Talk of introducing a thin capitalization rule should be put on hold until the matter is fully investigated.
Mr.Phan Vu Hoang, Tax Partner, Deloitte Vietnam
Regulations on thin capitalization are implemented extensively in various countries around the world. Putting these regulations into the practice in Vietnam, however, may require some deeper thought in terms of both the content and the time of implementation.
Complex and widely influential
Circular No. 96/2015/TT-BTC dated June 22, 2015 includes several amendments to the guidelines on the Law on Corporate Income Tax (CIT) with regard to loan interest, which allows enterprises to deduct more interest expenses related to their investment and business activities.
These are sound provisions that were introduced in the interests of businesses, creating more favorable conditions, and have therefore been positively welcomed and received by the business community because they indicate the government’s commitment to facilitating more favorable conditions for business operations. However, while taxpayers have only just started to enjoy benefits from these more relaxed regulations, they may soon feel significant tax impacts from interest expenses due to proposal from the Ministry of Finance (MoF) to introduce a thin capitalization rule.
The MoF is considering adding the proposal in the draft law amending and supplementing a number of articles of the tax law for submission to the National Assembly.
The draft provisions on thin capitalization put a cap on deductible interest expenses for CIT purposes, as follows: “Interest expenses on loans corresponding to loans exceeding equity five times (5:1) for the manufacturing sector and four times (4:1) for other sectors.”
As explained by the MoF, the provision intends to put a restriction on enterprises that have loans that far exceed equity. The provision aims mainly at limiting transfer pricing activities through the financial expenses of enterprises, especially foreign direct investment (FDI) enterprises, and to help strengthen financial security among enterprises. In other words, to minimize the financial risks of heavily indebted enterprises, which may lead to default.
In fact, most OECD countries have regulations on thin capitalization, for example the US (with a debt to equity ratio of 1.5:1), Canada (2:1), France (1.5:1), and Germany, Japan, and Russia (3:1). Such regulations are also implemented in many other countries and economies, such as Taiwan, New Zealand, Australia, Poland, the Netherlands, Spain, South Africa, Peru, Chile, and Brazil.
Nevertheless, not many countries specify different thin capitalization ratios for different lines of business, as proposed in the aforesaid draft. The existence of dual thin capitalization ratios between manufacturing and other sectors could give rise to numerous controversies about the applicable ratio between tax authorities and taxpayers, creating difficulties in implementation. For example, if an enterprise operates in many lines of business, including manufacturing, processing, and services, etc., how would the ratio be determined?
If the draft proposal is intended to minimize financial risks, the current content might not necessarily meet expectations. A high debt to equity ratio would be an indication that an enterprise has high financial risks, but it is far from being a key factor in concluding that the enterprise does indeed have high financial risks, for at least the two following reasons.
Firstly, the debt to equity ratio should be evaluated along with other ratios. For example, an enterprise’s debt to equity ratio of 10:1 can be considered high according to the draft, but if the enterprise has an operating profit before interest exceeding its interest expenses by 20 times (which means the profit can cover 20 times the interest payments), its financial risk should well be rated as low.
Second, to what extent this ratio is viewed as high would be dependent on the industry in which the enterprise is operating. For example, in capital-intensive sectors such as real estate, oil & gas, and trade, the debt to equity ratio is usually much higher than in the manufacturing sector.
In addition, the application of “equity” in the calculations of the debt to equity ratio as proposed in the draft law may also cause controversy.
Some companies with significant losses may have very low or even negative equity, thus the fixed debt to equity ratio cap (such as 5:1 or 4:1) would not accurately reflect the enterprise’s financial risks, or it may be controversial and difficult, if not impossible, to determine and apply the cap.
Perhaps in this case the concept of “contributed capital” would be more appropriate than equity, although contributed capital would not be free from problems (for example, the appropriate thin capitalization ratio may no longer be 5:1 or 4:1 and will have to be revised.
Additionally, the regulation regarding “ … the loan exceeding five times of equity …” would be misleading, because it is not specified if this is “one loan” or “the total loan amount”.
The word “loan” is not clearly defined to indicate whether it is short term or long term, which then can be interpreted as either. For some sectors such as trading, if the “debt” portion includes both short-term and long-term loans, the 5:1 ratio would be extremely unreasonable. In the debt to equity ratio commonly used for evaluating financial risks, normally only long-term loans are taken into account.
Time of implementation
Thin capitalization rules are not uncommon around the world. It is notable, however, that no ASEAN country currently has this provision in force. For example, Singapore is silent on the issue. In 2013 Malaysia decided to postpone the implementation of a thin capitalization regulation. Indonesia regulates that its Ministry of Finance has the authority to determine the debt to equity ratio of enterprises but so far the provision seems to have been ignored.
According to an August 2012 report from the OECD on thin capitalization, from a policy perspective the fact that a country does not have any regulations on thin capitalization can give it the edge in multinational corporations (MNCs) investing in that country.
Obviously, the introduction of a thin capitalization rule could immediately curb foreign investment, particularly from MNCs, because it will significantly increase their tax expenses and impair the attractiveness of the investment environment. The main reason for the Malaysian Government postponing the implementation of the thin capitalization regulation in 2013 was that they wanted to reassess in further detail the impact the regulation would have on FDI. In fact, one of the questions that foreign investors often pose to tax consultants in Vietnam before making their investment is: “Is there any thin capitalization rule in Vietnam?” If Vietnam is to apply this regulation without prior notice from 2016, it would be a significant hindrance to efforts to attract FDI compared with neighboring ASEAN countries.
In the context where the economy has shown signs of recovery but has not fully recovered, the business situation is not in a boom stage, and the exchange rate between the VND and other currencies such as the USD will continue to widely fluctuate in the future, businesses and investors are suffering from a lot of headaches in terms of cost control and profit monitoring.
In the near future, when the minimum wage increases (estimated to be over 12 per cent) along with a requirement for calculating mandatory insurance contributions on total income being introduced, it is expected to significantly increase costs to enterprises (especially wages), and they will have to carefully reconsider the earnings equation, which has already been problematic.
If from 2016 they have to take another variable called “thin capitalization” into the equation, investors, including both domestic and foreign, will have to evaluate, for another time, the effects of the rule on their upcoming investment projects in Vietnam that use loans (which is definitely not a small volume) and they may have to decide to cease various investment projects, as the yield would be lower than originally estimated. Such regulations could lead to a significant drop in the competitiveness of the investment environment in Vietnam compared to neighboring countries.
According to the OECD report, regulations on thin capitalization around the world are generally very complicated, because it is never a simple issue and has significantly wide impacts. With the above analysis, I believe that the immediate implementation of the currently drafted thin capitalization rule should be reviewed carefully. If this draft is implemented from 2016, various investment projects may stall as they often have to be evaluated years before and it will be too late to revise the assumptions.
Therefore, if the thin capitalization rule is to be implemented, the content and time for implementation should be amended to minimize unwanted effects on the investment environment as well as business operations in Vietnam.
Accordingly, the “fixed” ratio between debt and equity can be provided in a more flexible manner, for example, the Law can provide a general principle that the debt / capital contribution ratio will be stipulated by the government at different levels and times for certain industries. As for the time of implementation, instead of 2016, the introduction of a thin capitalization rule may be deferred to 2019 or 2020.
This postponement would help the National Assembly and the government to carefully assess the impact on domestic and foreign direct investment, and set a schedule for businesses to evaluate the impact and prepare appropriate financing sources for their investment projects in the future.