Thin capitalization

Thin capitalisation refers to a situation where a company is financed to a large extent by foreign capital instead of equity. This results from, among other things:

• taking out a high volume of loans,
• financing fixed assets through leasing
• obtaining bank loans to finance current business activity.

It is most common in international companies that, in order to reduce their tax bases, create artificial debt financing transactions that reduce the effective tax rate. The phenomenon described above brings with it two main problems. For creditors, the risk of insolvency of the company being financed. On the tax authorities' side, there is a significant loss of state budget revenues from tax revenues.

Credit risk of thin capitalisation

Many developed countries do not allow or significantly reduce thin capitalization. This is due to the fact that, very often, the use of this method of financing a company's activities increases the risk of the company's insolvency much more, and thus reduces the market position of the lender. In an economy in which the institution of bankruptcy is allowed, thin capitalization in a sense contradicts the institution's data. It happens because the bankruptcy is not a result of independent economic factors, such as, among others, the economic downturn, but a deliberate and well thought-out action by the entrepreneur. Therefore, such an institution would not constitute a possible aid, but rather an authorisation to engage in unreasonable economic activity . In view of the above, most jurisdictions have begun to introduce thin capitalization limits. This allows the use of this popular tool, but it has also secured the interests of creditors. This allows for simultaneous functioning of entities characterised by low capital value and high turnover of receivables at the same time.

Thin capitalisation and tax law

As it was mentioned at the beginning, thin capitalisation is a significant disadvantage for the state budget. By locating the beneficial owner in a country where such costs can be deductible from the tax base, he is significantly reduced. In this way, companies with international structures artificially generate a reduction in their income through intra-group financing . From the perspective of OECD countries, thin capitalization has been significantly reduced. Companies can still benefit from such financing, but part of those costs should nevertheless be excluded from tax deductible costs. For example, in the European Union, the EBITDA ratio is used as a proportional factor. Thus, taxpayers are obliged to exclude from tax deductible costs 30% of the excess of debt financing costs over EBITDA. This means that once this surplus is exceeded, thin capitalization will no longer bring tax benefits This allows, among other things, for significant savings in the state budget and the implementation of all the necessary mechanisms to counteract the phenomenon of tax evasion. However, this solution causes many problems for taxpayers who did not use the cost of debt financing to avoid taxation but only to run their own businesses. This is particularly noticeable in individual interpretations issued by tax authorities.

Footnotes

Thin capitalization — recommended articles

Income Shifting — Net gain — Foreign national mortgage — Repatriable — Currency risk — Bad debt recovery — Interventionism — Tax evasion — Trade exchange

References

• Gajewski D., (2013), Tax-related and Economic Consequences of Selecting the Method of Debt Financing of Companies with Regard to Thin Capitalisation in OECD Member Countries, "Contemporary Economics", Vol. 7, Iss. 2, p. 77-83
• Lohse T., Riedel N., (2013), Do Transfer Pricing Laws Limit International Income Shifting? Evidence from European Multinationals, "CESifo Working Paper", No. 4404
• West A., (2018), Multinational tax avoidance: Virtue ethics and the role of accountants, "Journal of Business Ethics", 153 (4), p. 1143-1156

Author: Karolina Kopecińska