EBITDA vs DER: The Battle Against Thin Capitalization

Oleh: Calvin Valenzuela, Tax Educator, Directorate General of Taxes

Have you ever heard of the “Thin Capitalization Phenomenon” in Canada? It was a notorious form of tax base erosion that occurred before 2012, significantly reducing the amount of corporate taxes. The base erosion arose from a related-party debt scheme involving groups of multinational companies operating across inter-sectoral business areas, mainly energy, mining, and financial services. The multinational companies established subsidiary companies as financing vehicles in Barbados or Luxembourg, which had lower tax rates compared to Canada. These subsidiary companies provided large loans to Canadian companies so that the Canadian companies could deduct the interest expenses to reduce corporate taxes. Meanwhile, the interest income received by the subsidiary companies was subject to a low tax rate. Despite the fact that the Canada Revenue Agency (CRA) never explicitly published the amount of tax losses for several reasons, the CRA issued new policies tightening the debt-to-equity ratio from 2:1 to 1.5:1.

Similarly, the Thin Capitalization Phenomenon occurs not only in Canada but also in Indonesia. Before 2015, the Directorate General of Taxes (DJP) had found many cases of thin capitalization during tax auditing, supported by findings from the Audit Board of the Republic of Indonesia (BPK RI), tax dispute results from the tax court, and various other sources. The Ministry of Finance issued Ministry of Finance Regulation (MOFR) Number 169/PMK.010/2015, regulating how to determine the ratio of debt to equity for tax purposes. The regulation stated that the maximum debt-to-equity ratio allowed is 4:1. If a company’s debt-to-equity ratio is higher than 4:1, the excess interest expenses must be fiscally adjusted. MOFR Number 169/PMK.010/2015 was the only quantitative anti–thin capitalization method, along with other predecessor qualitative instruments such as the arm’s length principle and others.

Building on the existing framework, on May 22nd, 2025, the Regulation of the Director General of Taxes Number PER-11/PJ/2025 was established. The regulation was an “all-in-one package” comprising many tax business procedures, including how to calculate the amount of interest expense that can be deducted for tax purposes. Article 85 introduced the new model of the annual corporate tax return, consisting of various new forms of attachments, including the L11-B attachment. The L11-B not only introduces the new form of the Debt-to-Equity Ratio but also provides a new quantitative method called EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization). The EBITDA method has raised fundamental questions: What are the differences between the EBITDA and DER methods? What are the pros and cons of each method?

From a conceptual standpoint, both methods share a similarity in creating a buffer line for the amount of deductible interest expense for tax purposes. The major difference between the EBITDA and DER methods lies in their respective approaches. The DER method uses a comparison between debt and equity, resulting in a ratio that can be either fiscally accepted or adjusted. The EBITDA method uses a fixed percentage to limit the excess amount of non-deductible interest expense. The DER method focuses on a company’s capital structure, whereas the EBITDA method highlights a company’s ability to pay, reflected by its adjusted earnings.

With these differences in mind, let’s talk about the pros of the EBITDA method: considering the fact that the EBITDA method is based on adjusted earnings, it may have a better ability to capture a company’s payment performance. Whatever changes appear in revenue would also impact EBITDA. The EBITDA method is supported by the Organization for Economic Co-operation and Development Base Erosion and Profit Shifting (OECD BEPS) Action Number 4. OECD BEPS Action 4 recommends the application of Fixed Ratio Rules to reduce thin capitalization, which share similar characteristics with the EBITDA method.

However, EBITDA has several cons: since the basis of the method is adjusted earnings, it requires more advanced knowledge and techniques to obtain the adjusted earnings through reconciliation. The EBITDA method also demands more skillful human resources supported by a more advanced accounting system. The nature of the EBITDA method, which uses adjusted earnings as its basis, could increase the probability of accounting-engineered practices. This method also requires advanced tax supervision to ensure that the EBITDA method is implemented fairly and properly.

In contrast, implementing the DER method requires only debt and equity data based on the regulations, which theoretically can be applied more easily either from the taxpayer’s or the tax authority’s supervision side. This method provides less room for manipulation since the data is derived from the balance sheet. The DER method is originally designed to prevent the capital structure from becoming too thin. The cons of the DER method are essentially the opposite of the EBITDA method. The DER method takes less consideration of a company’s profitability. Compared to EBITDA, the DER method appears more traditional, as many other countries have already moved to the EBITDA method. Another issue concerns the ratio, which cannot be applied equally to every sector, although there is a list of sectors exempted from using the 4:1 Debt-to-Equity Ratio in MOFR Number 169/PMK.010/2015.

At this stage, although other methods such as EBITDA have been clearly stated in the attachment of Directorate General of Taxes Regulation Number PER-11/PJ/2025, the technical stipulation that sets the implementation instructions for the EBITDA method or other methods besides DER has not yet been released. Therefore, the only viable option for now is the DER method. Now ask yourself, in the event that the stipulations of the EBITDA method are published, which method would you choose?

*)This article represents the personal opinion of the author and does not reflect the official stance of the institution where the author works.

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