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Newsletter | Articles Thin Capitalisation A company is thinly capitalised when its capital is made up of a much greater proportion of debt than equity (its gearing is too high). This can create problems for consumers and creditors as they bear the solvency risk of the company, which has to repay the bulk of its capital with interest. It may also be of interest to revenue authorities, who are concerned about abuse by excessive interest deductions. Thin Capitalisation rules can apply in situations where: A security is issued, which would not have been issued without a special relationship between the parties (tax deductions for interest on loans from group companies are stopped where the borrower would not have been able to sustain the debt on its own) A loan is made because of a guarantee given to the lender by a party related to the borrower Deductions in other situations will not be denied, for example, for rental paid on a lease by a thinly capitalised company where the lease is supported by a parent company guarantee. However, not all guarantees will give rise to adjustments, for example, upward guarantees from subsidiaries would not be caught. Credit Risk If all or most of the company’s capital comes from debt the providers of capital are ultimately competing with the company’s trade creditors for the same capital resources. If shareholders only introduce a nominal amount of paid-up share capital, then the company has lower financial reserves with which to meet its obligations. Many common law jurisdictions do not employ thin capitalisation rules in relation to raising and maintenance of capital, but some civil law jurisdictions do. In almost all jurisdictions there are certain types of regulated entity which require a certain amount of pre-paid share capital to be licensed to trade, for example banks and insurance companies, because if such companies were to fail and go into liquidation the economic effect of such failures can lead to a domino effect and catastrophic consequences for businesses and economies. Tax Issues If a country’s corporate laws permit countries to be thinly capitalised revenue authorities will often limit the amount a company can claim as a tax deduction on interest. However, some countries will not allow interest deductions above a certain level from all sources when a company is considered too highly geared under applicable tax regulations.