A company is said to be thinly capitalised when its capital is made up of a much greater proportion of debt than equity, i.e. its gearing, or leverage, is too high. This is perceived to create problems for two classes of people:
- 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.
If the shareholders have introduced only a nominal amount of paid-up share capital, then the company has lower financial reserves with which to meet its obligations. If all or most of the company's capital comes from debt, which (unlike equity) needs to be serviced, and ultimately repaid, it means that the providers of capital are ultimately competing with the company's trade creditors for the same capital resources.
At the risk of generalising, most traditionally common law countries do not tend to employ thin capitalisation rules generally in relation to raising and maintenance of capital. However, a number of civil law jurisdictions do.
However, in almost all jurisdictions there are certain types of regulated entity which require a certain amount, or a certain proportion, of paid-up share capital to be licensed to trade. The most common examples of this are banks and insurance companies. This is because if such companies were to fail and go into liquidation the economic effect of such failures can lead to a domino effect, which can have catastrophic consequences for other businesses and, ultimately, regional economies.
Even where countries’ corporate laws permit companies to be thinly capitalised, revenue authorities in those countries will often limit the amount that a company can claim as a tax deduction on interest, particularly when it receives loans at non-commercial rates (e.g. from connected parties). However, some countries simply disallow interest deductions above a certain level from all sources when the company is considered to be too highly geared under applicable tax regulations.
Some tax authorities limit the applicability of thin capitalisation rules to corporate groups with foreign entities to avoid “tax leakage” to other jurisdictions. The United States “earnings stripping” rules are an example. Hong Kong protects tax revenue by prohibiting payors from claiming tax deductions for interest paid to foreign entities, thus eliminating the possibility of using thin capitalisation to shift income to a lower-tax jurisdiction.
- Profits tax: Deductibility of interest expense. Hong Kong Inland Revenue Department, Departmental Interpretation and Practise Notes #13A. December 2004.