The 'thin' part of the term 'thin capitalisation' refers to the amount of the equity injected into the subsidiary by the parent relative to the amount of debt. Thinly capitalised structures are apt to be challenged by the local tax authorities whose tax base is being eroded in this way.
Thinly capitalised businesses would thereby enable transfer of taxable profits from the subsidiary to the parent by interest payments.
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 and set a limit on the debt:equity ratio beyond which interest is considered a capital distribution not available for deduction against taxable profits.
The test for tax purposes of a minimum acceptable proportion of equity is usually one which would be acceptable to an external lender such as an independent bank, lending directly to the subsidiary. Similarly the rate of interest is often tested by reference to real borrowing rates of other similar businesses.