Imagine you want to buy a house. You have two primary options: funding the purchase entirely with your own cash or putting a small percentage down and borrowing the rest from a bank. Corporations, mostly larger and operating in multiple jurisdictions, face a nearly identical choice when funding their operations. Whether to fund the capacity expansion of the subsidiary through equity or debt?
While both methods provide the necessary cash to operate, they trigger vastly different tax consequences, creating a phenomenon known as Thin Capitalization.
A company is said to be thinly capitalized when its capital structure is composed of a very small amount of equity and a disproportionately large amount of debt. The term itself paints a visual picture of a balance sheet where a massive block of debt sits heavily upon a “wafer-thin” layer of equity. While this might look risky from a financial stability standpoint, it is often an intentional and aggressive tax strategy. The rationale behind this approach lies in the distinct tax treatment of the two funding methods. When a subsidiary makes a profit and pays dividends to its parent company, those dividends are distributed from after-tax money, meaning the tax liability must be settled first. However, when that same subsidiary pays interest on a loan, tax laws generally treat that interest as a deductible business expense. This deduction reduces the company’s taxable profit before the tax liability is even calculated.
This structural difference creates a powerful incentive for multinational corporations to load their subsidiaries in high-tax jurisdictions (such as Pakistan, the UK, the US, and India) with debt owed to parent companies in low-tax jurisdictions (such as the UAE). By paying exorbitant interest on these internal loans, the high-tax subsidiary can wipe out its taxable profits, effectively paying zero tax locally, while the money shifts to the parent company as interest income where it faces little to no taxation. This practice is a classic example of Base Erosion and Profit Shifting (BEPS), forcing international bodies to intervene.
The Organisation for Economic Co-operation and Development (OECD) recognized that simple debt-to-equity ratios were too easily manipulated and failed to reflect economic reality. Consequently, under BEPS Action 4, the OECD shifted the global standard away from examining the sheer amount of debt toward analysing the company’s ability to service that debt. The modern guideline recommends limiting net interest deductions to a fixed percentage of a company’s earnings, specifically Earnings Before Interest, Tax, Depreciation, and Amortization (EBITDA), with a suggested cap typically hovering between 10% and 30%. This ensures that interest deductions are proportional to actual economic activity rather than artificial loan structures.
In Pakistan, the tax authorities have historically relied on the traditional ratio-based approach to curb this practice. Section 106 of the Income Tax Ordinance, 2001, specifically targets foreign-controlled resident companies (those where a non-resident holds 50% or more of the shares). The law mandates a strict 3:1 debt-to-equity ratio. If the foreign debt exceeds three times the foreign equity, any interest paid on that excess portion is disallowed and cannot be claimed as a tax deduction. Also, section 106A disallows any interest with respect to foreign debt that exceeds 15% of the earnings before the said interest, depreciation, and amortization.
This mixture of static and flexible thresholds remains a potent tool for the Federal Board of Revenue to prevent profit shifting by foreign entities.
The United Arab Emirates has also adopted the more modern, OECD-aligned approach within its recently implemented Corporate Tax regime under Federal Decree-Law No. 47 of 2022. Rather than relying on a rigid debt-to-equity ratio, the UAE applies a General Interest Deduction Limitation Rule. For standard businesses, net interest expenditure is deductible only up to 30% of the company’s tax-adjusted EBITDA. Recognizing that this calculation might be burdensome for smaller entities, the UAE law includes a safe harbour provision, allowing businesses with net interest expenditure below AED 12 million to deduct 100% of it, regardless of their EBITDA. Furthermore, any interest disallowed under the 30% cap can be carried forward for ten years, offering a degree of flexibility that the Pakistani system does not.
The Thin Capitalization rules serve as a global declaration that while companies are free to finance their operations as they see fit, they cannot use internal debt as a mechanism to hide profits from the taxman.
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.
