The Debt Diet: Why Companies Starve Equity to Feed on Tax Breaks
Debt vs. Equity: Why Corporations Prefer Borrowing
Imagine you want to move into a house. There are really two options: either pay for the thing outright with your own money, or put a small down payment on it and borrow the rest of the purchase price from a bank. Companies, especially big international groups managing companies in different countries need to make the same call for their subsidiaries too: whether to fund them with equity or debt.
While each of these two methods of obtaining the capital to operate and grow necessarily come with its own tax consequences, the differences are significant. If the subsidiary is financed by equity, any dividends paid are out of after-tax income.
What Does Thin Capitalization Mean in Corporate Tax?
A firm can be classified as thinly capitalized when its equity is minimal and its debt is comparatively higher. From a balance sheet perspective, one can note a large block of liabilities and a “wafer thin” block of equity. Despite the obvious risk of such a structure, thin capitalization is an accepted tax planning strategy.
The motivation for thin capitalization comes from how companies are taxed differently when they fund themselves through debt or equity. If a subsidiary makes a profit and pays dividends to its parent company, those dividends are paid from an after-tax income, meaning a corporate tax has to be paid first. However, in most tax systems, when a subsidiary pays interest on debt, that interest payment is treated as a deductible business expense. Since interest payments lower the profit that is taxable, companies end up paying less tax when they choose debt rather than equity. This tax reason is the most important reason thin capitalization is used by multi-national companies.
How Multinational Companies Use Thin Capitalization to Shift Profits
This structural tax difference incentivizes multinational corporations to load subsidiaries in high-tax jurisdictions such as Pakistan, the UK, the US, and India with related-party debt owed to parent companies in low-tax jurisdictions like the UAE. By charging excessive interest on these internal loans, the high-tax subsidiary can eliminate its taxable profits and pay little or no local tax.
The profits are instead transferred to the parent company as interest income, where they are taxed at a much lower rate or not taxed at all. This practice is a well-known form of Base Erosion and Profit Shifting (BEPS) and is a key reason international tax authorities and organizations have introduced anti-avoidance rules.
OECD BEPS Action 4: Limiting Interest Deductions to Prevent Profit Shifting
The Organisation for Economic Co-operation and Development (OECD) recognized that relying solely on debt-to-equity ratios was easily manipulated and did not reflect a company’s true financial position. Under BEPS Action 4, the OECD updated the global standard, focusing on a company’s ability to service its debt rather than just the amount of debt.
The modern guideline limits net interest deductions to a fixed percentage of a company’s earnings, specifically Earnings Before Interest, Tax, Depreciation, and Amortization (EBITDA). The recommended cap usually ranges between 10% and 30%, ensuring that interest deductions are aligned with actual economic activity rather than artificial internal loans.
Thin Capitalization Rules in Pakistan: Debt-to-Equity Limits and Interest Restrictions
In Pakistan, tax authorities have traditionally used a ratio-based approach to prevent profit shifting through excessive debt. Section 106 of the Income Tax Ordinance, 2001 specifically applies to foreign-controlled resident companies those where a non-resident owns 50% or more of shares.
The law enforces a strict 3:1 debt-to-equity ratio. If a company’s foreign debt exceeds three times its foreign equity, interest on the excess debt is disallowed and cannot be claimed as a tax deduction. Additionally, Section 106A limits interest deductions to 15% of EBITDA (Earnings Before Interest, Tax, Depreciation, and Amortization) for foreign debt.
This combination of static ratio limits and earnings-based thresholds provides the Federal Board of Revenue (FBR) with a powerful tool to curb profit shifting by foreign entities while ensuring compliance with international tax standards.
Thin Capitalization and Interest Deduction Rules in the UAE
The United Arab Emirates (UAE) has adopted a modern, OECD-aligned approach under its Corporate Tax regime (Federal Decree-Law No. 47 of 2022). Unlike traditional ratio-based systems, the UAE uses a General Interest Deduction Limitation Rule. Under this rule, net interest expenses are deductible up to 30% of the company’s tax-adjusted EBITDA for standard businesses. To reduce the compliance burden on smaller entities, the law provides a safe harbour: businesses with net interest expenditure below AED 12 million can deduct 100% of interest, regardless of EBITDA. Additionally, any interest disallowed under the 30% cap can be carried forward for up to ten years, offering greater flexibility compared to the Pakistani system.
These thin capitalization rules send a clear global message: while companies are free to choose their financing structure, they cannot use internal debt to artificially reduce taxable profits or evade taxation.
This article is for informational purposes only and does not constitute professional tax, legal, or financial advice. Tax laws in Pakistan, the UAE, and international jurisdictions are subject to change and interpretation. Readers should consult with a qualified tax advisor or legal professional regarding their specific business circumstances before making any financial decisions.
