Thin capitalization refers to a tax avoidance strategy employed by multinational corporations. It involves the excessive use of debt financing in a foreign subsidiary, typically through loans from related parties, to maximize interest deductions and minimize taxable income in high-tax jurisdictions.
The concept of thin capitalization is based on the premise that excessive debt leverage leads to tax avoidance since interest payments are tax-deductible expenses. By intentionally loading a foreign subsidiary with a disproportionately high amount of debt, the multinational corporation reduces its taxable income in the country with higher tax rates and shifts it to the country with lower tax rates. This allows the company to lower its overall tax burden.
Tax authorities are concerned about thin capitalization practices as they can lead to erosion of the country's tax base and result in reduced tax revenues. To counter this, many countries have implemented thin capitalization rules or regulations to limit the amount of interest deductions that can be claimed based on certain debt-to-equity ratio thresholds.
These regulations typically require the multinational corporation to maintain a certain level of equity in proportion to debt in its subsidiaries. If the debt exceeds a predetermined limit, tax authorities may treat a portion of the interest payments as a non-deductible expense, thereby increasing the taxable income of the subsidiary and reducing the tax benefits of the strategy.
Thin capitalization rules aim to ensure that multinational corporations are not artificially shifting profits to low-tax jurisdictions by primarily financing their operations with excessive debt.