Thin Capitalization Rules
How can I reduce taxes by using excessive loan scheme?
How do you choose between debt and equity in the capital structure of your overseas subsidiary? Each has both benefits and drawbacks. Taxwise, you may prefer debt because interest on debt is tax deductible while dividends on equity are not, especially in case that tax rate in the jurisdiction of subsidiary is much higher than parent company’s, where a subsidiary will reduce greater amount of tax than the increase of tax at a parent company. Here is a case that an Asia headquarter located in Singapore render borrowings to its Japan subsidiary.
While in Japan a subsidiary can reduce by 30% of interest at its tax filing, in Singapore a parent company increase its income tax by only 17% of interest. (According to Singapore tax laws, overseas interest income received in Singapore is not exempted from taxation) As a whole group, 13% (30%-17%) of interest will be gained as tax benefits.
Actually, interest income of the parent company is subject to withholding tax with 20% rate in Japan as interest is deemed domestic sourced income. However, many of tax treaties give concession rate. For example, Japan-Singapore tax treaty let you 10% tax rate applicable on interest instead of domestic tax rate of 20%. Tax authority does not think withholding tax is enough to prevent excessive tax avoiding behavio.
Thin Capitalization Rules:
The thin Capitalization Rules disallow a deduction of the excess interest expense paid or payable to the foreign parent company, if the debt-to-equity ratio exceeds 3:1. The annual average balance of interest-bearing debt to a foreign controlling shareholder exceeds three times the capital contributed by the foreign controlling shareholder, the excess interest expense is not deductible. Borrowings from third parties will be included if the loans are guaranteed by the foreign controlling shareholder.
Who are foreign controlling shareholders?
A foreign controlling shareholder is defined as a foreign corporation or nonresident individual that (1) directly or indirectly owns 50% or more shareholding in the company, or (2) is a foreign corporation in which 50% or more shareholding is owned by the same shareholder which directly or indirectly owns 50% or more shareholding in the company, or (3) has the power to control the company.
You may wish to raise interest rate while keeping the balance within less than 3 times the capital. However, you should be aware of transfer pricing rules. Transfer pricing rules allow tax authorities to adjust prices for cross-border intragroup transactions to what would have been charged by unrelated enterprises.
Earnings Stripping Rules