Thin Capitalisation

Thin capitalisation refers to a condition in which a company is financed with a high level of debt compared to its equity. This means it is highly leveraged. This method of financing is often used by multinational companies as a way of reducing tax; a lender in a low-tax country lends to a borrower in a country in which the borrowing cost can be deducted from profits for corporate tax purposes. As a consequence, profit can be shifted to a lower tax jurisdiction.

However, in the wake of wider initiatives such as BEPS and CRS, a number of national governments have been looking at the practice of thin capitalisation, and sought to impose limits on how much interest expense can be deducted for tax purposes.

Typically a thin capitalisation rule will prevent the complete deduction of interest if the ratio between debt and equity exceeds a certain level. There are two main categories of such rules – either the amount of interest which is deductible is restricted if the total debt-equity ratio exceeds a certain numerical value, or the internal debt-to-equity ratio is limited.

Recently, regimes from Australia and New Zealand, from Canada to Russia, and Indonesia to South Korea have all, in various ways, sought to introduce measures to counteract the use of thin capitalisation as a tax avoidance strategy.

In terms of Cyprus, current tax legislation does not provide for any rules when it comes to thin capitalisation, which makes it an ideal location in which to situate a holding company. However, caution needs to be exercised when it comes to interest deductions for loans which are not of a trading nature. Such interest payments are deemed non-deductible, whereas interest on a loan of a trading nature is treated as qualifying, and, therefore, eligible for deduction.

The battle against thin capitalisation is part of the wider picture in which national and international authorities are cutting-down on aggressive tax planning strategies and moves to shift profits from higher to lower tax jurisdictions. International companies which find themselves affected by the tightening regulations may want to consider using Cyprus as a base for their holding companies as there are no thin capitalisation rules currently in place, and because of its attractive low corporate tax rate.

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