Borrowing From Your Own Subsidiary to Shrink a Tax Bill
Interest paid is tax deductible, so a multinational can load debt into high tax subsidiaries and shift profit toward low tax lenders. Thin capitalisation rules exist to stop it.
The Deduction at the Centre
Almost every tax system treats interest paid on debt as a deductible expense while treating dividends paid on equity as a distribution of already taxed profit. This asymmetry means the way a business is funded changes its tax bill, even when the underlying operations are identical.
For a company funded from outside, this creates a general preference for debt that corporate finance has studied for decades. For a multinational group funding itself internally, it creates something more specific.
Interest paid to an unrelated bank leaves the group. Interest paid to a related company inside the group does not. Only the tax bill changes.
The Structure
Suppose a group has a subsidiary operating in a country with a 30 percent corporate tax rate and a financing entity in a jurisdiction taxing interest income at 5 percent.
The financing entity lends to the operating subsidiary. The subsidiary pays interest, deducting it against profit taxed at 30 percent. The financing entity receives that interest and pays 5 percent on it. Group cash has moved from one pocket to another, and the group tax bill has fallen by 25 percent of the interest amount.
| Entity | Effect | Tax rate |
|---|---|---|
| Operating subsidiary | Deducts interest expense | Saves at 30 percent |
| Financing entity | Receives interest income | Pays at 5 percent |
| Group | No net cash movement | Net saving of 25 points |
Being thinly capitalised means an entity is funded with a high proportion of debt relative to equity. The term describes the thin sliver of equity supporting a large stack of borrowing.
Why Tax Authorities Object
The objection is not that the arrangement is concealed. It is usually disclosed. The objection is that the debt has no commercial purpose independent of the tax outcome, and that a subsidiary borrowing far more than an unrelated lender would ever advance is not really engaged in a lending transaction at all.
The country hosting the operating business sees profit generated by activity within its borders being routed out as interest. The response has been a set of rules limiting how much interest a company can deduct.
How the Rules Work
Two approaches dominate, and many countries have moved from the first toward the second.
Debt to equity ratios are the older approach. Interest is deductible only on debt up to a fixed multiple of equity, commonly around three to one. Borrowing above that threshold still creates a real obligation, but the interest on the excess is not deductible.
Earnings based limits are the modern standard, promoted through international coordination on base erosion. Net interest deductions are capped at a percentage of earnings before interest, tax, depreciation and amortisation, typically around 30 percent. This links the deduction to the actual profitability of the operations rather than to a balance sheet ratio that can be engineered.
Most regimes include a small entity exemption so the rules do not burden ordinary businesses, and many allow disallowed interest to be carried forward for use in later years.
The Group Ratio Escape
A blunt earnings cap would penalise genuinely leveraged industries, where high external borrowing is normal and commercial. Many regimes therefore include a group ratio rule, permitting a subsidiary to deduct interest up to the ratio the whole group carries with genuine third party lenders.
The logic is sound. If the entire group is borrowing heavily from banks, a subsidiary carrying a proportionate share is doing something commercially normal rather than shifting profit. The test targets internal leverage that exceeds what the group carries externally.
Beyond Interest
Restricting interest deductions addresses one channel. Groups also shift profit through royalties for intellectual property, management fees, and transfer prices on goods and services. Interest simply attracted attention first because it is large, easy to document and simple to structure.
The broader response has been coordinated international work on base erosion and profit shifting, which addresses interest limitation alongside treaty abuse, transfer pricing documentation and hybrid arrangements. Interest limitation is one component of a wider architecture rather than a standalone fix.
The Bottom Line
Thin capitalisation rules exist because the deductibility of interest, combined with related party lending, lets a group relocate taxable profit without relocating any activity. Modern regimes cap net interest deductions at a share of earnings rather than at a balance sheet ratio, with a group ratio carve out so that genuinely leveraged businesses are not caught. For anyone analysing a multinational, the practical implication is that reported interest expense in a given jurisdiction may reflect tax structuring as much as it reflects the cost of financing the business there.