Updated
GL-T-04
Glossary · Taxes and residency
Thin capitalisation - when a company runs on owner loans and the tax authority rejects the interest
01 / In 30 seconds
The short answer
- 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
02 / In plain words
What Thin capitalisation means
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.
A case from practice
A client’s company was financed almost entirely by a loan from the owner with no clear terms. When reviewing the structure, we suggested bringing the proportion and terms into line — before the tax authority took an interest.
When it matters
- Financing a subsidiary
- A loan from the owner to the business
- Intra-group lending
- Buying real estate through a company
- Structuring an investment project
- A tax audit of a group
03 / What it covers
What is checked
Ratio
- Debt to equity
- Interest as a share of profit
- Thresholds
Relatedness
- A loan from the owner
- Intra-group loans
- Indirect relatedness
Conditions
- Market rate
- Security
- Term and repayment schedule
Consequences
- Denial of interest deduction
- Recharacterisation as dividends
- Additional assessments
04 / How it works
How to reduce the risk
Check the jurisdiction’s rules
The ratio, the interest cap, related-party rules.
Keep to the debt-to-equity ratio
How much equity is needed for the interest to be deductible.
Set market terms for the loan
Rate, term, security - as an independent lender would set.
Document it properly
Loan agreement, schedule, members' resolutions.
Keep to the payment schedule
Interest and principal are paid on schedule.
05 / Key facts
What you need to know
01What it is
Lots of debt, little equity
The company is funded mainly by loans rather than its own capital.
02Why companies do it
Interest reduces profit
Loan interest is usually deductible, while dividends are paid out of after-tax profit.
03How it is limited
Ratios and a share of earnings
A debt-to-equity limit or a cap on interest as a share of earnings before tax and depreciation. In the EU it is 30% of such earnings.
04Consequences
Deductions cut, interest recharacterised
Part of the interest is disallowed, and in some countries the payments are treated as dividends.
Common mistakes
Funding the company only with an owner loan
Combine equity and loans within the country's rules.
Setting a non-market rate on an internal loan
Set the rate an independent lender would charge.
Documenting a loan with no schedule or security
Set the term, repayment schedule and conditions as for an ordinary loan.
06 / Expert advice
How to prepare in advance
The financing structure is planned in advance: what part goes in as equity, what part as a loan, and on what terms. Intra-group loans are documented as genuine ones: a market rate, a term, a schedule and security where necessary. And the threshold rules of the particular country are checked — they differ significantly.
What we do for you. 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.
Dmitry NagyTax consultant, international taxation and compliance (ex-Big4)
07 / Questions
Frequently asked questions
A situation in which a company is financed mainly by loans rather than equity, to save tax on interest.
Interest reduces taxable profit, while dividends do not. Intra-group debt can be used to reduce profit artificially.
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.
Part of the interest will not be deductible, and in some jurisdictions the payments are recharacterised as dividends and taxed accordingly.
Yes, it is normal practice. What matters is keeping to market terms, a reasonable proportion to equity and proper documentation.
Those on which an independent party would have made the loan: a justified rate, a fixed term, a payment schedule and security where necessary.
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