at specific avoidance schemes or arrangements stops

them for the future. But, short of retrospective legislation, the Government

cannot recoup the tax lost to early users of the schemes. Consequently it has

little or no deterrent effect. This type of legislation is vulnerable to yet further

avoidance schemes, constructed to find a way around the letter of the law118

”.

The question that needs to be answered is - if general anti-avoidance rules conflict

with the rule of law is it better to have specific anti-avoidance rules?

5.4 Are specific anti avoidance rules the answer?

Specific anti avoidance rules certainly give legal certainty. Business people know

exactly what laws they are dealing with. They know what is prohibited and what is

not. They can plan their affairs without having to worry that they are infringing the

law. However, McBarnet and Whelan argue that the production of ever more detailed

rules simply encourages avoidance, or creative compliance, by the manipulation of

those rules, using the rules themselves as signposts as to how to achieve the effective

116

A General Anti-avoidance Rule for Direct Taxes: Consultative Document available at the following website

HMRC: http://www.hmrc.gov.uk/consult/consult_1.htm#4

117 Id – see para 4.1

118 Id – see para 4.9



39

avoidance119

(which is similar to the argument put forward by the British Government

in their consultative document discussed above).

McBarnet argues that two factors contribute to the practice of creative compliance.

One significant factor is the nature and operation of the law itself. She argues that the

law-making process leads to lobbying and compromise, legislators cannot address

every contingency that might arise and that drafting is fallible. More fundamentally,

she argues that it is in the nature of the law that it is open to different interpretations,

and that its meaning and application are arguable120

.

John Prebble argues that tax law is more susceptible to loopholes than other areas of

law. He illustrates this with a comparison to criminal law:

“Ms Turpin and Ms Good look very much alike. But Ms Turpin is a robber and

Ms Good a teacher. One of Ms Turpin‟s victims gets a good look at her and

manages to compose an identikit portrait. The portrait is a good likeness of Ms

Turpin but it looks even more like Ms Good. On these facts, nobody would

suggest that Ms Good, the teacher committed the crime. In tax law however, a

taxpayer crafts a series of legal transactions to represent an underlying

economic substance. Either calculatedly or not, the legal transactions

sometimes look more like some other economic substance. Perhaps what is

economically a partnership looks more like a mortgage. Absent an anti-

avoidance rule, tax law will ordinarily tax the transaction as a mortgage and

not a partnership. We can compare that characterisation to criminal law

finding Ms Good guilty of robbery because the victim‟s simulacrum of the

robber looks more like Ms Good than Ms Turpin. Criminal law does not work

like that, but income tax does.”121

119

McBarnet, D. and Whelan, C., “The Elusive Spirit of the Law: Formalism and the Struggle for Legal

Control” (1991) 54 MLR 848.

120 McBarnet D., “When Compliance is not the solution but the problem: From changes in law to changes in

attitude” Centre for Tax System Integrity Research School of Social Sciences Australian National University

Canberra, Working Paper No.18 August 2001.

121 Prebble, J, Income Taxation: A Structure Built on Sand (2002). Sydney Law Review, Vol. 24, No. 3, pp. 301-

318, 2002. Available at SSRN: http://ssrn.com/abstract=1604973



40

McBarnet gives a rather amusing example of how specific rules can be manipulated:

“When it was proposed in the United Kingdom (UK) that value added tax

(VAT – akin to the new Australian goods and services tax) should be levied on

domestic fuel, hitherto exempt, there was extensive protest on the basis that the

old and the poor would suffer. In the event, not everyone suffered. Some

institutions, including university student residences, found a nice way to avoid

the new costs involved in heating and hot water. They would sell their boilers,

which of course remained exactly where they were in the institution‟s

basement, to a separate company. The company would buy the fuel to heat the

water. The company would have to pay VAT on the fuel but, as a commercial

enterprise, could reclaim it. The company then sold the water to the institution.

