A company is usually financed or capitalized through debt and equity. Thin Capitalization is defined as capital in a much greater proportion of debt against equity that normally creates problems to creditors and revenue authority. Thin capitalization bears the solvency risk to a company forcing it to repay the bulk of its capital in terms of interests. Thinly capitalized companies are sometimes referred to as highly leveraged or highly geared.
The method in which a company is capitalized can have a significant impact on the amount of profit it reports for tax purposes. The tax rules of almost any country usually allow a deduction for interest paid or payable in arriving at the tax measure of profit. The higher the level of debt in a company, and thus amount of interest it pays, the lower will be its taxable profit. For this reason, debt is often a more tax efficient method of finance than equity.
As it’s mentioned above, Thin Capitalization rules, determine how much of the interest paid on corporate debt is deductible for tax purposes. Such rules are primarily of interest to private equity firms, which use significant amounts of debt to finance leveraged buyouts.
For this reason, country tax administrations often introduce rules that place a limit on the amount of interest that can be deducted in calculating the measure of a company’s profit for tax purposes. Such rules are designed to counter cross-border shifting of profit through excessive debt, and thus aim to protect a country’s tax base.
Thin Capitalization rules typically operate by means of one of two approaches:
a) Determining a maximum amount of debt on which deductible interest payments are available.
b) Determining a maximum amount of interest that may be deducted by reference to the ratio of interest (paid or payable) to another variable.
Thin capitalization rules usually operate by limiting, for the purposes of calculating taxable profit, the amount of debt that can give rise to deductible interest expenses. The interest on any amount of debt above that limit will not be deductible for tax purposes.
In each country, different approaches are used to determine the maximum amount of debt that can increase the deductible interest payments. Nevertheless, in general there are two approaches: i) the arm’s length approach, ii) the ratio approach.
i. The arm’s length approach: In this approach, the maximum amount of allowable debt is the amount of debt that an independent lender would be willing to lend to the company. The arm’s length approach usually considers the specific attributes of the company in order to determine its borrowing capacity.
ii. The ratio approach: In this approach, the maximum amount of debt on which interest may be deducted for tax purposes is established by a predetermined ratio, such as the ratio of debt to equity. The ratios that are used may or may not be intended to reflect an arm’s length position.
b) Limiting amount of interest that may be deducted by reference to its ratio to another variable.
A number of countries use a ratio approach that is based on the amount of interest paid or payable in relation to the amount of income out which that interest is paid. This is also known as an earnings stripping approach. The applicable ratio may be by reference, for example, to a ratio of the amount of interest to operating profit or a measure of cash flow (e.g. an interest to EBITDA ratio).
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