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Banking & Finance

Financing scrutiny

Released at: 10:44, 16/10/2015

Financing scrutiny

Ms. Huong Vu and Mr. Than Xuan Thinh, Partners in Tax and Advisory Services at EY Vietnam (Ernst & Young), look at the merits or otherwise of a thin capitalization rule in Vietnam.

In August 2015 the Ministry of Finance (MoF) released a draft law amending and supplementing certain tax laws for public comment before submission to the government and the National Assembly. One of the proposed changes to corporate income tax (CIT) that has been controversial in the business community is the “thin capitalization” rule. How should this rule viewed and is it necessary?

Why introduce a thin capitalization rule 

The common corporate financing structure includes equity and debt. The term “thin capitalization” is used to describe enterprises that have a high ratio of debt to equity (debt leverage).
Beside the commercial reasons for using debt leverage, enterprises may also use thin capitalization to reduce tax expenses. The accompanying table illustrates the tax perspective of debt leverage.

If the foreign shareholder is located in a country that does not tax or has a low tax rate on interest income, they are obviously motivated to fund their subsidiary in Vietnam in the form of a shareholder’s loan.

This is probably the main reason why countries apply rules against thin capitalization, where interest expenses are only deductible for CIT purposes to a certain limit. Naturally, enterprises do not like the rule because it limits flexibility in deciding the corporate financing structure and also incurs tax expenses in other “bona fide situations”, for example where high debt leverage is typical of certain industries.

International practice

From our quick survey, most developed countries around the world have CIT provisions relating to thin capitalization and several countries have applied it since the 1970s, whereas a number of developing countries have not applied these rules as yet (such as Malaysia, Indonesia, Thailand, and others). Countries with thin capitalization rules also differ in the methods restricting the amount of deductible interest expenses. Generally, there are two approaches.

The first is the “Ratio” method, which restricts the debt ratio (to equity, or total assets) or the interest ratio (to income) at a specific limit. Countries that apply this method include the US, China, Australia, and Canada. The second is the “Arm’s Length” method, which does not specify a certain limit but relies on arm’s length transactions in the same industry to consider the reasonability of debt leverage. Countries that apply this method include the UK and South Africa.

Those subject to the thin capitalization rule are also different among countries. There are countries that apply the rule only for cross-border borrowing transactions or borrowing transactions among affiliate companies, whereas there are countries that apply it for all borrowing transactions.

MoF proposal 

The thin capitalization rule proposed by the MoF is based on the Ratio method and restricts the debt/equity ratio at 5:1 for the manufacturing industry and at 4:1 for remaining industries, to be applicable from January 1, 2016. From 2019 the ratios will decrease to 4:1 and 3:1, respectively. The current proposal does not distinguish loans from domestic or foreign sources or borrowings from affiliate companies or independent parties.

This method is also in accordance with the conventions of several countries around the world and compliance seems simple. The ratios suggested by the Minister of Finance are quite “open” compared to other countries, where 3:1 or even 2:1 are common.

Necessary, but …

We do not attempt here to answer the question of whether Vietnam should introduce a thin capitalization rule at this stage or which ratios are reasonable, because, as with any new tax rule, it requires a thorough survey and evaluation of the impacts on both the State budget and the enterprises. Looking at other countries around the world and in the region, there is a clear trend towards applying such a rule, to counter tax avoidance using debt leverage. However, this rule is still not common in developing countries. As in other developing countries, Vietnamese enterprises mainly rely on credit for their financing needs, so introducing a thin capitalization rule must be carefully considered. The State can consider narrowing the scope of application in the early stages in order to thoroughly evaluate the impacts on the State budget as well as on enterprises, with the following principles. Firstly, the rule should only be applied on cross-border transactions, for the reason that domestic lenders are already required to account for their interest income, which should then result in a corresponding full deduction for the borrowers. In addition, tax authorities can easily control loan transactions from both the lender and borrower perspectives. Secondly, the rule should only be applied for transactions between related parties, because borrowings from third parties are normally for business reasons rather than tax avoidance. 

Further, the draft law should provide more detailed provisions on calculations and the time to compute the debt/equity ratios, to avoid a situation where the law is issued but implementation is pending further guidance via decree or circular.

In our opinion, applying the above principles will restrict any abuse of debt leverage for tax avoidance while also not affecting enterprises that have demand for raising funds for business activities. This is especially important for Vietnamese companies in the recovery stage following a long period of recession.

If the MoF retains its current proposal we believe there should be a more thorough survey for a regulatory impact assessment, in accordance with international practice. This assessment would assist the government and the National Assembly to have a broader and clearer view to make a decision, and the business community would thoroughly understand the importance and assess the impacts of the rule on their own enterprises. While both authorities and enterprises still lack a clear insight into the impacts of the proposal, conflicting arguments (which are sometime sentimental) are inevitable. 

(This article represents the authors’ personal views only and do not reflect or represent EY’s views). 

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