Thin capitalisation

Thin capitalisation is a very high level of gearing: it occurs when a company is funded almost entirely by debt with only a nominal amount of equity.

This is usually a problem primarily from the point of view of tax authorities. The typical method of tax avoidance employed is the use of a thinly capitalised subsidiary that borrows from the parent or an off-shore vehicle. The lender being in a low tax jurisdiction.

The result of this is that very little of the returns on capital are return on equity — profit, which is usually taxable in the country where the subsidiary is domiciled, or where is operations are. This increase the return on debt — interest paid, which is usually taxable where the lender is domiciled.

The end result is to shift taxable profits from where the profits are made to a tax-haven. Many countries have introduced thing capitalisation tax rules to prevent this, for example by imposing a withholding tax on interest paid by the thinly capitalised company.

Thin capitalisation rules usually take into account more than just the levels of debt and equity. UK rules consider whether the debt could have been raised on the same terms in an arms length transaction: an unconnected lender would be unlikely to lend enough to make a company very highly geared. This also covers the possibility of using artificially high rates to transfer profits.

This capitalisation may also be of concern to other creditor, or to suppliers or customers. Usually a they will have an implicit (or even explicit) guarantee from the parent group.

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