Thin capitalisation

What it means

Thin capitalisation is a situation where a company is funded mainly by debt from related parties instead of equity. The thin capitalisation rule in the income tax act limits how much interest on such loans a company may deduct as a tax-deductible expense.

The reason is simple: interest is deductible, distributed profit is not. A parent company could lend to its subsidiary instead of providing capital and extract profit as interest, shifting the tax base to a lower-tax country. The rule prevents such shifting.

In Slovakia, interest and related costs on loans and credit from related parties are deductible only up to a statutory share of tax EBITDA, meaning profit before tax adjusted for depreciation and interest expense. The current limit is 25 per cent.

How it works in practice

For every shareholder loan or loan from a sister company we calculate tax EBITDA and compare it with the interest. The excess is added back to the tax base in the tax return as one of the add-back items.

The rule applies alongside transfer pricing. First the interest rate must be at arm’s length, which we support by comparing bank offers, and only then is the EBITDA limit tested. We document both in the transfer pricing documentation.

In groups with cash pooling we track when the company draws from the pool and when it deposits, because interest on drawings can fall under the limit. When a group plans a major investment, we compare debt funding with an increase in equity from the angle of this rule as well.

What to watch out for

A loss-making company or one with low EBITDA can have a limit of almost zero, so it cannot deduct interest paid to its shareholder at all. For start-up projects funded by an owner’s loan we therefore often recommend a capital contribution outside share capital instead.

The rule does not cover loans from independent banks, but if a bank loan is secured by a guarantee or deposit from a related party, the tax office may examine whether it is really hidden group funding. We therefore assess the security structure together with the loan.