Thin capitalisation
Thin capitalisation
- What it is
- A situation in which a company is financed mainly by loans rather than equity
- Why it is done
- Loan interest usually reduces taxable profit, while dividends do not
- What the state does
- Limits the deduction of interest through thin capitalisation rules
- The main risk
- Part of the interest will not be deductible, and it is sometimes recharacterised as dividends
- Where it matters most
- In loans from related parties and from the company’s owner
In plain words
Thin capitalisation is a situation in which a company is financed mainly by loans rather than equity. The economic logic is clear: loan interest, as a rule, reduces taxable profit, while dividends are paid out of profit after tax. Financing a company with debt turns out to be more advantageous.
States respond with thin capitalisation rules. The approaches vary: a limit on the ratio of debt to equity, a cap on deductible interest as a share of earnings before interest, tax, depreciation and amortisation, special rules for loans from related parties. The common purpose is to prevent profits from being artificially reduced through intra-group debt.
The main focus of these rules is loans from the owner and related companies. That is where it is easiest to set non-market terms: an inflated rate, no security, no fixed term. In the event of a breach, part of the interest is not deductible, and in some jurisdictions the payments are recharacterised as dividends with all the tax consequences.
When it matters
What is checked
- Debt to equity
- Interest as a share of profit
- Thresholds
- A loan from the owner
- Intra-group loans
- Indirect relatedness
- Market rate
- Security
- Term and repayment schedule
- Denial of interest deduction
- Recharacterisation as dividends
- Additional assessments
How to reduce the risk
- 01Check the jurisdiction’s rules
- 02Keep to the debt-to-equity ratio
- 03Set market terms for the loan
- 04Document it properly
- 05Keep to the payment schedule
What you need to know
- Interest usually reduces profit, dividends do not
- The rules limit the deduction of interest
- The main focus is loans from related parties
- Loan terms must be at market level
- Interest may be recharacterised as dividends
Common mistakes
- Financing the company only with a loan from the owner
- Setting a non-market rate on an internal loan
- Documenting the loan formally, without a schedule or security
- Not checking the thresholds in the particular jurisdiction
- Not repaying the loan for years despite a formal term
What this means for a BRIDGES client
If your business is the source of income for an immigration application, its financial structure must withstand scrutiny. A loan from the owner on non-market terms is a typical weak point that is easier to fix in advance.
Frequently asked questions
01 /What is thin capitalisation?
A situation in which a company is financed mainly by loans rather than equity, to save tax on interest.
02 /Why does this interest the tax authority?
Interest reduces taxable profit, while dividends do not. Intra-group debt can be used to reduce profit artificially.
03 /How is the deduction limited?
Through a debt-to-equity ratio, a cap on interest as a share of profit, or special rules for loans from related parties. The approaches differ between countries.
04 /What happens in the event of a breach?
Part of the interest will not be deductible, and in some jurisdictions the payments are recharacterised as dividends and taxed accordingly.
05 /Can I lend to my own company?
Yes, it is normal practice. What matters is keeping to market terms, a reasonable proportion to equity and proper documentation.
06 /What do market terms mean?
Those on which an independent party would have made the loan: a justified rate, a fixed term, a payment schedule and security where necessary.
See also
Read next
This material has undergone editorial review by BRIDGES.
Financing your business with loans?
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