A company is typically financed or capitalised through debt or equity, or a mix of both. Thin capitalisation refers to the situation where a company is financed through a relatively high level of debt compared to equity. Thinly capitalised companies are sometimes referred to as highly leveraged or highly geared entities. This article is to analyse the tax rules on the level of debt accepted for financing by related parties for guidance.
The way a company is capitalised will often have a significant impact on the amount of profit it reports for tax purposes. Country tax rules typically allow a deduction for interest paid or payable in arriving at the taxable profit. The higher the level of debt in a company, and thus amount of interest it pays or payable, the lower will be its taxable profit. For this reason, debt is often a more tax efficient method of financing than equity. Unlike dividends, interest does not suffer economic double taxation, i.e., it is not taxed both in the hands of the debtor and in the hands of the creditor.
Multinational Enterprises (MNEs) are often able to structure their financing arrangements to maximise these benefits. Not only are they able to establish a tax-efficient mixture of debt and equity in borrowing countries, they are also able to influence the tax treatment of the lender which receives the interest – for example, the arrangements may be structured in a way that allows the interest to be received in a jurisdiction that either does not tax the interest income, or a jurisdiction which subjects such interest to a lower tax rate.
In view of the above, Tax Authorities seek to curb the abuse of the above tax planning mechanism by instituting measures to limit the use of debt instead of equity as a financing tool known as ‘THIN CAPITALISATION.”
Thin capitalisation rules typically operate by means of one of two approaches:
- determining a maximum amount of debt on which deductible interest payments are available; and
- determining a maximum amount of interest that may be deducted by reference to the ratio of interest (paid or payable) to another variable.
Thin capitalisation rules often operate by limiting, for the purposes of calculating taxable profit, the amount of debt that can give rise to deductible interest expenses. The interest on any amount of debt above that limit (excessive debt) will not be deductible for tax purposes.
Countries take different approaches to determining the maximum amount of debt that can give rise to deductible interest payments, but there are generally two broad approaches, namely:
- The “arm’s length” approach.
- The “ratio” approach.
Due to the use of innovative ways by businesses especially MNEs to minimise their tax liability using thin capitalisation, Tax Authorities keep a constant review of tax laws and interpretation to curb the abuse.
Below is my analysis on the thin capitalisation rules in Ghana with my conclusion and recommendation for guidance.
Legal framework
In Ghana, the legal position on the subject can be found in the following legislations: The Income Tax Act, 2015 (Act 896) as amended, Revenue Administration Act, 2016 (Act 915) as amended, with guidance from the Income Tax Regulations L.I 2244 and decided court cases.
- Legal analysis
- Tax avoidance (Section 99 of Act 915)
Section 99(1) of Act 915 states that despite any provision in a tax law, where the Commissioner-General (CG) is of the opinion that a person might otherwise secure a tax benefit under a tax avoidance arrangement, the CG may adjust the tax liability of that person in a way that the CG considers appropriate to counteract the tax benefit.
The CG may, pursuant to subsection (1) serve the person with a notice specifying the tax benefit; the arrangement; and the adjustment made by the CG.
A notice under subsection (2) may be incorporated in a notice of assessment. For the purpose of this section “tax avoidance arrangement” means, subject to subsection (5) an arrangement that has as a MAIN PURPOSE the provision of a tax benefit for a person; or an arrangement where the main benefit that might be expected to accrue from the arrangement is a tax benefit for a person; and “tax benefit”, in relation to a person, means avoiding, reducing or postponing a tax liability of the person; increasing a claim of the person for a refund of tax; or preventing or obstructing collection of tax from the person.
An arrangement is a “tax avoidance arrangement” only if it involves a misuse or abuse of a tax law provision having regard to the purpose of the provision and the wider purposes of the law in which the provision is situated.
Section 33 of Act 896
Section 33(1) states, where a resident entity which is NOT A FINANCIAL INSTITUTION and in which FIFTY PERCENT or more of the underlying ownership or control is held by an exempt person either alone or together with an associate has a DEBT-TO-EQUITY RATIO in excess of THREE-TO-ONE (3:1) at any time during a basis period, a DEDUCTION IS DISALLOWED for any interest paid or foreign currency exchange loss incurred by that entity during that period on that part of the debt which exceeds the three-to-one ratio, being a portion of the interest or loss otherwise deductible but for this subsection.
