What's BEPS got to do with it? Exploring the effectiveness of thin capitalisation rules

In October 2015, the OECD made a best practice recommendation in Action 4 of its BEPS project, suggesting a Fixed Ratio Rule in place of thin capitalisation rules. This review was almost 3 decades in the making, with the most recent OECD report on thin capitalisation rules published in 1986, which omitted guidance on how these rules could best be designed. Thin capitalisation rules’ strong emphasis on revenue base protection has resulted in their exponentially increasing popularity internationally since the 1960s. However, there is a growing body of literature critiquing the effectiveness of thin capitalisation rules. Accordingly, this paper approaches the issue of thin capitalisation from a novel perspective by conceptualising the cross-border debt bias as the ‘disease’ and thin capitalisation as merely the ‘symptom’. Grounded in the tax principle of efficiency, the overarching question guiding this paper is whether, given the opportunity to start over, the tax-induced cross-border debt bias would be better addressed by retaining thin capitalisation rules in their current form or whether an alternative reform would be more suited to dealing with this ‘disease’. The optimisation model developed in this paper shows that the OECD’s Fixed Ratio Rule is more effective than the current regime of thin capitalisation rules at protecting the tax revenue base from the most tax-aggressive multinational enterprises (MNEs). However, the model also indicates that it is ultimately more effective to align the tax treatment of intercompany funding to eliminate the ‘underlying disease’ (the tax incentive for thin capitalisation), rather than adopting rules that mitigate the ‘symptom’ (such as the OECD’s Fixed Ratio Rule). This research presents a unique contribution to the literature by simulating complex cross-border intercompany tax planning strategies. This facilitates a formal analysis of one of the most significant challenges presented by the mobility and fungibility of capital; namely, anticipating how an MNE structures its internal affairs in a tax-optimal manner given the current tax regime and suggesting tax administrative responses to BEPS accordingly.