There is as yet no VAT on water so, hey presto, nobody pays any VAT. And the

„where does it say I can‟t do that?‟ argument, along with a quick referral to

the rules, can be brought into play to justify it.”122

.

The absence of a general anti-avoidance rule could result in loss of tax revenue for

governments. The question that now needs to be answered is whether a general anti-

avoidance rule can be justified despite the fact that it could breach the rule of law or

whether specific anti-avoidance rules are the way forward or indeed whether countries

need a combination of the two. It appears that the arguments for and against either

choice counterbalance each other.

122

McBarnet, D. “When Compliance is not the solution but the problem: From changes in law to changes in

attitude” Centre for Tax System Integrity Research School of Social Sciences Australian National University

Canberra, Working Paper No.18 August 2001.


41

Chapter 6 - Conclusion

6.1 General Observations

The principles of a good tax system have evolved from the writings of Adam Smith in

1776 and are widely accepted today as being fairness, certainty, efficiency and

simplicity123

. However as we have seen from the discussion in the preceding chapter,

increasing the volume and complexity of rules, may not necessarily result in certainty.

Instead, new opportunities may inadvertently be provided for taxpayers to organize

their affairs in such a way as to avoid or evade tax124

. At the same time, general anti-

avoidance rules appear to breach the rule of law which arguably is necessary for a

country to have a properly functioning legal system.

This thesis argues that general anti avoidance rules are justified with respect to tax

although they breach the rule of law. Indeed one can argue that tax avoidance exploits

the formality of the law and therefore exploits the rule of law itself. Tax avoiders

should therefore not be allowed to rely on the rule of law to protect them125

. However,

this thesis also argues that anti-avoidance rules that are too general would breach the

rule of law to an unacceptable level. A general anti-avoidance rule such as Malawi’s

for instance does not give any guidance whatsoever as to what may be deemed to be

unacceptable tax avoidance. This makes the law so uncertain that it creates a bad

climate for investment. It is important to balance the desire of tax authorities to

maximise their tax revenue with the need to attract investment into the country. Legal

certainty gives confidence to investors that they will be able to plan and execute

decisions within levels of prediction of the conduct of the state.

123

Adam Smith quoted in Heilbroner, R. The Essential Adam Smith (1986).

124 McKerchar, M.A., Meyer, K. and Karlinsky, S, Making Progress in Tax Simplification: A Comparison of the

United States, Australia, New Zealand and the United Kingdom (August 5, 2008). FURTHER GLOBAL

CHALLENGES IN TAX ADMINISTRATION, McKerchar, M. and M. Walpole, eds., pp.359-375, Fiscal

Publications, Birmingham, 2006; UNSW Law Research Paper No. 2009-49. Available at SSRN:


125 Prebble, R and Prebble, J, Does the Use of General Anti-Avoidance Rules to Combat Tax Avoidance Breach






42

This thesis also argues that a general anti-avoidance rule on its own is not a good way

of combatting unacceptable tax avoidance. It is also necessary to have specific anti-

avoidance procedures as this guides investors and business planners on what is and is

not acceptable. It is only where an unacceptable anti-avoidance measure is not

captured by a specific anti-avoidance rule that the general anti-avoidance rule should

kick in.

Whilst Malawi does have some specific anti-avoidance provisions (those covering

transfer pricing for instance), it lacks specific thin capitalization legislation. Specific

thin capitalization legislation is necessary and should be in the forefront of the battle

against tax avoidance. We have seen from the discussion above that General Anti-

avoidance provisions can be useful to revenue authorities. However, these provisions

should contain appropriate safeguards for investors, Malawi’s General anti avoidance

provision does not contain these safeguards. The aim of a General anti-avoidance rule

should be to prevent tax avoidance and not to eliminate all certainty of tax treatment

enjoyed by businesses that are not engaged in avoidance.

