A company is said to be thinly capitalized when its capital is made up of a much greater proportion of debt than equity, ie. its gearing or leverage, is too high. This is perceived to create problems for two classes of people.
- consumers and creditors bear the solvency risk of the company, which has to repay the bulk of its capital with interest; and
- revenue authorities, who are concerned about abuse by excessive interest deductions.
Thin Capitalization rules can apply in situations where:
- A security is issued, which would not have been issued without a special relationship between the parties ( tax deductions for interest on loans from group entities are stopped where the borrower would not have been able to sustain the debit on its own );
- A loan is made because of a guarantee given to the lender by a party related to the borrower.
In view of Transfer Pricing issues, an entity ( which may be part of a group) may be said to be thinly capitalized when it has excessive debt in relation to its arm’s length borrowing capacity, leading to the possibility of excessive interest deductions. An important parallel consideration is whether the rate of interest is one which would have been obtained at arm’s length rate while comparing from independent lender as a standalone entity.
Arm’s length Principle:
In order to determine whether an entity ( or a group of entities) is thinly capitalized, it is necessary to :
- • Ascertain how much the company or companies would have been able to borrow from an independent lender ( the arm’s length amount); and
- • To compare this with the amounts actually borrowed from group companies or with the backing of group companies.
A comparison can then be made between the interest payable on the actual debt and that which would be payable on the amount which could and would have been borrowed at arm’s length. Deductions for corporation tax purposes can be limited to those on the latter amount.