TAX MATTERS: Interest on excessive debt capital…the Thin Capitalisation Rule

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EXPENDITURE is deductible for income tax purposes when it is incurred for purposes of trade or in the production of taxpayer income exclusive of expenditure of a capital nature and prepaid expenses.
With regard to the deductibility of borrowing costs, this is further guided by what the funds have been used for. Generally, borrowing costs on debt incurred on operating expenditure or related to working capital is tax deductible except when incurred in the production of exempt income, on acquisition of shares, preparatory to a take-over of the “target” company, borrowed to pay dividend or used to acquire or construct fixed assets. In related party arrangements, the deductibility of borrowing costs is further put to test by ventilating thin capitalisation and transfer pricing rules. This article focuses on thin capitalisation rules.

Companies usually finance their operations either by debt or equity. Where a company is financed primarily by debt, it is deemed to be thinly capitalised. Thin capitalisation can therefore be described as the use of high proportions of loan to equity capital in order to gain tax advantages. The Income Tax Act discourages thin capitalisation by limiting interest deductible for income tax purposes.