Thin capitalisation
Encyclopedia
A company 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.
, 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 bank
s 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.
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.
- 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.
Credit risk
If the shareholders have introduced only a nominal amount of paid-up share capitalShare capital
Share capital or issued capital or capital stock refers to the portion of a company's equity that has been obtained by trading stock to a shareholder for cash or an equivalent item of capital value...
, 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
Capital requirement
Capital requirement refers to -The standardized requirements in place for banks and other depository institutions, which determines how much capital is required to be held for a certain level of assets through regulatory agencies such as the Bank for International Settlements, Federal Deposit...
. 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
Bank
A bank is a financial institution that serves as a financial intermediary. The term "bank" may refer to one of several related types of entities:...
s and insurance companies. This is because if such companies were to fail and go into liquidation
Liquidation
In law, liquidation is the process by which a company is brought to an end, and the assets and property of the company redistributed. Liquidation is also sometimes referred to as winding-up or dissolution, although dissolution technically refers to the last stage of liquidation...
the economic effect of such failures can lead to a domino effect
Domino effect
The domino effect is a chain reaction that occurs when a small change causes a similar change nearby, which then will cause another similar change, and so on in linear sequence. The term is best known as a mechanical effect, and is used as an analogy to a falling row of dominoes...
, which can have catastrophic consequences for other businesses and, ultimately, regional 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 "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.