A
company
A company, abbreviated as co., is a legal entity representing an association of people, whether natural, legal or a mixture of both, with a specific objective. Company members share a common purpose and unite to achieve specific, declared ...
is said to be thinly capitalised when the level of its debt is much greater than its
equity capital
In finance, equity is ownership of assets that may have debts or other liabilities attached to them. Equity is measured for accounting purposes by subtracting liabilities from the value of the assets. For example, if someone owns a car worth $2 ...
, i.e. its
gearing, or leverage, is very high. An entity's debt-to-equity funding is sometimes expressed as a ratio. For example, a gearing ratio of 1.5:1 means that for every $1 of equity the entity has $1.5 of debt.
A high gearing ratio can create problems for:
* creditors, which bear the solvency risk of the company, and
* revenue authorities, which are concerned about excessive interest claims.
Credit risk
If the shareholders have introduced only a nominal amount of paid-up
share capital
A corporation's share capital, commonly referred to as capital stock in the United States, is the portion of a corporation's equity that has been derived by the issue of shares in the corporation to a shareholder, usually for cash. "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.
In general, most common law countries tend not to employ thin capitalisation rules 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
bank
A bank is a financial institution that accepts Deposit account, deposits from the public and creates a demand deposit while simultaneously making loans. Lending activities can be directly performed by the bank or indirectly through capital m ...
s and
insurance companies
Insurance is a means of protection from financial loss in which, in exchange for a fee, a party agrees to compensate another party in the event of a certain loss, damage, or injury. It is a form of risk management, primarily used to hedge ...
. This is because if such companies were to fail and go into
liquidation
Liquidation is the process in accounting by which a company is brought to an end in Canada, United Kingdom, United States, Ireland, Australia, New Zealand, Italy, and many other countries. The assets and property of the company are redistrib ...
the economic effect of such failures can lead to a
domino effect
A domino effect or chain reaction is the cumulative effect generated when a particular event triggers a chain of similar events. This term is best known as a mechanical effect and is used as an analogy to a falling row of dominoes. It typically ...
, which can have catastrophic consequences for other businesses and, ultimately, national economies.
Tax issues
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 “base erosion and profit shifting" to other jurisdictions. The United States “earnings stripping” rules are an example. Hong Kong protects tax revenue by prohibiting payers 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.
Thin capitalisation rules determine how much of the interest paid on corporate debt is deductible for tax purposes. Such rules are of interest to
private-equity firm
A private equity firm is an investment management company that provides financial backing and makes investments in the private equity of startup or operating companies through a variety of loosely affiliated investment strategies including leve ...
s, which use significant amounts of debt to finance
leveraged buyout
A leveraged buyout (LBO) is one company's acquisition of another company using a significant amount of borrowed money ( leverage) to meet the cost of acquisition. The assets of the company being acquired are often used as collateral for the loa ...
s, and in the context of strategic acquisitions, where the purchaser wishes to push debt into higher taxed countries with significant pre-tax income.
Article on thin capitalisation rules on AltAssets.com
See also
* Base Erosion and Profit Shifting
References
{{Reflist
External links
United Kingdom HMRC - introduction to thin capitalisation
* ttp://www.ils-world.com/newsletter/66/capitalisation.shtml Newsletter - Thin capitalisation
Financial capital
Corporate taxation
Debt