A Liberian tax lawyer has called on tax policy makers to put into place or strengthen the existing tax policy to protect the Liberian tax base from profit repatriation since taxes form part of the three points of the budgetary triangle of government’s spending; namely taxes, expenditures and borrowings.
Rufus Senyon who is currently studying Comparative International Tax Law at Uppsala University, Sweden said in an article: “Tax revenue is the striking bedrock to finance government’s spending and repayment of debt because excessive borrowings coupled with high interest charges could erode the tax revenue and render government’s expenditures on the delivery of public goods and services impossible.”
“Therefore, from tax policy perspectives for Liberia to increase its annual revenue to 1 billion that we yearned for and even more so, rigorous tax policy measure is the best way to go. Borrowing which is counterproductive to development because interest charged on the monies borrowed must be serviced by tax revenue collected which erodes tax revenue thereby leading to downward spiral in government adequately and efficiently delivering on public goods and services,” he explained in the article.
Senyon pointed that many multinational and multi-million companies are opting to finance their subsidiaries with debt that includes deductible interest which is more effective in plummeting the tax base of source state, thereby leading to less tax payment or avoidance of taxation than equity- financing in which dividends distributions are not deductible.
“Recognizing the use of Thin Capitalisation (more debt financing) schemes for tax avoidance by parent companies, the Organization for Economic Co-operation and Development (OECD) opted to address base erosion and profit shifting (BEPS) in BEPS Action 4 report in 2013 in which countries were called upon to devise effective provisions to limit base erosion or protect its tax base against tax avoidance planning,” the article stated.
It added that OECD, therefore, recommended that countries should adopt a consistent approach of international best practices regarding base erosion and profit shifting if high interest deductions are to be addressed, thereby protecting its tax base.
Senyon clarified in the article that contrary to some misconceptions, Liberia does have Thin Capitalization rule (or ”anti-avoidance approach”) towards based erosion and profit shifting by the use of thin Capitalization schemes.
He also advised policy makers that some aspects for instance, applicability of Specific Anti-avoidance rule like Thin Capitalisation rule, Controlled Foreign Company rule (CFC) or the Arm’s Length Principle (ALP) of the Transfer Pricing Guidelines, must be detailed in the tax law to avoid legal scrimmage over its interpretation. See full article below.
Analysis of Thin Capitalisation Rule – ‘’A Perspective on Liberia Tax Base Vis-a-Vis Profit Repatriation.’’
Tax Policy Consideration
The global emergence of cross- border trade has led to multinational enterprises setting up subsidiaries in jurisdictions of high tax rates with the objective of gaining the share of the profit of their subsidiaries. And there is no tax law of a country that prohibits as to how a parent company chooses to finance subsidiary companies, they may do so by debt financing (loan financing) or equity financing (by shares) or the mixture of both; and neither are there any breach of international laws regarding the methods of financing that a company chooses to finance its subsidiaries activities. However, if it is debt financing by the parent company to subsidiary, the latter must pay interest for the utilization of the loan over the time (time value concept of money) which is a deductible expense on the taxable income, unless there is special rules in place in the jurisdiction of the subsidiary.
If it is equity financing where the parent company own shares as a mean of financing the subsidiary, dividend would be distributed to the parent company and in most jurisdictions, dividends are not deductible in computing taxable income. Also, if there is participation exemption rule, the dividend may not be subject to withholding tax. Undoubtedly, financing a company with debt that includes deductible interest is more effective in plummeting the tax base of source state, thereby leading to less tax payment or avoidance of taxation than equity financing in respect of which dividends distributions are not deductible. This analysis is premised on the fact that it has been long identify that debt financing is an aggressive tax planning tool by multinational enterprises through thin Capitalisation schemes for their subsidiary to be financed with more debt than equity capital. This is confirm by IMF, Spillovers in International Corporate Taxation p. 30 (IMF 2014).
Against this background, tax policy requires stringent measures to protect the tax base from profit repatriation since taxes form part of the three points of the budgetary triangle of government spending namely taxes, expenditures and borrowings. Tax revenue is the striking bedrock to finance government spending and repayment of debt because excessive borrowings couple with high interest charges could erode the tax revenue and render government expenditures on the delivery of public goods and services impossible.
Recognizing the use of Thin Capitalisation (more debt financing) schemes for tax avoidance by parent companies, the Organization for Economic Co-operation and Development (OECD) opted to address base erosion and profit shifting (BEPS) in BEPS Action 4 report in 2013 in which countries where called upon to devise effective provisions to limit base erosion or protect its tax base against tax avoidance planning. Countries were encouraged to develop rules to counter the use of related party debt financing through which profits repatriation are carried out from high tax jurisdictions to low or no tax jurisdictions. The OECD, therefore, recommended that countries should adopt a consistent approach of adopting international best practices regarding base erosion and profit shifting if high interest deductions are to be addressed thereby protecting its tax base. So in 2015, in its final BEPS Action 4 report, the OECD recommended a fixed ratio between 10% and 30% that limits interest deductions on profits before EBITDA arising from debt financing by parent companies to subsidiaries.
