Thin Capitalisation refers to a financial condition where a company operates primarily on borrowed funds, or debt, rather than equity capital provided by shareholders. This financing structure can offer tax advantages as interest payments on debt are tax deductible, whereas dividend payments on equity are not. However, it might also introduce financial risks or tax-related scrutiny depending on jurisdictional regulations.
Many tax authorities have specific rules to address thin capitalisation, often limiting the amount of interest expense a company can deduct for tax purposes based on its debt-to-equity ratio or related-party debt levels. For instance, a multinational company might use thin capitalisation to shift profits to lower-tax jurisdictions by increasing interest payments to entities in those regions.
As an example, consider a corporation with $5 million in debt and only $500,000 in equity capital. Tax authorities may scrutinize such a setup to ensure the debt isn't excessively skewed to evade local taxes. Companies must carefully balance their capital structure to remain compliant while optimizing their tax and financial planning strategies.