6.2 Critique of Malawi’s General Anti-Avoidance provision and

suggested solutions

1. We saw in chapter 1 that not all types of tax avoidance are unacceptable. In fact

tax planning is on the whole considered to be acceptable. No one is under an

obligation to arrange his affairs so that he incurs as much of a tax liability as

possible. As Lord Upjohn stated in the case of IRC v Brebner126

, “…no

commercial man in his senses is going to carry out commercial transactions

except upon the footing of paying the smallest amount of tax involved”127

.

Section 127 of the Taxation Act makes no clear distinction between acceptable and

unacceptable tax avoidance – this means that tax planning also comes within the

ambit of the Act. Whether or not it is acceptable depends on the Commissioner’s

“opinion” and the measures that will be taken to redress that also depends on what

126

43 TC 703

127 Id at p718


43

“he determines .. to be just and reasonable”. The Commissioner also has the

discretion of directing “that such adjustments shall be made as respects liability to

tax as he considers appropriate to counteract the avoidance or reduction of

liability to tax which would otherwise be effected by the transaction or

transactions”.128

This thesis proposes:

(A) that there should be a clear definition of what constitutes tax avoidance.

The UK Revenue Authority in the GAAR consultative document129

proposes the following guidance as to what constitutes tax avoidance:

(i) For the purposes of this rule tax avoidance, in relation to a

company means

(a) Not paying tax, paying less tax or paying tax later than would

otherwise be the case or,

(b) Obtaining repayment or increased repayment of tax, or

obtaining repayment earlier than would otherwise be the case,

or

(c) Obtaining payment or increased payment by way of tax credit,

or obtaining such payment earlier than would otherwise be the

case.

(ii) References in this rule to tax avoidance include creating a loss or

other amount with a view to tax avoidance in another accounting

period or by another company130

.

(B) That acceptable tax planning should be specifically excluded from the

operation of the general anti-avoidance rule. Again, what is deemed to be

“acceptable” should also be defined in clear language. Again the

consultative document defines acceptable tax planning as follows:

128

See Section 127 of the Malawi Taxation Act

129 Supra

130 Id See Paragraph 6.5.2


44

Acceptable tax planning means arranging one‟s affairs so as to avoid

tax in a way that does not conflict with or defeat the purpose of the tax

legislation.

The fact

(a) That the purpose of a transaction is to take advantage of a relief or

allowance provided by the tax legislation, or

(b) That a transaction is specifically exempted from an anti-avoidance

provision, is an indication, but not conclusive indication, that it is

acceptable tax planning131

.

(C) That the tax consequences of applying the rule should be clearly laid out.

Currently the tax consequences of breaching this rule are unclear as it depends

on the Commissioner’s discretion. It must be pointed out again however, that

with respect to thin capitalisation the Commissioner’s practice has been to

construe a deemed dividend where the debt to equity ratio exceeds 3 to 1.

However, this does not prevent him from taking whatever other measure he

deems appropriate in the circumstances. This makes the consequences of

breaching this rule as yet uncertain.

2. The Act accords too much discretion to the Commissioner. Too much discretion in

the hands of tax authorities raises the very real issue of Corruption. While one

would hope that revenue authorities will be unbiased and unaffected by the

influence of Multinational companies, it would perhaps be a little unrealistic to

rely on such hope. Further, too much discretion could result in arbitrary decisions

being made against the tax payer creating uncertainty in the law. It is suggested

that some of the proposals made in (A), (B) and (C) above could address this

situation.

3. This thesis further proposes that the MRA should adopt a system of pre-transaction

clearings guaranteeing that the General Anti-Avoidance rule will not be applied, as

long as the transaction is carried out as described when the clearance was sought

and that as soon as a clearance system is functioning, MRA should publish

131

Id See Paragraph 6.5.10


45

anonymous accounts of transactions that have been cleared; This will increase

legal certainty to a great extent.

6.3 Specific Thin Cap Rules: Which way for Malawi?

If Malawi is to come up with specific thin capitalisation rules, should it base it on the

British or German approach or neither?