What is Liberia approach to adopting thin capitalization rule? Or is there a resemblance of thin Capitalisation rules as proposed by the OECD against base erosion and profit shifting? From a tax law perspective, while flicking through the pages of Liberia Consolidated Revenue Code as amended 2021 including the immediate prior version 2011, my investigation has led me to analyze section 203 (d) that limit interest deduction on taxable income in a tax year. We read as provided in section 203 (d) Liberia Revenue Code ‘’the deduction for interest payable to any person other than a resident bank is limited to the amount of interest received plus 50% of taxable income other than interest income”. In accordance with the Revenue Code, interest deduction of loan on taxable income in a tax year is capped or limited by a maximum amount based on a defined metrics of calculation.
This is a semblance of the approaches or anti-avoidance rule to counter thin Capitalisation as recommended by the OECD. This is so because, the concept of Thin Capitalisation rules which is an anti-avoidance approach towards base erosion and profit shifting is typically by means of one of two approaches: 1) determining a maximum amount of debt on which deductible interest payments are available; and b) determining a maximum amount of interest that may be deducted by reference to the ratio of interest (paid or payable) applying the EBITDA. As it is the case amongst European countries base on the EU directive not more than 30% interest of EBITDA is deductible.
There is no generally acceptable definition of “thin capitalization rules”. It is good to note with the term “thin capitalization” lies a focus on debt in relation to equity, a tax avoidance scheme for profit repatriation. If the taxation of the interest paying company is considered, for tax purposes, in relation to the debt-equity ratio of the company, then it is a form of thin-cap-rule (or anti-avoidance approach) to limit interest deduction thereby protect the tax base. The legal consequence of “thin capitalization” may differ between different thin-cap-rules. Some countries re-characterize the interest to dividends, and some countries simply deny interest deduction.
The first approach to thin Capitalisation rules which is the determination of maximum amount of debt regarding the deduction of interest as to the applicability is a subject for discussion at another time. However, for this article, I have chosen to provide persuasion and to dislodge the widely held misunderstanding that Liberia does not have thin Capitalisation rule (or ‘’anti-avoidance approach’’) towards based erosion and profit shifting by the use of thin Capitalisation schemes, this is on the contrary. I encourage 1) more investigation into this debate by tax policy analysts, advisors and tax lawyers to the OECD approaches in the report of BEPS Action 4 to Thin Capitalisation rules (‘’Anti-avoidance rule’’). 2) Regarding section 15 of the Liberia Revenue Code ‘’Anti-avoidance Rule’’ should be more specific as to the method (s) of Re-characterization of counterfeited transactions which objective is tax avoidance.
For instance, if it is the applicability of Specific Anti-avoidance rule like for example Thin Capitalisation rule, Controlled Foreign Company rule (CFC) or the Arm’s length principle (ALP) of the Transfer Pricing Guidelines, it must be detailed in the tax law to avoid legal scrimmage over its interpretation. As a comparatist of international tax law, I have compared the tax laws of various countries, for example, Ghana tax law specifically in section 31(5)(a) of Income Tax Act 896 of 2015 permits the Commissioner General to use the ALP to re-characterize debt financing in a controlled relationship as equity financing.
In South Africa, section 31 of Income Tax Act 58 of 1962, as amended by Taxation Laws Amendment Act 24 of 2011, provides that the ALP must be applied to financial assistance in cross-border transactions. And also applied thin Capitalisation rule by limiting interest deductions towards thin Capitalisation schemes at 40% of EBITDA (deduction of related-party interest and finance expenditure is limited) to protect its tax base, and there is a proposal to further limit EBITDA at 30% in the 2020 and 2021 Budgets. This is an attestation of my argument and also as indicated by the prima-facie in the OECD approach to thin Capitalisation that Liberia does have ‘’thin Capitalisation rule’’ (or anti-avoidance rule’’) towards thin Capitalisation schemes of profit repatriation.
Therefore, from tax policy perspectives for Liberia to increase its annual revenue to 1 billion that we yearned for and even more so, rigorous tax policy measures is the best way to go. Borrowings which is one of the three points of the budgetary triangle of government spending is counterproductive to development because interest charged on the monies borrowed must be serviced by tax revenue collected which erodes tax revenue thereby leading to downward spiral in government adequately and efficiently delivering on public goods and services. So it is prudent that government go with the option of raising tax revenues through robust tax policy measures like the one detailed in this article. I would also like to encourage civil society groupings to amplify the debate through the formulation of robust tax policy measures to straighten our tax base towards reactionary schemes in our tax jurisdiction.
About the Author: Rufus B. Senyon is a Student of Comparative International Tax Law at Uppsala University, Sweden with emphasis in Tax Treaty Law & Transfer Pricing; serve for over 4 years as Auditor & Senior Tax Associate at ‘’Parker & Company, LLC,’’ (a Certified Public Accountants & Business Advisors Firm). Served as Part-time lecturer at various universities in Liberia for Elements of Taxation course base on Liberia tax jurisdiction for over 8 years now dating back to 2013.