Thin capitalisation
Tax.
The loading up of a foreign subsidiary’s capital structure with interest bearing debt.
This has the effect - among other consequences - of transferring taxable profits from the foreign subsidiary to the parent. (Because the subsidiary is paying a lot of debt interest to the parent, thus lowering the taxable profits of the subsidiary and increasing the profits of the parent.)
Thinly capitalised structures are apt to be challenged by the local tax authorities whose tax base is being eroded in this way.
The 'thin' part of the term 'thin capitalisation' refers to the amount of the equity injected into the subsidiary by the parent.
The thin capitalisation tax rules may deem that the equity capital is too 'thin' compared with the related amount of debt which this equity is supporting.
The test for tax purposes of a minimum acceptable proportion of equity (usually expressed as a debt:equity ratio) is one which would be acceptable to an external lender such as an independent bank, lending directly to the subsidiary.
