ATAF members have reported that excessive interest payments are one of the most prevalent and simple of the profit-shifting techniques used by multinational enterprises in Africa and poses a significant risk to African tax bases. The fluidity and fungibility of money makes it a relatively simple exercise to adjust the mix of debt and equity in a group company.
Most countries treat tax debt and equity differently for the purposes of their domestic law. Interest on debt is generally a tax-deductible expense for the payer and taxed in the hands of the payee. Dividends, or other equity returns, on the other hand, are generally not tax deductible and are typically subject to some form of tax relief (an exemption, exclusion, credit, etc.) in the hands of the payee. While, in a purely domestic context, these differences in treatment may result in debt and equity being subject to a similar overall tax burden, the difference in the treatment of the payer creates a tax-induced bias, in the cross-border context, towards debt financing.
In the cross-border context, subsidiary entities may be heavily debt financed, using excessive deductions on intragroup loans to shelter local profits from tax. The interest receipts often arise in jurisdictions where they are subject to low or no tax.
Most African countries are capital importers and will be net borrowers rather than net lenders. Taxpayers in African countries are usually the subsidiaries referred to above and will usually be net payers of interest rather than net payees. The tax deductibility of interest payments and potential profit shifting through excessive interest payments is therefore of high priority to most African countries
that uses a fixed ratio test based on an entity’s interest/earnings ratio, which provides an effective tool to combat base erosion and profit shifting.