Thin Capitalisation

A group funds a subsidiary mostly with loans instead of share capital, the subsidiary pays interest, which may reduce taxable income, and a tax authority may scrutinise whether the financing and deductions fit its rules. The OECD's Action 4 recommends linking net interest deductions to economic activity through an EBITDA-based approach.

Australia labels its regime thin capitalisation and applies a fixed-ratio test of 30% of tax EBITDA to certain entities, with alternatives. Start with capital structure, since debt creates repayment and interest obligations while equity carries ownership risk, and the balance affects financial resilience as well as tax.

Calculate debt to equity as total debt divided by equity, which is a diagnostic, though negative or tiny equity can make the ratio unstable. Separate related-party loans, because owner or group loans may draw transfer-pricing review while third-party debt can also fall within modern limitation rules.

Check local scope, since small businesses, financial entities or particular industries may be treated differently and not every company is covered. Identify debt deductions, because interest, fees and economically similar financing costs may count and the statutory definition can exceed the coupon, and identify offsetting income, since many rules focus on net interest or net debt deductions and gross expense alone can overstate the restricted amount.

Calculate the right earnings base too, as tax EBITDA is a statutory measure, not necessarily the company's accounting EBITDA, so reconcile carefully. Check the fixed ratio, because some jurisdictions cap net deductions as a share of adjusted earnings and the percentage and definitions are local.

Check the group ratio, since an alternative may permit more deduction when the wider group is highly leveraged, though eligibility and computation can be complex. Check specific anti-avoidance rules as well, because artificial debt creation or non-arm's-length terms may face restrictions even if a general ratio passes.

Review debt purpose, since financing an acquisition, operations or capital investment can have different risk and documentation needs, and model losses, because a company with low earnings or losses can face a tight deduction cap despite genuine interest payments. Track carryforwards, as some regimes allow disallowed amounts or unused capacity to be used later under conditions, so a denial may be timing rather than permanent.

Consider withholding tax and transfer pricing, since interest paid across borders can trigger separate withholding obligations and related-party loan rate, amount and terms should be supportable, and a deduction ratio is not proof the loan itself is arm's length. Review covenants, because reducing debt for tax reasons can affect lender agreements and cash, and watch refinancing, since rate rises can push deductions above limits even if debt principal is unchanged, so forecast multiple scenarios.

Use consolidated data, as group ratio tests and guarantees may require information from parent entities, distinguish tax and solvency, because a company can pass a tax limitation but still have too much debt to survive a downturn, and avoid the old shorthand, since some older rules used debt-to-equity thresholds while newer rules emphasise earnings, so name the applicable law and year. For owners, thin capitalisation is a warning that financing choices affect both risk and deductible interest, the correct test comes from local law, not a global ratio, and a financing change should be modelled over several years with documented calculations such as debt schedules, interest income, tax earnings and elections, because the earnings base and interest rates can move independently.