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
Treatment of Thin Capitalisation in Malawi
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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
Treatment of Thin Capitalisation in Malawi
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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
Treatment of Thin Capitalisation in Malawi
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“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
9 Rohatgi, Roy. Basic International Taxation (Second Edition) Volume 2: Practice of International Taxation
(2007) at page 138
10 Id
Treatment of Thin Capitalisation in Malawi
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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
Treatment of Thin Capitalisation in Malawi
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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
18 Rohatgi, Roy. Basic International Taxation (Second Edition) Volume 2: Practice of International Taxation
(2007) at page 142
19 OECD Paris (1987). International Tax Avoidance and Evasion – Four Related Studies at p 11.
Treatment of Thin Capitalisation in Malawi
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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
Treatment of Thin Capitalisation in Malawi
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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.
Treatment of Thin Capitalisation in Malawi
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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
26 Rohatgi, Roy. Basic International Taxation. (2002) at page 399
Treatment of Thin Capitalisation in Malawi
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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
Treatment of Thin Capitalisation in Malawi
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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
Treatment of Thin Capitalisation in Malawi
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.
35 Finnerty, C; Merks, P; Petriccione, M; and Russo, R. Fundamentals of International Tax Planning (2007) at
page 221
36 See Taxes, repatriation strategies and multinational financial policy (2003) Journal of Public Economics 87,
73-107.
Treatment of Thin Capitalisation in Malawi
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.
38 Rohatgi, Roy. Basic International Taxation (Second Edition) Volume 2: Practice of International Taxation
(2007) at page 216
39 Finnerty, C; Merks, P; Petriccione, M; and Russo, R. Fundamentals of International Tax Planning (2007) at
page 222
Treatment of Thin Capitalisation in Malawi
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
41 Rohatgi, Roy. Basic International Taxation. (2002) at page 396
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.
Treatment of Thin Capitalisation in Malawi
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.
Treatment of Thin Capitalisation in Malawi
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.
Treatment of Thin Capitalisation in Malawi
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
Treatment of Thin Capitalisation in Malawi
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
Treatment of Thin Capitalisation in Malawi
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
Treatment of Thin Capitalisation in Malawi
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
Treatment of Thin Capitalisation in Malawi
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.
Treatment of Thin Capitalisation in 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
Treatment of Thin Capitalisation in Malawi
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
Treatment of Thin Capitalisation in Malawi
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.
Treatment of Thin Capitalisation in Malawi
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.
Treatment of Thin Capitalisation in Malawi
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
Treatment of Thin Capitalisation in Malawi
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
Treatment of Thin Capitalisation in Malawi
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
Treatment of Thin Capitalisation in Malawi
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
Treatment of Thin Capitalisation in Malawi
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
90 Rohatgi, Roy. Basic International Taxation. (2002) at page 409
Treatment of Thin Capitalisation in Malawi
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
Treatment of Thin Capitalisation in Malawi
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 .
Treatment of Thin Capitalisation in Malawi
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
Treatment of Thin Capitalisation in Malawi
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
Treatment of Thin Capitalisation in Malawi
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
Treatment of Thin Capitalisation in Malawi
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
Principles of the Rule of Law? (2010). Saint Louis University Law Journal, Forthcoming. Available at SSRN:
http://ssrn.com/abstract=1523043
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:
http://ssrn.com/abstract=1273005
Treatment of Thin Capitalisation in Malawi
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
Principles of the Rule of Law? (2010). Saint Louis University Law Journal, Forthcoming. Available at SSRN:
http://ssrn.com/abstract=1523043
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
Principles of the Rule of Law? (2010). Saint Louis University Law Journal, Forthcoming. Available at SSRN:
http://ssrn.com/abstract=1523043
Treatment of Thin Capitalisation in Malawi
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
Principles of the Rule of Law? (2010). Saint Louis University Law Journal, Forthcoming. Available at SSRN:
http://ssrn.com/abstract=1523043
115 Dworkin, R.M. The Model of Rules The University of Chicago Law Review, Vol. 35, No. 1. (Autumn, 1967),
pp. 14-46.
Treatment of Thin Capitalisation in Malawi
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
Treatment of Thin Capitalisation in Malawi
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
Treatment of Thin Capitalisation in Malawi
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.
Treatment of Thin Capitalisation in Malawi
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:
http://ssrn.com/abstract=1398643
125 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
Treatment of Thin Capitalisation in Malawi
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
Treatment of Thin Capitalisation in Malawi
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
Treatment of Thin Capitalisation in Malawi
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
Treatment of Thin Capitalisation in Malawi
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):
http://www.hmrc.gov.uk/manuals/intmanual/intm570000.htm
Treatment of Thin Capitalisation in Malawi
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
http://www.hmrc.gov.uk/manuals/intmanual/INTM433050.htm
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
Treatment of Thin Capitalisation in Malawi
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!
Treatment of Thin Capitalisation in Malawi
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) :
http://www.hmrc.gov.uk/consult/consult_1.htm#4
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
Treatment of Thin Capitalisation in Malawi
49
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von Brocke K and Perez E G * International Transfer Pricing Journal Volume 16 No. 1
January/February, 2009
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