Thin capitalization occurs when companies finance investments and operations through a level of debt far higher than their level of equity. High-tax countries create an incentive for companies to finance investments with debt because interest payments are tax-deductible, while the costs associated with equity financing are most often not. Some multinational corporations take advantage of the tax benefits associated with debt financing by lending money internally from subsidiary entities in low-tax countries to entities in high-tax countries. Tax savings in high-tax countries typically exceed the increased tax paid in low-tax countries, decreasing worldwide tax liability.

To discourage this form of international debt shifting, many countries have implemented so-called thin-capitalization rules (thin-cap rules), which limit the amount of interest a multinational business can deduct for tax purposes. The two most common types used in practice are “safe harbor rules” and “earnings stripping rules.” Safe harbor rules restrict the amount of debt for which interest is tax-deductible to a predefined debt-to-equity ratio. Interest paid on debt exceeding this set ratio is not tax-deductible. Earnings stripping rules limit the tax-deductible share of debt interest to pretax earnings.

Just three of 27 countries covered have only a debt-to-equity ratio in place. For instance, Turkey’s debt-to-equity ratio is 3:1. Let’s say a Turkish business takes a $100 loan from its foreign subsidiary. Its current equity amounts to $10, resulting in a debt-to-equity ratio of 10:1. The annual interest on the loan is 5 percent, or $5. Because the business’ debt-to-equity ratio is 10:1, but Turkey’s debt-to-equity ratio is 3:1, only the tax liability of the debt within the set ratio—5 percent of $30, or $1.5—is tax-deductible.

Most European countries covered have interest-to-pretax-earning limits in place. Most commonly, the limit is set at 30 percent of EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization). For example, assume that a parent company takes a $100 loan from its subsidiary requiring interest payments of $5. If EBITDA are $10, only $3 (30 percent of $10) of the $5 in interest paid are tax-deductible.

Ireland is the only country covered in this map with no formal thin-cap rules.

It is important to keep in mind that thin-cap rules not only limit international debt shifting but can also impact real economic activity, such as investment and employment.

Detailed information on OECD countries’ interest deduction limitations can be found here.