As the discussion in Chapter 4 noted, the British and German thin capitalization rules

have evolved over the years and have not been without their criticisms. Both countries

rules have at various stages been found to be discriminatory from an EU perspective.

Both countries have drafted and redrafted their rules several times. The UK has even

taken the drastic measure of abolishing its separate thin capitalisation rues and

replacing it with legislation that forms part of the extended transfer pricing regime.

Notwithstanding these changes, both the current UK and German thin capitalisation

rules have also been found to be wanting. Germany’s thin capitalisation rules for

instance, have been criticised for being too complex. They have also been criticised

for infringing the net principle i.e. the full deductibility of all expenses related to the

business income. They have been criticised for the low level of deductible interest

expenses and the lack of suitability of the escape clause and for their failure to

consider R&D expenses incurred for purposes of determining taxable EBITDA132

.

The UK’s own new thin capitalisation rules have not been spared from criticism either

in terms of both content and its practical implementation. In March 2010, the UK Tax

Authorities issued a new guidance on the application of thin capitalisation rules.133

Deloitte has observed that while the new guidance is an improvement on its

predecessor, there is still a long way to go before there is a common understanding of

132

See Hallerback D,“Problemfelder der neuen Zinsschrankenregelung des § 4h EStG”, Der Betrieb (2008), at

12. referred to in “Group Financing: From Thin Capitalization to Interest Deduction Limitation Rules” as cited

by von Brocke K and Perez E G * International Transfer Pricing Journal Volume 16 No. 1 January/February,

2009 at p.34

133 Available on Her Majesty’s Customs and Revenues website (HMRC):




46

exactly how the UK’s arm’s length thin capitalisation rules work134

. KPMG has also

observed that the practical application of this guidance will be challenging for both tax

payers and HMRC as successful implementation of an arm’s length approach requires

extensive practical experience - (HMRC itself admits that “it is difficult to specify

precisely what is required for an attempt to demonstrate an arm’s length standard”135

).

KPMG further notes that HMRC will have resourcing challenges in order to

implement the revised guidance successfully and observes that “it will be interesting

to see how HMRC handles this against a backdrop of pressure to reduce public sector

headcount”136

.

Although, the UK Tax authorities have criticised what they call the “safe harbour”

(also known as the debt to equity ratio) saying, “there is an element of arbitrariness in

defining for tax purposes acceptable and non-acceptable levels of debt by way of a

statutory maximum level applicable to all taxpayers, and such an approach does not

replicate the processes which an independent lender would follow when deciding how

much he would be prepared to lend to a particular borrower. This is the main reason

why the UK does not endorse the concept of statutory safe harbours and Inspectors

should not accept that any safe harbours are applied in practice137

,” this thesis

believes that Malawi’s current practice of construing a constructive dividend when the

debt to equity ratio exceeds 3:1 is not necessarily the worst way of dealing with thin

capitalisation. At the very least it offers a certain level of certainty to tax payers. The

UK’s own arm length method of dealing with thin capitalisation has (as discussed

above) been criticised for being not clear enough with tax specialists wondering how

the thin capitalisation question is to be answered considering the fact that HMRC are

134

Deloitte Global Transfer Pricing Tax Newsletter Arm’s Length Standard - April/May 2010 at p. 3 Available

at Deloitte: https://www.deloitte.com/assets/Dcom-

Global/Local%20Assets/Documents/Tax/Newsletters/dtt_tax_armslengthstandard_100412.pdf

135 See HMRC International Manual: Available at


136 KPMG Analysis of HMRC’s Updated Thin cap Guidance. Available at KPMG:

http://www.kpmg.co.uk/email/03Mar10/191662/HMRC's_Updated_Thin_Cap_JNeighbour_DHead_accessible.p

df

137 See HMRC Thin Capitalisation Guidance - Introduction to thin capitalisation (legislation and principles) note

INTM541020. Available at HMRC: http://www.hmrc.gov.uk/manuals/intmanual/INTM541020.htm

https://www.deloitte.com/assets/Dcom-Global/Local%20Assets/Documents/Tax/Newsletters/dtt_tax_armslengthstandard_100412.pdf



http://www.kpmg.co.uk/email/03Mar10/191662/HMRC's_Updated_Thin_Cap_JNeighbour_DHead_accessible.pdf




