On the enforceability of the thin capitalization regime

The Constitutional Court announced, that by means of judgment C-665-2014, it had declared the exequibility of Article 118-1 of the Tax Statute, which enshrines the misnamed thin capitalization regime in Colombia.

It is established that the provision under attack is constitutionally valid inasmuch as: 1) it applies to all taxpayers, reason for which it does not violate the principle of equality, 2) the rule does not intend to direct the investment or financing strategies of the economic actors, reason for which the principles of freedom of enterprise and equity of the tax system are not affected, 3) the rule applies to all economic actors as of its enactment, without the particular arguments on the indebtedness of each economic actor being valid, reason for which it cannot be established that such provision violates the constitutional right to due process.

Although the analysis of the Constitutional Court is valid, and is respected, it must be indicated that the so-called thin capitalization regime is not such, and its legal consecration distorted the intention of the legislator, reason for which it imposed on the Colombian businessman -unjustifiably- a disproportionate and disproportionate burden consisting of not being able to deduct the interest generated on debts, whose total average amount during the corresponding taxable year exceeds the result of multiplying by 3 the net worth of the taxpayer determined as of December 31 of the immediately preceding year. In the author's opinion, this rule, seen from the point of view of what was intended and did not remain, violates the constitutional principles of non-retroactivity, equity and tax justice.

According to international experience, and in accordance with the guidelines issued by the OECD, thin capitalization regimes are introduced in local legislations as an anti-elusive legislative technique aimed at recharacterizing (in capital or equity operations), the indebtedness operations entered into between national companies with foreign related entities when as a result of such operations the indebtedness of the receiving entity exceeds three times its own equity. This is because it is presumed that such operations would have the sole purpose of generating an exorbitant interest payment (tax deduction) by the national entity, which would erode the taxable base of the country of the receiving entity. It is under this understanding that this regulation was presented before Congress and this is stated in the explanatory memorandum of Law 1607 of 2012 when it states that: "in Colombia there is a bias of deductibility of interest versus non-deductibility of dividends, for which reason companies tend to finance most of their projects through credit. This often occurs through the use of subordinated loans with partners or collateral provided by related parties abroad. Thus, the partners receive the return of the investment in the form of deductible interest in Colombia, reducing in turn the equity of the company for tax purposes". What ended up remaining in the law was the worst of all worlds; an unjustified restriction on the deduction of interest paid by local entrepreneurs to unrelated parties in Colombia (including financial entities) and with clear retroactive effects, since, in general, companies pay interest on long-term indebtedness which could have been contracted prior to the entry into force of this rule. At the same time, this regime establishes an unjustified advantage (thanks to the theory of moderate monism adopted by the Constitutional Court, according to which tax treaties take precedence over domestic law) for certain national businessmen who pay interest to companies resident in countries with which a double taxation avoidance treaty has been signed, since such thin capitalization system would not apply to them.

In conclusion, it is not enough for the Constitutional Court to review the enforceability of the rules from a merely formal point of view, but it must do so taking into account factors such as the will of the legislator, the effect that certain measures generate in industry and commerce and the damage that they may generate by having retroactive effects against the addressee.