Meaning
Fiscal regulation that limits the amount of interest expense a company can deduct from its taxable income. Deductions are often capped at a percentage of the entity’s earnings before interest, taxes, depreciation, and amortization. Interest stripping rules prevent multinational groups from shifting profits to low-tax regions through excessive intercompany loans.
Deduction Limit
Borrowing from third parties usually faces different scrutiny than internal funding. If the interest paid to a parent company exceeds the cap, the excess is treated as a non-deductible expense. This effectively increases the tax paid in the country where the operations are located.
Debt Structure
High leverage becomes less attractive when the cost of servicing the debt cannot be fully offset against profits. This forces companies to maintain a more balanced capital structure with a higher proportion of equity. The rules are part of a global effort to align tax payments with economic activity.
Investment Return
Investors calculate the net return on a project by considering these limits on interest deductibility. Changes to these rules can turn a profitable project into one that fails to meet the internal rate of return needed for approval. The rules are a primary consideration in the design of cross-border acquisition financing.
Borrowing costs are modeled under several tax scenarios to ensure the debt remains serviceable if earnings drop.
