Thin Capitalisation

Interest is usually deductible against profit, while dividends are not. A group can therefore fund a subsidiary in a high-tax country with intra-group loans, so that profits leave as deductible interest and are taxed lightly where the lender is based. Rules respond in two main ways. One sets a ratio of debt to equity beyond which interest is not deductible. The other, now more common, caps net interest at a share of earnings, often between 10% and 30% of EBITDA, a measure of profit before interest, tax and depreciation. Details vary by country and often include exceptions for small amounts of interest or for group-wide ratios. Disallowed interest is added back to taxable profit and may be carried forward. Treasury and tax teams must plan group financing around these limits. Without a cap, interest on related-party loans could shrink a subsidiary's taxable profit to almost nothing.

A foreign parent funds its local subsidiary with a large loan at a high interest rate. The subsidiary's interest bill wipes out most of its profit. The tax authority applies a cap based on a share of earnings, disallows the excess interest and adds it back, so the subsidiary pays tax on a higher profit.