This blog is written by Mr. Saif Uddin Khilji. Please read this blog and provide your valued comments

 

THIN CAPITALIZATION

 

A company is typically financed (or capitalized) through a mixture of debt and equity. “Thin capitalization” refers to the situation in which a company is financed through a relatively high level of debt compared to equity. A company is said to be thinly capitalized when the level of its debt is much greater than its equity capital, i.e. its gearing, or leverage, is very high. An entity’s debt-to-equity funding is sometimes expressed as a ratio.

 

TAX ISSUES

 

The way a company is capitalized will often have a significant impact on the amount of profit it reports for tax purposes. Country tax rules typically allow a deduction for interest paid or payable in arriving at the taxable profit. The higher the level of debt in a company, and thus the amount of interest it pays, the lower will be its taxable profit. For this reason, debt is often a more tax efficient method of financing than equity.

 

In order control high gearing, Country tax administrations often introduce rules that place a limit on the amount of interest that can be claimed or deducted in calculating a   company’s taxable profit for the year. Such rules are designed to counter cross-border shifting of profit through excessive debt, and thus aim to protect a country’s tax base.

 

PAKISTAN TAX LEGISLATION

 

The concept of thin capitalization has been brought in Pakistan tax legislation in order to control foreign companies from injecting high debt instead of equity in their subsidiaries formed in Pakistan. Section 106 of the Income Tax Ordinance, 2001 provides rules to control thin capitalization.

 

Thin capitalization rules apply to Foreign Controlled Resident Company (FCRC), in which 50% or more of the underlying ownership is held by a non-resident person (either alone or together with an associate). Where foreign debt to foreign equity ratio of a FCRC, at any time during a tax year, exceeds 3:1, profit on debt paid by the company in that year on the part of the debt exceeding 3:1 ratio will not be allowed as deduction, while computing income of the FCRC. This rule is also applicable to the Pakistan branch of a foreign company.

 

“Foreign debt” in relation to a foreign-controlled resident company, means the greatest amount, at any time in a tax year, of the sum of the following amounts, namely: —

 

  • The balance outstanding at that time on any debt obligation owed by the foreign-controlled resident company to a foreign controller;
  • The balance outstanding at that time on any debt obligation owed by the foreign-controlled resident company to non-resident associate of the foreign controller;
  • the balance outstanding to a person other than the foreign controller or an associate of the foreign controller where that person has a similar amount of debt obligation to the foreign controller or a non-resident associate of the foreign controller;

 

Provided that the debt is not an interest free loan, profit on debt is deductible to the foreign-controlled resident company and is not taxed under this Ordinance or is taxable at a rate lower than the corporate rate of tax applicable on assessment to the foreign controller or associate

 

“Foreign equity” in relation to a foreign-controlled resident company and for a tax year, means the sum of the following amounts, namely: —

 

(a) The paid-up value of all shares in the company owned by the foreign controller or a non-resident associate of the foreign controller at the beginning of the tax year;

 

(b) Share premium account of the company at the beginning of the tax year as the foreign controller or a non-resident associate would be entitled to if the company were wound up at that time; and

 

(c) Accumulated profits and asset revaluation reserves of the company at the beginning of the tax year as the foreign controller or a non-resident associate of the foreign controller would be entitled to if the company were wound up at that time;

 

However, in order to arrive at the figure of foreign equity, the sum of aforesaid amounts shall be reduced by the sum of the following amounts, namely: —

 

(i) Loan payable by the foreign controller or a non-resident associate of the foreign controller at the beginning of the tax year to the foreign-controlled resident company; and

 

(ii) Accumulated losses at the beginning of the tax year, the amount by which the return of capital to the foreign controller or non-resident associate of the foreign controller would be reduced by virtue of the losses if the company were wound up at that time.

 

 

Saif Uddin Khilji

September 1, 2020

 SuK BLOG 01092020