Thin Capitalisation: An Issue That Should Not Be Looked At Thinly

01 October 2013
By Amanda Pletz, Dr. Emmanuel Llinares, and Robert Patton

In this article from BNA's Transfer Pricing International Journal, NERA Director Dr. Emmanuel Llinares, Associate Director Robert Patton, and Senior Consultant Amanda Pletz examine the complexities of thin capitalisation, an issue that is often overlooked when analysing intra-group relationships. A company is said to be thinly capitalised when it has a high level of debt relative to equity. In a transfer pricing context, thin capitalisation can become an issue if tax authorities believe that an affiliate's related-party debt appears to exceed what that entity would be able to borrow from the market on a stand-alone basis, which can then lead to "excessive" interest deductions. While in many countries, rules of thumb are still relied upon -- regardless of the business, strategic situation, industry, or economic environment -- to establish limits on what may be treated as debt for tax purposes, the authors argue that there are economically sound approaches that can be used to determine whether an observed debt-to-equity ratio is consistent with independent (or arm's length) ratios in the industry of the company being evaluated. This article sets out a framework that can be applied in those jurisdictions where thin-capitalisation legislation is sufficiently flexible as to accommodate a more analytical approach.