47

also dismissive about the idea of using comparables for gearing138

. This thesis

suggests that Malawi should consider incorporating its current practice into specific

thin capitalisation legislation but should consult thoroughly with the business

community before doing so.

There is no easy way to answer the question of which set of rules Malawi should copy

and there is certainly no way of answering it without conducting specific research on

which method would work for Malawi. The discussion in Chapter 2 of this thesis has

shown that different countries have their own ways of dealing with thin capitalisation.

None of these are perfect and none of these should be copied recklessly.

As a matter of fact one critique that can be made about some of Malawi’s laws is that

in the country’s hurry to enact new laws and to be considered at par with the more

developed world, not enough thinking or consultation goes into the legislation drafting

process. Some of Malawi’s statutes have actually been copied word for word (and not

always that precisely) from legislation in other jurisdictions without taking into

account the needs of the local market and the particularities of Malawi’s economy139

.

The same mistake should not be made when considering how to amend both the

general anti-avoidance rule and how to draft a suitable specific anti-avoidance rule.

What works for Germany and the UK may not necessarily work for Malawi. While

Malawi’s economy is growing, it is as yet not quite as sophisticated as Germany’s or

the UK’s. Malawi’s Tax Authorities should not be expected to negotiate their way

through complex rules that they’ve copied from another country which may not even

be relevant in the Malawian context.

The UK and German Tax Authorities have frequent consultations with the business

community. For instance, while the UK is considering introducing a General Anti-

138

Deloitte Global Transfer Pricing Tax Newsletter Arm’s Length Standard - April/May 2010 at p. 4. Available

at Deloitte: https://www.deloitte.com/assets/Dcom-

Global/Local%20Assets/Documents/Tax/Newsletters/dtt_tax_armslengthstandard_100412.pdf

139 A rather perturbing example of this can be found in the Capital Markets Development Act. Section 43 (1) of

the Act refers to a “controlling Transactions shareholder”. However, there is no definition of a controlling

Transactions shareholder in the entire Act nor is there further mention of such shareholder. No reference to this

shareholder can be found in any other law in Malawi either. It is evident that when copying the Act, the

draftsman forgot to copy the definition too!




48

Avoidance rule, it has prepared a Consultative document examining the advantages

that such rule would have in countering tax avoidance and considering how it might be

framed140

. Readers are invited to comment on the likely effectiveness and efficiency

of a general Anti- Avoidance Rule constructed on the principles of the Consultative

document. The document further raises some practical questions about the

administration of such rule and invites suggestions as to how those questions might be

answered. A General Anti-Avoidance rule will not be introduced until the consultation

period is over and the Inland Revenue has received feedback.

Malawi needs to involve the business community in more discussions prior to making

changes in tax legislation. In a recent meeting141

with business people conducted

jointly by MRA and the Malawi Confederation of Chambers of Commerce and

Industry (MCCCI) to clarify some aspects of the new tax measures for 2010/11

financial year as announced by the Minister of Finance in Parliament, tax payers

called for wider consultations prior to implementation of tax changes. This thesis

concludes that the best way forward for Malawi is not to copy other countries’ rules

but to draft sensible and practical rules that take into account Malawi’s own particular

circumstances.

140

Available on Her Majesty’s Customs and Revenues website (HMRC) :


141 Meeting held in Blantyre, Malawi at on July 8, 2010 – information obtained from Malawi Revenue Authority

website. Available at MRA: http://www.mra.mw/display_details.php


http://www.mra.mw/display_details.php


49

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