Subsection 2 further states that for purposes of this section, “exempt person” means a non-resident person; a resident person for whom interest is paid to an exempt person by a resident entity or for whom a foreign exchange gain realised with respect to a debt claim against the resident entity constitutes exempt income; or is not included in ascertaining the exempt assessable income of that person; and “resident entity” means a resident partnership, resident company, resident trust or permanent establishment of a non-resident person in the country.
The above provision is a specific anti avoidance provision employed in addition to the general anti avoidance provisions in section 34 of Act 896, and section 99 of Act 915 to counteract any exploitation in the deductibility of interest which satisfies the residual deduction rule as outlined in section 9 of Act 896 in the determination of taxable profit.
The terms “debt” and “equity” used in section 33 of Act 896, shall be construed as; a “debt” means an obligation to pay an amount owed to an exempt person as mentioned in subsection (2) of section 33 of Act 896; and an “equity” means the sum of Stated Capital and Income Surplus as provided in paragraph 20 of L.I. 2244.
Interest (Section 10 of Act 896)
Section 10 of Act 896 states that, for the purpose of section 9 of Act 896, interest incurred by a person during a year of assessment under a debt obligation of the person is incurred in the production of income to the extent that; where the debt obligation was incurred in borrowing money, the money is used during the year or was used to acquire an asset that is used during the year in the production of the income; and the debt obligation was incurred in the production of income in any other case.
Interest is tax deductible when it satisfies the provisions in Section 9,10, 33, and 34 of Act 896, and section 99 of Act 915. Failure to fully comply with all the provisions stated above may result in a taxpayer not been able to fully deduct such interest.
The thin capitalisation ratio (3:1) is a clear unambiguous indicator which must be self-assessed by a taxpayer when considering the financing option, they intend to employ.
- Exclusions from the thin capitalisation rule
In view of the above provisions in section 33(1) of Act 896, the debt-to-equity ratio (3:1) rule IS NOT APPLICABLE TO RESIDENT FINANCIAL INSTITUTIONS. Section 133 of Act 896 defines “financial institution” as; a bank regulated under the Banking Act, 2004 (Act 673); a non-banking financial institution regulated under the Non-Banking Financial Institutions Act, 2008 (Act 774); or any other category of person prescribed by Regulations.
- Can excess disallowed deductions be rolled forward?
Deductions of interest or foreign currency exchange loss incurred in excess of the debt-to-equity ratio (3:1) is DISALLOWED.
Excerpts from the provisions of section 33(1) of act 896, states “a deduction is disallowed for any interest paid or foreign currency exchange loss incurred by that entity during that period on that part of the debt which exceeds the three-to-one ratio, being a portion of the interest or loss otherwise deductible but for this subsection”. This disallowance will give rise to a permanent difference between the accounting profits and the tax profits which will never be deductible for tax purposes.
Conclusion
In conclusion, Ghana’s tax laws allow deduction of interest expense which is wholly, exclusively, and necessarily (residual deduction rule) incurred on a debt used in the generation of the income or through financing of an asset which is used in the generation of the income by a resident entity other than a financial institution which has fifty percent or more of the underlying ownership or control being held by an exempt person either alone or together with an associate if the debt-to-equity ratio is not in excess of 3:1. The interest or foreign currency loss of debt which is in excess of the 3:1 ratio is permanently disallowed.
Recommendations
I recommend to taxpayers to consult a chartered tax practitioner for advice when considering a financing (equity or debt) option to be deployed to a resident entity which is NOT A FINANCIAL INSTITUTION and in which FIFTY PERCENT or more of the underlying ownership or control is held by an exempt person either alone or together with an associate so that the DEBT-TO-EQUITY RATIO will not exceed THREE-TO-ONE (3:1) at any time during a basis period, because a DEDUCTION will be DISALLOWED for any interest paid or foreign currency exchange loss incurred by that entity during that period on that part of the debt which exceeds the three-to-one ratio.
This article is my personal and professional opinion as a tax practitioner in the discharge of my duties as a GHANAIAN CITIZEN who seeks the success of Ghana, and it is not a representation of the opinion of any institution.
The author is a Chartered Tax Practitioner- a Member of ICAG and a Member of the Chartered Institute of Taxation Ghana
[email protected]; [email protected]; @ib_asare; 0244 423 960
