Thin capitalisation rules: A second-best solution to the cross-border debt bias?

One of the most significant trends in the evolution of global tax systems has been the rise from relative obscurity of thin capitalisation rules, which are perceived as anti-avoidance rules which limit tax base erosion from cross-border interest deductions. However, over the same timeframe, innovations to financial instruments have challenged the traditional financial and legal distinctions between debt and equity, which in the cross-border setting has exposed the prevalence of economic inefficiencies in the design of the international tax system. 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’. Despite their prevalence, it is unclear whether thin capitalisation rules: (1) attain tax neutrality (specifically, do these rules mitigate the debt bias); (2) are effective in both theory and practice. This provides the basis to examine whether a cross-border manifestation of a fundamental reform could eliminate the need for existing thin capitalisation rules, which are presently a second-best solution to the tax-induced cross-border debt bias. Accordingly, this paper: (1) considers reforms traditionally designed to address the domestic debt bias; specifically, the allowance for corporate equity (ACE), comprehensive business income tax (CBIT), combined ACE-CBIT and allowance for corporate capital; (2) examines the literature and implementation experience of the ACE, the only one of these fundamental reforms which has been experimented with in practice, to consider whether it is effective in both theory and practice; (3) presents the possibility of extending the combined ACE-CBIT to the cross-border context as an alternative to thin capitalisation rules.